64430 POVERTY THE WORLD BANK REDUCTION AND ECONOMIC MANAGEMENT NETWORK (PREM) Economic Premise SEPTEMBER 2011 • Number 64 JUN 010 • Numbe 18 Special Economic Zones: What Have We Learned? Thomas Farole It has been more than 50 years since the establishment of the first modern special economic zones (SEZs). During this time, SEZs have been credited with underpinning the dramatic export-oriented growth of China and other East Asian countries. While they remain a controversial instrument, policy makers appear to be increasingly attracted to economic zones. Since the mid-1980s, the number of new zones has grown rapidly, with significant expansion in developing countries. But in this postcrisis environment, the context in which zones operate is changing; increasingly, the effectiveness with which they are designed, implemented, and managed will determine their success. This note outlines key lessons that have emerged from the experiences of zone programs in developing countries over recent decades. Ask three people to describe an SEZ and three very different (i) Attracting foreign direct investment (FDI); images may emerge. The first person may describe a fenced-in (ii) Serving as “pressure valves� to alleviate large-scale unem- industrial estate in a developing country, populated by foot- ployment; loose multinational companies enjoying tax breaks, with labor- (iii) Supporting a wider economic reform strategy; and ers in garment factories working in less than optimal condi- (iv) Acting as experimental laboratories for the application of tions. In contrast, the second person may recount the “miracle new policies and approaches. of Shenzhen,� a fishing village transformed into a cosmopolitan Since the 1970s, starting in East Asia and Latin America, city of 14 million, with per capita gross domestic product zones have been designed to attract investment in labor-intensive (GDP) growing 100-fold in the 30 years since it was designated manufacturing from multinational corporations. SEZs became as an SEZ. A third person may think about places like Dubai or a cornerstone of trade and investment policy in countries shift- Singapore, whose ports serve as the basis for a wide range of ing away from import-substitution policies and aiming to inte- trade- and logistics-oriented activities. grate into global markets through export-led growth policies. In fact, all three of these descriptions are appropriate. These Economic zones have had a mixed record of success to date, descriptions highlight the diverse ways in which the concept of and they have remained controversial, both on economic and “special� economic zones has been operationalized and under- social grounds. In any case, since the mid-1980s, the number of score the challenge of attempting to say anything specific about new zones has increased rapidly, with dramatic growth in devel- such a heterogeneous instrument. SEZs are typically estab- oping countries. For example, in 1986, the International La- lished with the aim of achieving one or more of the following bour Organization’s (ILO) database of SEZs reported 176 zones four policy objectives (FIAS 2008): in 47 countries; by 2006 this rose to 3,500 zones in 130 coun- 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise tries (Boyenge 2007). The rise of traditional export processing (ii) Ensuring zones are economically sustainable and deliver zones (EPZs), and their success in contributing to export-led positive externalities, including facilitating upgrading and growth in regions like East Asia, is partially attributable to an structural transformation, and catalyzing economic re- unprecedented era of trade and investment globalization that forms, and started in the 1970s and accelerated during the 1990s and (iii) Ensuring the sustainability of economic zones from an in- 2000s, driven by the fragmentation of manufacturing into geo- stitutional, social, and environmental perspective. graphically dispersed global production networks. Attracting Investment and Creating Jobs: Traditional EPZs were designed to attract investment by en- Old Models and New Challenges abling countries to better exploit a key source of comparative advantage—low-cost labor—that was otherwise underutilized Regardless of the model, it is clear that some countries have because of low levels of domestic investment and barriers (reg- been more successful than others in using zones to attract FDI, ulatory, infrastructure, and so forth) preventing FDI. These encourage export-oriented production, and create jobs. Indeed, EPZs have operated under simple principles: allow investors to after reviewing the experiences of economic zones across many import and export free of duties and exchange controls; facili- countries over the past three decades, some clear principles tate licensing and other regulatory processes; and (usually) re- emerge regarding the policies and practices that are associated duce or eliminate these firms from obligations to pay corporate with “static� success. taxes, value-added taxes (VAT), or other local fees. To maintain The case of Bangladesh emphasizes the importance of posi- control, EPZs have normally been fenced-in estates with strict tioning the zone program to leverage the country’s comparative customs controls at entry, and sales are typically restricted advantage. Indeed, while the program in Bangladesh initially mainly to export markets. aimed to attract high-technology investment, it only took off The model has been extremely successful in many coun- when it made a concerted effort to focus on the garment sector, tries. For example, it allowed the Dominican Republic to create which allowed it to leverage its comparative advantage in low- more than 100,000 manufacturing jobs and shift dramatically wage labor. It also highlights another observation about SEZs— away from reliance on agriculture. Similar stories of industrial- their incubation period. Even the biggest SEZ success stories ization and job creation can be seen in Mauritius, the Republic like China and Malaysia started slowly and took at least 5 to 10 of Korea, Taiwan, Honduras, El Salvador, Madagascar, and years to build momentum. In Bangladesh, the program started more recently in Bangladesh and Vietnam. However, it is clear in the early 1980s, but only began to attract investment on a that this model is now increasingly running up against its limi- large scale in the early 1990s. From a policy perspective, this tations. Indeed, it is perhaps no longer fit-for-purpose, given the means that governments need to be patient and to provide con- changing macroeconomic and regulatory environment in the sistent support to zone programs over long time periods, a par- global economy. This creates significant challenges for develop- ticular challenge in countries whose political cycles are shorter. ing countries that are still in the early stages of their zone pro- Beyond the wage-based advantages of Bangladesh, the critical grams. Some of the basic principles at the heart of traditional contribution of the zone program was not in fact incentives, EPZs are no longer (or perhaps never were) sustainable sources which are relatively modest in global terms, but instead the pro- of competitiveness. vision of serviced industrial land infrastructure and relatively In the postcrisis environment, in which competition for FDI reliable supply of power. Indeed, recent research (Farole 2011) is likely to remain much more intense than it was in the past, shows that on a global basis, infrastructure reliability has a sig- SEZs are likely to continue to grow in importance. But it is not nificant impact on SEZ success, while incentives have had no the existence of an SEZ regime, a compelling master plan, or measurable effect. even a fully built-out infrastructure that will make the differ- Another example is Honduras, which has also been highly ence in attracting investment, creating jobs, and generating successful in attracting investment in the garment sector, but spillovers to the local economy. Rather, it is the relevance of the has faced challenges in maintaining competitiveness. While SEZ programs in the specific context in which they are intro- the Honduran free zone program was built on trade prefer- duced, and the effectiveness with which they are designed, im- ences, labor cost arbitrage and a certain amount of “good tim- plemented, and managed on an ongoing basis that will deter- ing,� this was just the starting point. Key to success was the mine success or failure. role of dynamic, local entrepreneurs in catalyzing foreign in- The remainder of this note outlines key lessons that have vestment. While it is too simplistic to say that private sector emerged from the experiences of zone programs in developing development of zones is better than public sector develop- countries and is organized around three main issues of critical ment (bearing in mind the success of many East Asian coun- interest to policy makers: tries and of Mauritius with public sector–led models), in (i) Making economic zones successful in attracting firms that many countries the private sector can be much more dynamic create jobs, in implementing zones, and is in any case an important source 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise of expertise and risk management. In the case of Honduras, a Moving from Static to Dynamic Gains: Can stagnant government-run zone program was transformed SEZs Deliver Structural Change? when the law was changed to allow for private development of For economic zones to be a success in the long term, they zones. Government then focused on providing not only the should contribute to structural transformation of the econo- regulatory framework in which the private sector thrived, but my, including diversification, upgrading, and increased open- also critical infrastructure and services, most notably a high ness. This requires leveraging dynamic economic benefits from quality port, road connections to the zones, and on-site cus- investment and employment. Countries that have been suc- toms services that provide investors with efficient import and cessful in deriving long-term economic benefits from their SEZ export procedures. programs have established the conditions for ongoing exchange In contrast, the generally unsuccessful experience of zones and the accompanying hard and soft technology transfer be- in Africa to date highlights some important lessons in zone de- tween the domestic economy and investors based on the zones. velopment. First, it is important to separate political support This includes investment by domestic firms into the zones, for- from political objectives in zone projects. While strong com- ward and backward links, business support, and the seamless mitment from government is needed, projects must be care- movement of skilled labor and entrepreneurs between the fully designed based on clear strategic plans—the commercial zones and the domestic economy. case must be there. Moreover, that commercial case must be From a policy perspective, this suggests shifting from a tra- based on sustainable sources of competitiveness. Second, de- ditional fenced-in EPZ model to an SEZ model that eliminates spite the concept of zones as enclaves, in practice their success is almost fully entwined with the competitiveness of the national legal restrictions on forward and backward links and domestic economy and the national investment environment. Many participation. But it will also require implementation of much zones in Africa are operating in an environment of poor nation- broader policies beyond the scope of any SEZ program, in- al competitiveness. And regardless of what is done inside the cluding: promoting skills development, training, and knowl- zones, they face challenges in linking the zones and global mar- edge sharing; promoting industry clusters and targeting links kets, including critical infrastructure challenges regarding with zone-based firms at the cluster level; supporting the inte- ports, roads, and electricity. Third, putting in place a clear and gration of regional value chains; supporting public-private in- transparent legal and regulatory framework codifies the pro- stitutions, both industry specific and transversal; and ensur- gram strategy and establishes the “rules of the game� for all ing labor markets are free to facilitate skilled labor moving stakeholders involved in the process, but de facto implementa- across firms. tion is of equal importance. In many SEZs, the authority re- The case of the Dominican Republic, for example, high- sponsible for developing, promoting, and regulating the pro- lights that while low labor costs, trade preferences, and fiscal gram lacks resources and capacity as well as the institutional incentives can each play a role in catalyzing a zone program, authority to carry out its mandate. they are almost never sustainable. Indeed, they create pressure Economic zones also face changing regulatory environ- for further distortions and “race-to-the-bottom� policies, in- ments. One example of this is the growth of regional trade cluding extending and increasing incentives (rather than ad- agreements and of regional integration more broadly. If a dressing more difficult factors of the investment environment) zone-based firm is prohibited from selling to the domestic and granting exemptions on minimum wage and labor rights market, but suddenly the regional trade agreement makes its (rather than addressing productivity or labor market rigidities). neighboring countries “domestic� from a customs perspec- For the Dominican Republic, and many other lower-middle- tive, this will have an enormous impact on investors’ business income countries whose zone programs have focused on basic models and on the attractiveness of zones. From an institu- assembly, manufacturing and trade, the main growth opportu- tional perspective, it will be increasingly critical for zone pro- nities are now in services sectors, especially information and grams to look beyond their borders and develop integrated or communication technology (ICT), business services, and more at least harmonized approaches to SEZ legal and regulatory knowledge- and research and development– (R&D) intensive frameworks, particularly on the treatment of exports, rules of sectors. This requires fostering innovation, which emphasizes origin, and fiscal incentives. Regional integration offers signifi- the need for zones to avoid becoming enclaves, as well as the cant opportunities for economic zones in terms of expanding importance of skills development and training. market access. Perhaps more interestingly, particularly for But facilitating structural transformation through SEZs is small countries, there may be potential for using zones to link not a mechanical process that simply requires the right policies. up regional suppliers and leverage economies of scale in pro- The principal factors explaining why many countries have dis- duction. Linking regional SEZs to infrastructure investments torted economic structures and lack sufficient dynamism are to create “growth corridors� may be a powerful new route to political in nature. It is in this context that SEZs can perhaps be competitiveness. most effective in catalyzing processes of economic reform. In- 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise deed, this is the classic case of China’s SEZs, which were used as females in the labor force tends to decline. Thus, countries that a vehicle to test liberal economic reforms and introduce them remain wed to traditional labor-intensive, low-skill EPZ activi- to the wider economy in a gradual way. Thus, while the idea of ties will be forced in time to adjust, and it will be critical to con- integration between SEZs and the domestic economy is ulti- sider the economic and social implications some of these ad- mately the key to structural transformation, where economic justments may have. reforms are politically sensitive to implement, it is precisely the Ensuring that the rights of workers are upheld and, beyond enclave nature of zones that can be their key to success. this, that efforts are made to provide the training and social in- Several important lessons can be drawn from the Mauritius frastructure needed to enable individual workers to thrive, will case, which represents another example of how SEZs can cata- ultimately be critical to ensuring the sustainability of zone pro- lyze structural change through economic and political reform. grams so they can deliver the dynamic economic benefits dis- First, it highlights the importance of the political process and cussed in this note. Thus, zone programs will need to strength- of having a specific political champion behind the zone pro- en their approach to social and environmental compliance gram, a lesson that was also learned from experiences in China issues, establish clear standards, and put in place effective mon- and Malaysia (especially Penang). Second, not only does the itoring and evaluation (M&E) programs. At the national policy Mauritius case again emphasize the importance of domestic level, economic zones should be seen as an opportunity to ex- investment in the zone program, it shows that integration of periment with policy innovations. the zone program must go beyond the physical and financial— These same principles—of policy experimentation, clear it must also be integrated strategically. Indeed, one of the main standards, and robust M&E—are also applicable in the environ- differences between zone programs that have been successful mental field. Some EPZs have been criticized in the past for and sustainable and those that have either failed to take off or promoting “dirty� industries and failing to meet environmental have become stagnant enclaves is the degree to which they have standards. SEZs, however, offer an ideal environment for envi- been integrated into the broader economic policy framework ronmental policy experimentation, not only because of their of the country. In Mauritius, the EPZ program was a pillar of enclave nature, but also because they have built-in compliance the country’s development strategy. Unlocking the potential of mechanisms that do not typically exist outside the zones, such zones requires clear strategic integration of the program, with as issuing of licenses, the ability to monitor firms in a short time government playing a leading, active role in facilitating their frame, and ultimately the ability to revoke a license, terminate growth and development vis-à-vis the local economy. a lease, or impound goods. This context could offer interesting opportunities, particularly for innovations in both social and Sustainability: Emerging Issues for SEZs environmental policy. Indeed, while the concept of developing SEZ impacts on host societies go well beyond economic effi- low-carbon zones is still in its infancy, it is already being adopt- ciency. Zone programs that fail to offer opportunities for qual- ed in several SEZs around the world. ity employment and upward mobility for trained staff, derive Conclusions their competitive advantage from exploiting low-wage workers, and neglect to ensure environmental sustainability are unlikely As SEZ programs continue to proliferate, particularly in devel- to be successful in achieving the possible dynamic benefits, and oping countries, it is critical for policy makers to learn from are likely to be forced into a “race to the bottom.� By contrast, past experiences and anticipate the implications of the emerg- zone programs that recognize the value of skilled workers and ing and potential issues discussed in this note. Future SEZ pro- seek to provide the social infrastructure and working environ- gram success will require adopting a more flexible approach to ment in which such workers thrive will be in a position to fa- use SEZ instruments effectively to leverage a country’s com- cilitate upgrading. parative advantage and ensure flexibility so that the zone pro- One example in which sustainability is getting attention in gram can evolve over time. Fundamentally, this approach will economic zones is in the area of gender. Firms located in eco- require a shift in mindset away from the traditional reliance nomic zones are known to have much more female-intensive on fiscal incentives and wage restraint to instead focus on fa- employment than firms in the rest of the economy (Milberg cilitating a more effective business environment that fosters and Amengual 2008). In this regard, zones have created an im- firm-level competitiveness, local economic integration, inno- portant avenue for young women to enter the formal economy. vation, and social and environmental sustainability. This ap- On the other hand, zones have long been criticized for failing to proach will also require proactive, flexible, and innovative meet labor standards, particularly for not appropriately consid- policy approaches to address the significant macroeconomic ering the specific needs of female workers. Moreover, as firms challenges that will impact SEZs in the near future, in addi- and zones upgrade—both into new, higher value-added sectors tion to the many unanticipated challenges that will undoubt- and to higher value-added within existing sectors—the share of edly also shape the environment in the years to come. 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise About the Author Farole, T. 2011. Special Economic Zones in Africa: Comparing Performance and Learning from Global Experiences. Washington, Thomas Farole is a Senior Economist in the International Trade DC: World Bank (http://issuu.com/world.bank.publications/ Department at the World Bank. This note is based on chapter 1 docs/9780821386385). of Special Economic Zones: Progress, Emerging Challenges, and Fu- FIAS. 2008. “Special Economic Zones: Performance, Lessons ture Directions (http://issuu.com/World.Bank.Publications/ Learned, and Implications for Zone Development.� World Bank, Washington, DC (http://www.ifc.org/ifcext/fias.nsf/Attach- docs/9780821387634). mentsByTitle/SEZpaperdiscussion/$FILE/SEZs+report_ April2008.pdf). References Milberg, W., and M. Amengual. 2008. “Economic Development and Boyenge, J. P. S. 2007. “ILO Database on Export Processing Zones, Working Conditions in Export Processing Zones: A Survey of Revised.� Working Paper, ILO, Geneva (http://www.ilo.org/ Trends.� Working Paper, ILO, Geneva (http://ilo.org/public/ public/libdoc/ilo/2007/107B09_80_engl.pdf). french/dialogue/download/wp3englishfinal.pdf). The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduc- tion and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise