Tempo de leitura: 46 minutos
The Political Economy of Special Economic Zones
Lotta Moberg
Abstract
This paper is a first attempt to apply a robust political economy framework to explain when Special Economic Zones (SEZs) can contribute to economic development. In a robust political economy, institutions channel the actions of self-interested individuals to promote economic progress. SEZs can promote economic growth, but tend in the wrong institutional context to foster misallocated investments and skewed incentives. Policy makers that introduce SEZ must overcome the knowledge problem to avoid misdirected economic planning. Yet, the scheme can only fulfill its purpose if they also overcome the incentive problem. That means avoiding destructive rent-seeking behavior, both from businesses and from government authorities. The political economy framework of SEZs can be applied to judge their potential efficacy, something that orthodox studies of country features such as natural resources, education level or zone location fail to do. The Indian and Chinese experiences with SEZ illustrate these points.
Keywords: Special Economic Zones, Political Economy, Economic Development, Economic Calculation, rent-seeking.
JEL codes: B52, B53, H25, O24, O43, P26.
Lotta Moberg
George Mason University
Department of Economics
Fairfax, VA; United States
Lmoberg2@gmu.edu
703-732 2172
1 Introduction
Special economic zones (SEZs) are superior to many growth policies. Several countries successfully used SEZs to encourage economic development in a dynamic and market compliant way. SEZ programs have on the other hand been utterly unsuccessful in many countries. This paper is an attempt to understand why some zone schemes succeed and others fail in promoting economic growth.
SEZs can encourage investments, often by offering a more liberalized business climate, with lower taxes and tariffs, and less stringent regulations. A business community that flourishes in a zone can have great positive externalities with the potential to pull the rest of the country on a path of faster economic development. SEZs can spur technological know-how, alleviate unemployment and even contribute to countrywide policy reforms. China‟s economic liberalization, with massive poverty alleviation as a result, is attributed in part to the implementation of the SEZ concept.
It is a conundrum that some SEZs, despite their potential, have not seemed to make much difference, and in some countries even become drags on the economy. For instance, the Philippine authorities invested in lots of infrastructure for their zone in Bataan. The port was upgraded, a new damn was constructed for energy supply and new fancy office buildings were erected. Yet for long, the zone failed to attract much business, rendering the project a big and very expensive failure for the government (Warr, 1987; FAB 2013).
Explanation of SEZ success or failure often concern the quality of the infrastructure, location and the zones‟ areal size (Farole, Akinci, 2011: 221; Pradeep, Pradeep, 2008). Bad roads and unreliable power supplies deter foreign investors. Inappropriately designed facilities in zones cause congestion or social problems. Other problems include inadequate maintenance, zone promotion, policy coordination and tax incentives, as well as excessive performance requirements (FIAS, 2008: 5, 50). The alleged problems with the export processing zone in Dakar, the capital of Senegal, were an excessive bureaucracy, high electricity costs and a lack of a sufficiently cheap labor force. In addition, the location was poorly selected, far away from the port of Dakar and isolated from major trading routes (Cling, Letilly, 2001: 22).
Successful zones on the other hand, are well connected to the domestic market, with zone investors drawing production factors from domestic sources (Farole, Akinci, 2011: 217). Locations near urban areas, national borders and skilled labor as well as good timing are other cited recipes for success (Yuan, Eden, 1992). Sometimes, SEZ success is simply attributed to policy makers targeting “the right industry”. For instance, while zones geared towards hightechnology businesses have been successful in some countries, this was not the case in Bangladesh. Only when the authorities allowed garment producers to invest in its zones did they attract significant investment (Farole, Akinci, 2011: 41). It seems there are as many explanations of a zone‟s success or failure as there are zones. Different SEZ models are simply relevant in different contexts (Farole, 2011a: 2).
The source of the confusion in explaining SEZ success lies in how success is defined. Studies measuring SEZ success look at employment, FDI, export and production growth in the zones as indicators. They compare such aggregate statistics to previous trends and to the rest of the country (e.g. FIAS, 2008: 35). A cost-benefit analysis may compare the gains against the cost of establishing SEZs (Warr, 1989: 66). Jayanthakumaran (2003: 63) argues that a cost-benefit analysis shows that the zone programs in South Korea, Malaysia, Sri Lanka, China and
Indonesia are “economically efficient and generate returns well above the estimated opportunity cost”.
These methods however fail to account for the dynamic effects of SEZs. They obscure the spread of knowledge from foreign corporations to domestic business as well as the zones‟ propensity to lead to countrywide economic reform. Since many SEZs tend to change, adjust and expand, they are better described as processes than fixed policy packages. SEZs must be considered successful when they have a positive effect on the economy in the long-run.
The conventional explanations for SEZs fail to address the underlying causes of success, and are rather depictions of the result of successful or failed SEZ schemes. If the “right” industries should invest in SEZs, the question remains who is to determine what those industries are. While good infrastructure helps attract businesses, we need to ask what allows for the discovery of the right location for those roads, bridges and buildings. Successful SEZs require that decision makers can find the proper policies for the zones and have the incentive to implement them more widely. They must in other words both overcome a problem of knowledge and one of incentives.
A robust political economy framework is a tool for analyzing when the right policies can come about. In an ideal world, policy makers are both omniscient and benevolent social wealth maximizers. They declare the optimal economic policies and have no problems pursuing them. In this world, SEZs cannot fail, or can only do so under highly unlikely and unfortunate circumstances. A political economy analysis relaxes assumptions about perfect knowledge and benevolence (Boettke, Leeson, 2004: 101; Pennington, 2011: 3).
When both market actors and public officials are imperfect in their knowledge and motivations, economic coordination relies on the right institutional context (Pennington, 2011: 2). A robust political economy is one that yields beneficial outcomes despite the flaws of policy makers and people in business. Its institutions channel the actions of self-interested and badly informed people into activities that increase social welfare. In a market, a robust political economy drives people to enrich themselves by serving one another (Hayek, 1960: 76). In politics likewise, the right institutions drive self-interested policy makers to institute policies that increase welfare.
A robust political economy analysis helps us understand when a seemingly successful SEZ may in fact be a drain on the economy. SEZs look successful when they attract businesses, but they may simply be located in an area naturally disposed for high growth or in a developmentally progressive country. That does not mean that the SEZs are a net positive to the economy. Governments can also create seemingly successful SEZs by transferring resources from other areas to the designated zone. More wealth being located in the zones does not make it a good growth strategy. Also, countries that have SEZs often grow for reasons unrelated to their zones. SEZ “success” is thus not synonymous with economic growth countrywide or even in the zone itself. The relevant metric is whether an SEZ makes a positive long-term contribution to a county‟s economy. For this to happen, decision makers must be able to discover the right policies and zone locations, and have the incentive to institute them.
All policies introduced under non-robustness are not economically damaging. Sometimes policy-makers are lucky and get it right. Some policy makers do have benevolent motives with introducing SEZs. Yet, under non-robust institutions, imperfect knowledge and policy makers‟ self-interest bias policies towards other ends than economic prosperity. Finally, a robust political economy analysis of SEZs does not reveal whether the SEZ scheme is the best development strategy amongst all other options. What is can tell us is whether the policy should yield benefits, given that a country chooses the SEZ path. That may seem a modest claim, but institutional robustness is a crucial safeguard against policy makers with imperfect knowledge and self-interested motives inflicting harm to the economy with their policies.
After an overview of the SEZ concept in Section 2, Section 3 explores the robust political economy framework for SEZs. Section 4 further illustrates the political economy implications by studying the Chinese and Indian experience with SEZs, and Section 5 concludes.
2 The SEZ concept
The concept of areas with special privileges has been around at least since the 16th century but the first modern SEZ was founded in Ireland in 1959 (Guangwen, 2003). By 1975, there were a total of 79 SEZs in 25 countries (ILO, 2007). In the 1980s, after China‟s economic reforms, SEZs gained popularity and they have since 1990 been adopted worldwide. By 1995, there were around 500 SEZs in the world, a number that only a decade later was estimated to between 3,000 and 5,000 zones. The majority of SEZs are located in developing countries (Carter, Harding, 2011: 8). Some noteworthy SEZs making the news lately are projects in Kenya, Belarus, Myanmar, Laos and China.[1]
SEZ businesses usually enjoy benefits such as lower tariffs and taxes. Many zones also offer lower environmental requirements, looser labor regulations and other policies that lower the cost of doing business. Some SEZ authorities even have the autonomy to determine their own tax and regulatory policies or have their own judicial system. In other countries in contrast, national governments set the rules and may impose requirements on SEZ firms regarding their type of production, degree of foreign ownership and how many domestic workers they must employ. With enough such requirements, many SEZs resemble state planned industrial clusters, rather than liberalized free zones. SEZs can therefore both be spaces under more and less government control than the rest of the country.
SEZs take on different names depending on such things as the businesses they focus on or the markets firms can access. Free trade zones may offer facilities for storage, transshipment and redistribution while export processing zones (EPZs) are mainly for manufacturing and exporting industries. Zone status can be granted single enterprises to constitute so called
“single factory zones”. Free ports are generally large and diversified (FIAS, 2008: 3, 10; Costachie, 2008; Farole, Akinci, 2011: 2). While this way of differentiating between zones may be useful when studying certain industries or trade policies, conventional labels offer little guidance for an analysis of the political economy of SEZs and their institutional context. Therefore, “Special economic zones” (SEZs) will henceforth be used as a general term.
SEZs can spur economic growth through different mechanisms. Better conditions for businesses attract more foreign direct investment (FDI) by multinational corporations. Domestic businesses relocate to zones with more liberal policies than the rest of the country. Firms that form clusters in zones can benefit from network effects and economies of scale (Porter, 1998; Porter, 2000; Harrison, 1992: 27). Many zones both create employment opportunities directly, and indirectly by increasing the demand for domestic production factors. In addition, new international enterprises investing there may spread technological expertise outside zone boundaries (FIAS, 2008: 32).
It might seem strange that governments do not implement beneficial policies nationwide rather than confining them to certain areas. Three explanations for this are worth considering. One is that zones form clusters that would not come about otherwise, due to the inability of businesses to coordinate their locations as effectively (Farole, Akinci, 2011: 147-8).[2] Second, governments do not know the effects of certain policies, and SEZs provide test grounds to try them out (Sit, 1985: 84). Third, nationwide reforms are infeasible due to resistance from the political elite or from the public. SEZs may then be a politically realistic second-best policy option. The robust political economy analysis in this paper will test the validity of these arguments.
3 Robust political economy
The problems of inadequate knowledge and adverse incentives are at the very heart of a robust political economy framework. I address these problems in turn to examine how SEZs can be introduced in an institutionally robust context.
The knowledge problem
Picture for a moment a group of policy makers scratching their heads over the task of finding the best model for a new SEZ. Assuming that they are all benevolent social welfare maximizers allows us to focus on their problems with inadequate information (Ikeda, 2005: 35). The knowledge problem means that government bureaucracies are unable to promote technological progress by planning economic production and resource allocation (Lavoie,
1985: 52-54). Because they cannot amass all the needed information, they are unable to calculate the most efficient structure of production or plan the organization of cooperative creation. Not only is the knowledge that they would need dispersed throughout the society. It is also of the kind that cannot be communicated to others in a useful way (Hayek, 1945). A functioning market depends on intuitions that entrepreneurs and investors can accrue only through years of practice.
The SEZ planners may realize the contradiction in their task of finding the optimal zone location. Any site is unlikely to be profitable for investment if market entrepreneurs have not found it as a good location for investment already. Lower taxes will surely bring some firms to the zone, but this may just result in a wasteful relocation of current economic activity within the country. This dilemma is much alike that of other forms of industrial policy. To benefit the economy, government officials need to have insights that private actors lack about how best to allocate resources and where to pursue investments. Since this is seldom the case, governments that intervene in the economy with public resources see unintended and possibly damaging consequences but little growth (Ikeda, 2005; Kirzner, 1985: 123; Mises, 1977: 25) .
The argument against this skepticism to government interventions is that government interventions can support the formations of industrial clusters. As a government policy however, cluster formation is prone to the same failure as other government interventions (Desrochers, Sautet, 2004). The knowledge necessary to coordinate clusters that add value is not in the hands of policy makers but of market actors. As a result, governments tend for example to promote more high tech clusters than is compatible to their countries‟ comparative advantage (Davies, Ellis, 2000). Clusters do not cause economic growth but rather form as a result of a sector‟s progress (Martin, 2001; Seshadri, Storr, 2010: 362). No one can really predict where the industrial centers of the future will locate or what they will produce, since clusters tend to form spontaneously from private market coordination (Miller, Cote, 1989). The claim that governments facilitate cluster coordination by investing in SEZs is therefore not convincing.
Although governments are not in the position to choose proper SEZ locations and industries, SEZ schemes do not have to succumb to this knowledge problem. There are ways that they can delegate these crucial decisions to people of adequate knowledge.
Private decision making
The knowledge problem emerges when decision making is trusted to policy makers with inadequate understanding of market conditions. They can however avoid the problem by shifting this role to market actors. SEZ planners who want to target specific industries can overcome the knowledge problem by not specifying the location of zone investors. Several countries, including Mauritius, Fiji, Togo, Senegal, Cameroon, Nigeria Kenya and Honduras, even allow “zone status” to single firms or factories, with all the privileges that entails (Costachie, 2008: 145; Carter, Harding, 2011: 3; Farole, 2011b: 42; Engman, 2011: 49). Since the single-firm zone deviates from the traditional notion of a zone, it is less commonly described as an SEZ. The strength of such schemes is however, that private investors in a particular industry are allowed to find proper locations for their production. Governments can therefore solve the knowledge problem by not limiting businesses to particular areas.
Government officials can also choose zone location but let the private sector determine which industries to locate there. This division of decision making can also avoid the knowledge problem. Governments do not need to pick market winners and losers to create economic zones for growth (Auty 2011: 213). However, as long as the government is financing zone development, this does not insure against wasting public funds. Resources are easily misallocated when SEZ planners spend lavishly on infrastructure, such as roads, energy supply and telephone lines. The SEZ planners may want to avoid the embarrassment that the area is left idle if it turns out not to be an attractive location for businesses. Yet, while the SEZ appears successful if it attracts business, the benefits they bring may not outweigh the costs.
The SEZ planners should therefore exploit the knowledge of private investors further, and demand that the private sector pays for the infrastructure. This is the model of many “private” SEZs, which in general have shown better result than those relying on government investments (FIAS, 2008: 4). When market entrepreneurs make the full investment decision, their self-interest drives them to limit their ventures to wealth increasing projects. SEZs are therefore more likely to succeed as voluntary entrepreneurial projects than as political schemes (Pennington, 2011: 205).
There is a chance of course that private investors will not take on this development task. Many places will need to provide more than the lower tariffs and taxes that SEZs may offer, such as natural resources, stable environment and good institutions (Morriss, Moberg, 2012: 12, 57). This fact may make the private zone model less politically attractive for government officials, but it is economically prudent. If investing firms miscalculate, the loss accrues to them and not on the country‟s taxpayers. If the SEZ is misplaced and unattractive, it will be miserably empty but with no losses incurred on the hosting country. Even smaller private zones are therefore superior to those that are slightly more developed and vastly more expensive. The small SEZs in Sri Lanka have been described as a failed project (Prihodko et al., 2007: 149; Madani, 1999: 106). On the other hand, they received little public investment in the form of warehousing, transport infrastructure and standard factories (Aggarwal, 2005: 37). In a simple cost-benefit sense, the Sri Lankan zones may therefore have generated returns above their opportunity costs despite their flaws (Jayanthakumaran, 2003: 63).
Private SEZs are becoming more popular (FIAS, 2008: 7). The Philippines saw their first private SEZs in 1991. Since then, the number of private zones in the country grew rapidly, to 76 zones in 2008 compared to only seven public ones (Id: 64). Many of the successful SEZs in Central America and the Caribbean‟s in the 1980s and in Southeast Asia in the 1990s enjoyed little government planning and support (Id: 26). In the Dominican Republic, most private zones have clustering around the capital, with good access to high skilled labor and good infrastructure. The government-developed zones meanwhile are located outside the capital in an effort to encourage regional development (Id.: 46). When the Honduran government granted SEZ access to more foreign investors, private zone investments increased to overtake the publicly operated zones. In 2011, only one public zone remained, hosting a mere 11 companies (Engman, 2011: 59).
Decentralized political decision making
Political realism tells us that empty or undeveloped zones do not look good in photographs. The SEZ planner may therefore be reluctant to rely on the private sector for zone development. Fortunately, there may be another way to avoid the knowledge problem, namely through sufficient decentralization of government decision making. Local governments, which are often well oriented in local conditions, may have a sufficiently good understanding about a zone‟s potentials. Local bureaucrats can also observe how conditions change on the ground and more rapidly decide on policy changes. They can thus mimic the reactions of private investors to market dynamics.
Local zone regulators can also be more entrepreneurial and radical when designing and implementing policies (Farole, Kweka 2011: 5). For instance, the decentralized system of the
United Arab Emirates allowed the ruler of Dubai to determine that their financial center would have British common law, rather than the Shari‟ah law that prevails in the rest of the country. This allowed it to attract multiple businesses that would have been reluctant to work within the restrictions of Islamic finance (Strong, Himber, 2010).
Decentralization also lets zone authorities test very different models. They can observe and copy policies that work elsewhere and thus learn from other SEZs. They are less likely therefore to severely miscalculate the effects of different policies. One mistake by a zone regulator furthermore, affects one SEZ in the country rather than all of them, like in the case with national SEZ policies. Local policy makers can act like market entrepreneurs and introduce policies in a trial-and-error fashion, making SEZs into test-beds for policymaking. As I discuss later, this dynamic was a driving force behind China‟s gradual reform. Malaysia, Jamaica, Kuwait, and Jordan have also used their SEZs as test-beds to demonstrate the impact of different policies (FIAS, 2008: 50).
The dynamic that decentralization fosters encourages the introduction of more SEZs, which can ultimately lead to national policy reforms. Cling and Letilly (2001) observe several cases in Asia where the success of one zone encouraged the introduction of another. Several Asian countries ultimately abandoned the model of low-tariff SEZs when they opened up to trade.
As SEZ policies spread nation-wide, zones become decreasingly “special”. In Central America, Honduras expanded its SEZ program several times since its launch in the 1970s, until the government in 1998 declared the whole country a “free zone area” (Farole, Akinci, 2011: 49).
The diminishing importance of SEZs is often an indication that they are reshaping national policy. Due to national reforms, South Korea‟s manufacturing zones became increasingly irrelevant, contributing only 2.9% to exports of manufacturing goods by 1985 (Burman, 2006: 11). Similarly, in Taiwan new investments in the zones had virtually dried up by 1980, as infrastructure and duty-free arrangements improved throughout the country (Id.: 10).
Two of the arguments presented in Section 2 for why governments introduce SEZs rather than take on nationwide economic reforms have merit. It is possible that policy makers do not know the effects economic reforms, and therefore use SEZs to try them out. Testing policies on a smaller scale can also be a way to overcome political resistance, whether by the people or the political elite. SEZ policies can become showcases for reforms and convince people in power of their benefits.
The incentive problem
Solving the knowledge problem is not sufficient for a well functioning SEZ program. Like other policies that offer special privileges, SEZs create opportunities for rent-seeking and hence the incentives for policy makers to use them for personal gains. Policy makers therefore need the incentives to promote economic growth, if they are to enact beneficial reforms (Reder, 1982: 25).
To explore the incentive problem, we relax the assumption that the SEZ planners are benevolent. Government officials pursue higher salaries, benefits and social status. Democratically elected politicians want public support and votes in the next election, while bureaucrats seek prestigious titles, larger offices, bigger staff, more leisure and the occasional trips to a pleasant resort on behalf of their agency. Self-interest is not a problem in the right institutional context, but the wrong institutions will lead officials to pursue their personal goals by means of rent-seeking and corruption. Besides an opportunistic profiteering from rent-seeking businesses, policy makers may introduce policies like SEZs to create rentseeking opportunities (Wallis, 2006: 25).
To profit from SEZs, their regulators can for instance allow procurement contracts to those offering the highest bribes, or demand bribes from the companies investing in the zone. Government policy makers may extract bribes and favors from local officials who are eager to see their town being designated a special zone. They can also use SEZs to alleviate pressure for economic reform that would threaten their rent-seeking revenues elsewhere. SEZs can therefore serve to isolate economic liberalization and openness away from officials‟ rentseeking turfs.
Even if the highest-ranking people in government refrain from using SEZ schemes in this way, the policy may still be hostage to rent-seeking if the incentives of the executing bureaucracy are not right. Bureaucrats can increase costs by claiming higher expenses than necessary for the project (Niskanen, 1971) or waste public funds by shirking on the job (Tullock, 1965). Bureaucrats can demand bribes from the SEZ businesses or give zone infrastructure contracts to people who are willing to pay them for the privilege. Infrastructure obtained this way will likely be of poor quality. It may end up costing more to maintain than the economic benefits it brings, or even remain idle (Farole, Akinci, 2011: 4). SEZs thus attract corruption much like other massive governmental infrastructure investment schemes that demand large amounts of resources (Beaulier, Subrick, 2006).
The more layers of corrupt agencies that a firm must pass to obtain various permits, the higher is the risk that it will pay more in bribes than it makes in profits (Shleifer, Vishny, 1993). If each bureau extracts as much as it can from a business, SEZs can become common pools of graft for bureaucrats, making the system unpredictable and opaque for investors (Easterly, 2002: 247). Such disbursed and anarchic corruption can kill economic growth (Frye, Shleifer, 1997).
If the SEZs are designed to serve as vehicles for corruption, they will be inherently difficult to reform into successful SEZs. The experience with SEZs in Russia in the 1990s exemplifies what happens when zones are at the center of corruption and criminal activity. The legal environment in their SEZs ended up even more insecure for investments than the rest of the country. A reform in 2005 aiming to discourage corruption saw the Russian government introducing SEZs with more federal regulation and less tax benefits. While the corruption seems to have diminished, little productive economic activity has blossomed in its place. The reforms did also not change the public perception of the zones in Russia as centers of corruption (Tuominen, Lamminen, 2008: 11-12).
Robust rent-seeking?
It seems plausible that SEZs schemes may not always be negative for the economy when there is some rent-seeking involved. Perhaps policy-makers can strike longer lasting rent-seeking arrangements with zone investors that offer higher returns over all that one-off deals for building bridges. In principle, such as scheme could benefit the people of the country more than having no SEZ at all. Just like officials may distribute rights like exports quotas to firms in exchange for rents (Krueger, 1974), they can continuously maintain SEZ status to businesses in exchange for bribes or favors. SEZ permits must then be attractive enough to be of value to businesses, so the zones must be more than clusters of poor infrastructure.
It is therefore quite plausible that SEZs can attract business while still being very corrupt. Firms benefit from investing in a zone as long as the rents they must pay to government officials are lower than their gains from SEZ status. They may consider the under-the-table payments just another tax of doing business. This can create flourishing business communities, as long as the rent-seeking does not dissipate all their extra profits from being an SEZ firm. Many international firms may shun investing in a corrupt environment, but domestic firms are more likely to endure the corrupt climate due to the lack of better domestic alternatives and a higher cost of venturing abroad. They will however leave as well if the rents that they must pay rise to dissipate their benefits from investing in a zone.
To avoid extracting too much rent from SEZ businesses, the SEZ planners need to make a credible long-term commitment to companies. However, such a commitment is only viable if they can promise that both their own and future government administrations will adhere to it (Haber, 2002: xv). Any rent-seeking arrangement like this is therefore highly unstable in the longer run.
Even if SEZ planners could introduce stable rent-seeking schemes, with SEZs that look successful by virtue of attracting investments, these are likely to drain the economy as a whole. The policy will therefore not be robust in the political economy sense of aligning selfinterests with economic progress. Single factory SEZs, where a firm can choose its location, illustrate the point. Governments can grant “zone status” to single firms regardless of their location. They can exchange tax-funded benefits in exchange for rents in the form of bribes and favors that go straight into the officials‟ pockets. While the arrangement may be uphel for a long time, the scheme does not benefit the economy and is therefore not robust.
The democratic solution
There are institutions with potential to actually solve the incentive problem. In a functioning democratic and transparent system, public officials often gain personally from growth promoting SEZ schemes. They politicians enjoy public support and thus electoral votes if they can take credit for good SEZ policies. If the link between politics and economic outcomes is clear, they have a stake in designing growth promoting zone schemes. Political and fiscal decentralization both link a politician‟s policy judgments more directly to his chance of reelection.
Democracy and decentralization in combination also give local officials the incentive to make sure that their bureaucracies do not engage in low-level corruption. In contrast to a central government, they are better able to understand what incentive scheme can work for their agencies to create a clean bureaucracy. This logic also holds for any system that rewards lowlevel officials for good SEZ performance, even in a non-democratic context.
Private SEZs
Private zone development, previously found to be a solution to the knowledge problem, can also be a solution to problems stemming from adverse incentives. The model aligns incentives of private developers trying to maximize their profits with providing the best business climate possible at the lowest cost. They therefore tie economic progress in a zone very directly with the rewards to its developers. Private zones are also less likely to end up as vehicles for rentseeking. When government officials are not providing the infrastructure and other conveniences to SEZ firms, corrupt officials have fewer opportunities to extract rents from companies.
Private companies also have very different incentives from government officials when it comes to making the SEZs more attractive for companies. While governments compete for businesses by adjusting taxes, tariffs and subsidies, private developers are generally unable to change such policies. They must instead compete for investments by creating a more attractive business climate (FIAS, 2008: 21). Just as producers of goods attract different kinds of consumers when competing with quality rather than price (Hirschman, 1970: 47), private SEZs attract fewer firms that are mere bargain hunters for tax breaks or that rely on cheap labor for their production, and more technology intensive businesses. Private zones are therefore more likely to generate longer-term investments as well as countrywide technology transfers. Studies also show that private zones have an overall better record than public zones on environmental and social indicators (FIAS, 2008: 21, 46).
4 Two contrasting SEZ schemes
The experiences with SEZs in India and China illustrate many of the points made in this paper. While no SEZ case is black or white, I will use the Indian SEZ scheme to show in what ways SEZs may not be robust. China on the other hand, seems to have broadly overcome these problems.
The Indian case
India introduced their first SEZ in 1965 and by 2000, the country had still only established seven small zones (Gopalakrishnan 2011: 139). India introduced a new SEZ Act in 2005, offering more attractive business incentives (Kahn 2008: 69). Modeled on the Chinese SEZ program, the goal is to development larger scale zones (Palit, Bhattacharjee, 2008: 88; Seshadri 2011: 28). Overall, the impact of the Indian zone scheme on the economy is deemed to have been small (Engman et al. 2007: 18). The exports from the Indian zones always been just a fraction of the country‟s total (Seshadri, Storr, 2010: 348). Still, by the end of 2010, India had approved as many as 580 SEZs, of which 367 have been notified but only 112 were exporting (Dep. Of Commerce 2013)[3].
Let us start with India‟s possible knowledge problems, which Seshadri and Storr (2010) argue has been the key challenge to success for India‟s export processing zones. The Indian governmental authorities have often determined both zone location and the nature of zone production. Because they often chose poor, backward and unattractive zone locations, the policy was poorly matched with market conditions. In addition, SEZ regulations frequently posed obstacles for businesses in the zones to subcontract with firms outside the zones. Therefore, the most successful zones were already high performing before becoming SEZs (Seshadri, Storr, 2010: 363). To gather the necessary information to design the zones, the Indian government often employed think-tanks to do the analysis. Palit and Bhattacharjee (2008: 182) argue that the government needs to conduct more research to gather more information to make these decisions.
A solution to the knowledge problem would however rather rely on decentralization of decision-making. Prior to 2005, the Indian zone authority was a government department office, without any autonomy over SEZ approval clearances and zone development (Aggarwal, 2005: 16). With the 2005 SEZ Act, the Indian government gave greater discretion to both State and Central government to regulate zones “as they see fit” (Burman, 2006: 5). Yet Harding (2011: 163) points out that the government still has broad powers to direct resources to the new SEZs. The government has allegedly also designated 60% of the new zones are by as technology zones (Id.: 166). Sri Lanka and Bangladesh offer a comparison. They both had more decentralized SEZ governance, with SEZ authorities with more autonomy, and their SEZ schemes seem to have outperformed those in India (Aggarwal, 2005: 16, 42-44).
India also has problems with adverse incentives in their government bureaucracy. Low-level corruptions is widely spread (TI, 2011: 12), and the SEZ scheme offers officials many opportunities to extract rents. Aggarwal (2005) finds that prior to 1991, the Indian Board of Approval granted companies SEZ status, after which additional permission must be sought from the Secretariat of Industrial Approvals, the Ministry of Commerce, as well as from state and central government departments. The only rationale behind the arduous process seems to be the protection of rent-seeking opportunities. As of 2005, most companies had to go through 15 authorities to enter an Indian zone. In a survey, over 60% of SEZ firms reported frequently paying “irregular payments”, both to custom clearance and zone authorities (Id: 26). Since 2005, a “single-window” policy has allegedly simplified the registration process. The 2005 law is however complicated and unclear, so the process may still be opaque and complicated (Harding, 2011: 164).
The Chinese case
If India is a case study of a country with both knowledge and incentive problems, China seems to show that they can also find their solutions. China introduced its SEZs as a part of their economic reforms in the end of the 1970s. While the zones initially looked like a big failure, they now host a significant share of the country‟s economic activities, and have been described as the engines of China‟s regional economy (Fu, Gao, 2007: 22-23). Policies initially introduced in the zones have subsequently spread to other Chinese regions. While not all of China‟s SEZs have prospered, the scheme is generally considered a success.
China‟s decentralized system of governance has been important for China‟s general economic success (Xu, 2011; Li, Li, Zhang, 2000: 283), but it was likely also the most important factor in making China‟s SEZ scheme robust. Xu (2011) describes the Chinese system as a
“regionally decentralized authoritarian regime”. While the central government appoints and promotes local officials, policymaking is extensively delegated to the lower levels of bureaucracy. Political decentralization has allowed the Chinese SEZ program to be both innovative and to created clear property rights among local governments, which allowed them to act “as a conglomerate or as a holding company” (Li, Li, Zhang, 2000: 283). Some Chinese zones were granted more autonomy than others. The SEZ in Shanghai could implement its own regulations, allowing the Shanghai stock exchange to emerge as a self-regulated regional market, supervised by the municipal government (Xu, 2011).
The Shenzhen zone, near Hong Kong, illustrates the benefit of limiting official zone planning. Although initial guidelines for the Shenzhen zone stipulated that foreign direct investors had to be high-technology firms, the government later simplified the provision to “some technology”. This allowed the SEZ to grow on the back of its comparative advantages, in particular the abundance of cheap labor. Deregulations allowed for the appropriate linkages to the domestic market, making the Shenzhen SEZ a successful project (Farole, Akinci, 2011: 222).
China is also an example of how decentralization can allow SEZs to become test-beds for new policies. The Chinese zones were confined areas where liberalizing reforms could be tried out on a small scale (Cling, Letilly, 2001; Li, Li, Zhang, 2000). Their success demonstrated the benefits of liberalization to pivotal figures in the Communist Party, who then allowed the SEZ scheme to be implemented more widely (Crane, 1990: 91-98; Xu, 2011).
Despite its non-democratic political institutions, China also overcame the incentive problem. The Chinese system of power granted positions and salaries to local leaders based on the economic progress of their area. With their promotion and employment on the line, local leaders had the incentive not to retard local progress (Xu, 2011). In their competition with other Chinese regions, provincial leaders were encouraged to outperform each other in economic performance. Many therefore embarked on policies like privatization of stateowned enterprises that yielded high economic returns (Li, Li, Zhang, 2000).
5 Final remarks
This paper is a first robust political economy analysis on special economic zones (SEZs). The goal has been to show that the underlying growth promoting potentials of an SEZ model become clearer when examining the institutions that channel information and incentives of officials and businesses.
The framework in this paper can be applied to other development policies to understand the underlying causes of their success or failure to promote prosperity. Further research on SEZs should also include case studies applying the robust political economy framework. While this theoretical overview necessarily has been brief in its empirical applications, the approach may show its strength when applied in more detailed policy analyses.
Further research on SEZ will surely reveal deficiencies in the rough criteria for robust policies suggested here. For instance, Weingast et al. (1995: 55) emphasize the durability of the Chinese decentralized system of governance. Mechanisms for sustainability may also be a necessary condition to prevent governments from centralizing a well functioning and decentralized SEZ scheme. Those who claim that corruption is a market enhancing institution (Jeff, 1964; Lui, 1985; Beck, Maher, 1986) may object to the notion of robustness by claiming that SEZs with corrupt foundations should be better than no SEZs. On the other hand, SEZs may prove to be potent tools for policing corruption (Wei, 1999).
I have suggested that a robust political economy framework helps clarifying what needs to change for an SEZ program to work. Both the knowledge and incentive problems must be solved for SEZs to promote economic progress and avoid possibly becoming vehicles for corruption. There is evidently more than one solution. Private zone development allows the decision making about zone investments to lie with the people with market knowledge. It also limits the magnitude of rent-seeking opportunities. Private development can thus avoid both the knowledge problem and the incentive problem. Limited zone planning and decentralization can alleviate the knowledge problem but also risks aggravating the problem with low-level corruption. It therefore needs to be combined with either democratic accountability or a Chinese style top-down reward system to address the incentive problem. Depending on the institutional context, countries can tread very different paths to make their SEZs robust.
Acknowledgements: I would like to thank Tyler Cowen, Christopher J. Coyne and Vlad Tarko, at George Mason Department of Economics, for invaluable insights and suggestions.
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[1] News articles are available at http://allafrica.com/stories/201306200154.html;
http://news.belta.by/en/news/econom?id=701579; http://www.mmtimes.com/index.php/national-news/3213-sezdevelopment-project-links-myanmar-thailand-at-asean-summit.html; http://www.nationmultimedia.com/aec/Laos-specialeconomic-zone-attracts-investors-30215777.html; http://www.bbc.co.uk/news/business-24322313 (all accessed Oct. 13, 2013).
[2] This coordination problem is a classical argument for state involvement in industrialization; see Rosenstein-Rodan (1943).
[3] http://commerce.nic.in/pressrelease/pressrelease_detail.asp?id=2704
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