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The promises and challenges of special economic zones

On Tuesday 29 May 2018, the Oxford Urbanists and Cities that Work hosted a panel event titled “Can Special Economic Zones (SEZs) Drive Growth in Developing Cities?” to discuss evidence for improved policy.

How should we think about Special Economic Zones (SEZs)? What benefits can they bring to developing cities? Where do they fall short? How can governments set them up for success?

On 29 May 2018, Michael Blake, a cities economist with the International Growth Centre, moderated a discussion on these themes, with three leading experts: Tony VenablesXiaolan Fu, and Alejandro Riaño. The event constituted the third public discussion in the Oxford Urbanists’/Cities that Work collaborative efforts to facilitate policy-relevant dialogue regarding major challenges currently facing cities across the developing world.

The panelists each viewed SEZs through different lenses. Professor Venables helped simplify the discussion with basic economic principles, drawing from his background in spatial and trade economics. Professor Fu grounded the discussion in granular, practical examples from her field-level work on Chinese SEZs. Professor Riaño drew from his experience researching SEZs in Latin America and sharpened the discussion with points relating to international trade theory and policy.

To open, Blake set forth a basic working definition of an SEZ as “a region designated within a country to have more liberalised business policies and other government investments intending to increase investment and production.” (For a more comprehensive discussion of terminology, see the Introduction of Farole 2011.)

The promise of SEZs

All three panelists agreed that SEZs can be a productive second-best policy solution in regions where the surrounding business environment may be less than optimal. As Professor Venables put it, SEZs can help countries to generate a productive business environment “at least somewhere.” In his view, SEZs can help provide – in a spatially concentrated area – several of the necessary conditions that external investors may seek. These might include adequate infrastructure, an educated and skilled labour force, and local input suppliers.

In turn, a well-executed SEZ can generate spill-overs to the rest of the economy, as export-oriented industries expand and domestic firms outside the SEZ upskill in order to supply SEZ firms. Professor Venables emphasized that countries should focus on generating investment that would not have happened in the absence of an SEZ. Otherwise, the costs of setting one up may not be justified.

Professor Fu highlighted the important role SEZs can play as “policy labs.” Governments can use them as testing grounds for more liberal business policies and then scale up the ones that work (and scrap the ones that don’t), as China has done over the past two decades. She contrasted this approach to liberalization with the once-off “big bang” phenomenon witnessed in Eastern Europe following the demise of the Soviet Union.

Professor Riaño argued that SEZs should aim to relieve particular economic distortions, rather than try to provide an economic panacea. As one example, he described how Mexico’s maquiladoras –duty-free export processing zones – absorbed excess labour supply after the U.S. government terminated the Bracero Program in 1964. (For further information on this, see Heid et al. 2013, a paper co-authored by Professor Riaño).

Professor Riaño also illustrated ways in which SEZs can facilitate production diversification away from primary commodities. This is often a priority for low-income economies, which, in frequently depending on one primary commodity, face significant macroeconomic risk. SEZs have helped the Dominican Republic and Mauritius transition away from concentrations in bananas and sugar, respectively, into higher value-added manufacturing.

“Professor Fu highlighted the important role SEZs can play as “policy labs.” Governments can use them as testing grounds for more liberal business policies and then scale up the ones that work (and scrap the ones that don’t), as China has done over the past two decades. ”

Referring to an influential model by economists Dani Rodrik and Ricardo Hausmann, Professor Riaño suggested that SEZs can contribute to an economy’s “self-discovery.” The model illustrates how in the absence of government intervention, a developing economy may have too little investment in the “pre- self discovery phase” and too much product diversification in the “post- self discovery phase.” SEZs can counteract these market failures by encouraging investment and then clustering production in sectors in which a country has a comparative advantage.

Yet while SEZs may theoretically promise immense benefits for developing regions, the panelists agreed that they often fall short in practice. The second half of the discussion focused on how governments can guide SEZs to success.

What makes a successful SEZ?

First, panelists agreed that governments must work closely with investors and remain attentive to their needs. The panelists pointed to Ethiopia’s Hawassa Industrial Park, where the government has not only attracted firms, but worked closely with them to set up the SEZ. Professor Venables added that the presence of PVH, a textile manufacturing giant, has enabled Hawassa to attract high-quality input suppliers and talented labor.

Professor Fu contrasted Ethiopia’s SEZ success with the less successful case of Nigeria through the lens of Chinese investment. She noted that, in Ethiopia, Chinese firms have sourced inputs and labour domestically, uplifting the local economy, while in Nigeria, Chinese firms have largely relied on imported inputs. Spillovers have been less frequent.

The discussion also made clear that, for SEZs to prove successful, governments must provide firms with productivity benefits rather than simply tax breaks. When potential investors are deciding whether to get involved in an SEZ, the panelists agreed, tax incentives are often among the least important of their considerations.

Instead, investors prioritize high-quality infrastructure, efficient administration (e.g., “one-stop shops” for licensing and regulatory support), and adequately skilled labour forces. (Using investor surveys, Steenbergen and Javorcik (2017) confirm that pure financial incentives are among the least important factors for SEZ investment.) Professor Venables noted that Indian SEZs have suffered from prioritizing tax incentives over more substantial productivity enhancers.

The most flagrant SEZ mishaps seem to be those in which governments fail to detect and support the most promising types of economic activities. Panelists concurred that this often results when governments pick sectors to receive SEZ benefits without sufficient input from the private sector and investment communities. Professor Riaño cited a recent Planet Money podcast that illustrated the Argentine government’s attempt to set up a manufacturing zone for Blackberry phones in Tierra del Fuego, the southern tip of the South American continent – hardly an instance of comparative advantage.

Drawing on these ideas, Professor Fu argued that African SEZ successes of the future will look very different—sectorally speaking—from East Asian success of the past. Many African countries don’t have the local supply chains needed for the types of electronics and manufacturing production that drove East Asia’s growth, she noted. Meanwhile, the so-called “Fourth Industrial Revolution” may render labour-intensive manufacturing (a major driver of foreign investment, particularly in South Asia) a less successful SEZ bet in Africa.

Professor Fu suggested that African SEZs should not exclusively focus on producing exports for the world market, as many East Asian countries have done. Instead, they should concentrate on improving domestic and regional productivity, and then move up the global value chain to produce goods for higher-income consumers.

Looking ahead

Audience questions concerned the political challenges of SEZs, the links between SEZs and cities, the role of the internet in shaping the future of SEZs, and differences between FDI vs. domestic investment.

Two questions concerning governments’ involvement in SEZs after they launch produced healthy disagreement among the panelists: How actively should governments guide an SEZ’s transition from one industry focus to another as an economy grows? Should governments actively close an SEZ in the face of potential failure?

Professors Fu and Riaño agreed that governments should step in to alleviate potential failures and guide SEZs toward new sectors. Professor Venables argued that SEZs are “birthplaces” for foreign investment, from which local market forces should determine any necessary changes.

In closing, Professor Riaño discussed the relative lack of empirical work on the economic effects of SEZ policies, a significant opportunity for future researchers. Perhaps the event inspired a few budding academics to dig deeper into SEZs.

This blog has been originally published here.

Paul Healy is an M.Sc. candidate in Economics for Development at the University of Oxford and incoming J.D. candidate at Yale Law School. 

Further reading

For those interested in further reading on SEZs in developing countries, we recommend the following resources to get started:

Farole, T. and G. Akinci (Eds.) (2011): “Special Economic Zones Progress, Emerging Challenges, and Future Directions,” The World Bank, Directions in Development Series.

Heid, B., L. Mario, and A. Riaño (2013): “The Rise of the Maquiladoras: A Mixed Blessing,” Review of Development Economics, 17(2), 252–267.

Steenbergen, V. and B. Javorcik (2017): “Analysing the impact of the Kigali Special Economic Zone on firm behaviour,” IGC Working Paper F-38419-RWA-1.

World Bank Group: Trade and Competitiveness Global Practice (2016): “Special Economic Zones in the Dominican Republic: Policy Considerations for a More Competitive and Inclusive Sector,” Online policy briefing.

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