IAAJ I j58j EXPORT PROCESSING ZONES The Economics of Enclave Manufactuning Peter G. Warr FILE 0 S ince the mid 1960s, many developing countries have tried to stimulate exports of nontraditional manufactures. One form this effort has taken is the establishment of export processing zones (EPZS). Many EPZS were set up in the early 1970s; by the early 1980s around thirty-five existed in Asia alone, with an aggregate employment of at least 250,000 (United Nations 1985). Globally, their importance was probably more than twice as great. EPZS are special enclaves, outside a nation's normal customs bar- riers. The firms inside them are mostly foreign and enjoy favored treatment with respect to imports of intermediate goods, taxation, and infrastructure. They are also free from industrial regulations applying elsewhere in the country. These privileges are subject to the conditions that almost all of the output is exported and that all imported intermediate goods are used within the zones or else re- exported. Despite the heavy state investment involved, perusal of govern- ment documents on EPZS invariably reveals confusion about the economic and welfare effects of the zones. Similar confusion is also present in the economic literature on EPZS. This article tries to clarify the issues and to draw out the crucial relationship between the benefits and costs of establishing EPZS and the overall trading regime of the host country. The frame of reference is the economic welfare of citizens of the host country. The article starts with a simple theoretical analysis, which is then illustrated by case studies from four East Asian countries. The most common activities in EPZs have been labor-intensive light manufacturing processes: electronics assembly, garment pro- < 1989 The International Bank for Reconstruction and Development!/The World Bank 65 duction, assembly of light electrical goods, and so forth. A notable feature of the firms in the zones is their international mobility. Firms leaving an EPZ in one country often migrate to an EPZ in another, in which conditions are more favorable. The "footloose" character of EPZ firms has been overlooked in most of the small amount of theoretical work that has appeared. This literature has drawn upon the classical Heckscher-Ohlin model of production.' Insofar as the model treats capital as being interna- tionally mobile, it fails to capture the international mobility of cap- ital goods-which is central to the functioning of EPZS. The main conclusion of most of the literature-that EPZS necessarily reduce the welfare of the host countries-is thus largely irrelevant for EPZS as they actually operate. Empirical work on EPZs has also tended to overlook the footloose character of EPZ firms. It has therefore had a misplaced preoccupa- tion with the factor intensity of production within the zones. In an otherwise useful descriptive study of EPZS, Spinanger claims that they tend to produce welfare benefits analogous to those resulting from a movement toward free trade, because the elimination of tariffs and other distortions causes factor intensities of production "to correspond more closely with the factor endowment of the host country" (1985, p. 65). This conception of an EPZ rests on the traditional assumption that capital is internationally immobile. It assumes implicitly that the capital used in the EPZ is domestic capital in fixed supply, which has moved there from elsewhere in the host country. Once this assumption is discardecd, the factor intensity of production within EPZS is of limited relevance for an assessment of their welfare impact. Although most of the literature on EPZS has been concerned with their benefits and costs, it has stopped short of formal benefit-cost analysis. The explanation is usually that the data are inadequate. In fact, EPZS are closely monitored by host governments; compared with the data available for other public projects in developing coun- tries, the statistical information on EPZS is unusually complete. It includes detailed time series of exports, imports, employment, use of utilities, infrastructure, and administrative costs. What the empir- ical studies have lacked has been an analytical framework, so that the benefits and costs of EPZS can be identified conceptually and quantified empirically. This article describes the footloose character of EPZ firms and the incentives and other facilities in a "typical" EPZ. It then looks at the economic performance of EPZS in four Asian countries: Indonesia, the Republic of Korea, Malaysia, and the Plhilippines. Using a sim- ple conceptual framework-the "enclave mnodel"-the article ana- lyzes the benefits and costs of the four Asian EPZS. Finally, it dis- cusses the relationship between EPZS and trade policy in general. 66 Research Observer 4, no. 1 (January 1989) In its standard forms, international trade theory treats factors of The Foodoose production-capital, labor, land-as immobile internationally but Manufacturer mobile domestically. In contrast, commodities are considered mo- bile across, as well as within, international boundaries. EPZs exploit the international mobility of capital goods owned by a "footloose" manufacturing firm, combine them with domestic labor (relatively immobile internationally), and produce traded goods which the firm exports. The firm tries to move its capital equipment to countries in which it can earn the highest rate of return. This process can be viewed as an indirect form of exporting labor. The foreign firm producing within the EPZ receives the services of domestic labor. In return, the workers receive wages and some train- ing. Not surprisingly, many of the countries establishing EPZS have also engaged in the direct export of temporary labor, to the Middle East and elsewhere.2 In the case of EPZS, the capital goods move to where the labor is; with labor export, the movements are reversed. A simple model to represent the international mobility of capital goods has been developed byJones (1980) and Caves andJones (1985). This article uses an amended version of the Caves and Jones model to bring out the essential economic features of EPZS. The processing activity within the zone produces final traded goods using three kinds of inputs: traded intermediate inputs, capital goods, and labor. The traded intermediate inputs include the electronic com- ponents, plastic casings, electrical circuitry, and so forth used in pro- ducing electronic goods, and the textiles, buttons, cotton thread, and so forth used in producing garments. The prices of these goods, the wages paid, and the return to the capital goods used are formally related by (1) PI = SEa:pi + aKjRj + aLiw where Pj is the price of the final goods j; P, is the price of the interme- diate input i; ay, aKj, and aLi are the amounts of intermediate good i, capital goods, and labor, respectively, required to produce a unit of good j; and w is the wage rate. These variables determine Rj, the rate of return to capital goods resulting from the production of good j in an EPZ. It is convenient to define the value added per unit of production of goodj, Vj, by (2) V, = P, - Eia,fP, and (1) now becomes (3) V1 = aKIR, + aLIW. Peter G. Warr 67 Figure 1 Figure 1 represents equation 3 for two Poor country countries, labeled "poor" and "rich." In the V. u rich country unit labor costs, aLjw, are higher Value Rich than in the poor country, but unit require- added country ments of capital goods, aKj are lower. The A rich country's schedule thus has a higher ver- tical intercept (unit labor costs)-that is, point B > B lies above point C--and a lower slope (unit capital good requiirement) than the poor c , country's. A footloose manufacturer moves to the Ri country where the highest value of Rj can be Rate ot return to mobile capital goods realized. This is represented by the shaded surface in the diagramn. When unit value added is high, implying high returns to the capital goods specific to commod- ity j, the rich country is able to attract the processing activity. The rich country uses the scarce capital goods more efficiently-its unit capital good requirements per unit of output are lower-and in this case unit labor costs are relatively unimportant. But if unit value added falls, implying a squeeze on returns to its capital goods, unit labor costs become relatively more important. Below point A, the process moves to the poor country. This analysis is consistent with the "product cycle" process identified by Vernon (1966). It suggests a gradual migration of newly developed manufacturing processes from rich countries (where scarce capital goods are used more efficiently) to poor cotntries (where unit labor costs are lower) as international competition forces down the unit value added generated by these processes. The Economic In the early 1970s, after Japan had relaxed restrictions on invest- Environment ment abroad, other Asian countries competed to attract these and of the EPZ similar foreign investments. Light manufacturing, intensive in the use of unskilled or semiskilled labor, was identified as a target: it was well suited to EPZS. The zones appeared to offer the advantages of export promotion without threatening thle position of indigenous manufacturers. The "typical" EPZ had four characteristics: DUTY-FREE IMPORT OF RAW MATERIALS. Raw materials required for the production of exports may be imported duty-free and irre- spective of quantitative restrictions in the domestic economy. Prod- ucts may be exported without payment of export taxes, sales duties, and so forth. Although goods produced in EPZS may not normally 68 Research Observer 4, no. I (January 1989) be sold domestically, special permission to do so may be given when consignments are rejected by foreign buyers or fail to meet delivery deadlines. Such sales simply displace imports that would have oc- curred from other sources and usually attract normal customs du- ties. EPZ firms' purchases of raw materials and intermediate goods from domestic suppliers are frequently subsidized, in an attempt to encourage links with the home economy. The subsidies, commonly called "rebates" or "drawbacks," are intended to offset the effects of domestic protection. In the early 1970s it was hoped that links of this kind would generate big benefits to the local economy, both because the social cost of producing these goods was below their market prices and because EPZ firms would transfer technology to domestic suppliers. TAX HOLIDAYS. Firms in an EPZ are often exempted from normal income tax provisions for three to ten years. The firms often nego- tiate successfully to extend these tax holidays by threatening to move to another country. Once relocated, the firm's tax-free holiday begins again. The Philippines offers a generous schedule of deductions instead of tax holidays. Very little tax revenue has been raised from its EPZS, because most firms declare overall trading losses.3 Some firms have declared losses every year for more than a decade, while still pro- ducing and even expanding. Vertically integrated firms use transfer pricing to relocate their profits internationally, thereby minimizing their global tax burdens. The Philippines experience suggests that efforts to monitor transfer pricing are ineffective and that tax holi- days are less important than they may appear. STREAMLINED ADMINISTRATION. EPZ firms usually have to con- form to simplified administrative requirements, which often deal with a special government agency. They are exempted from many national rules, such as restrictions on foreign ownership of firms (EPZ firms are usually allowed to be fully foreign-owned), restric- tions on repatriation of profits, restrictions on the employment of foreign nationals, and requirements for special approval for import- ing capital equipment. EPZ firms may also obtain a share of the host country's allocation of import quotas-vital for garment producers wishing to export to the European Economic Community. INFRASTRUCTURE AND UTILITIES. An EPZ consists of a heavily fenced area policed by customs officials to prevent duty-free mate- rials from being smuggled into the domestic economy. Its infrastruc- Peter G. Warr 69 ture and telecommunications are normally superior to those in the host economy, but not as good as those in industrial countries. Utilities are often subsidized. Electricity tariffs are especially im- portant, because light manufacturing firms are heavy users of elec- trical power. The rates charged in EPZS are frequently below, and never above, industrial rates elsewhere in the host country. The same applies to rental rates. Some firms rent buildings from a gov- ernment agency; others lease land within the zone and construct their own buildings. The Economic This section summarizes the results of detailed studies of EPZS in Record in four Asian countries: Four Asian * Indonesia: The Jakarta Export Processing Zone Countries * The Republic of Korea: The Masan Free Export Zone * Malaysia: The Penang Free Trade Zone * The Philippines: The Bataan Export Processing Zone. All four began operations in the early 1970s. Each is the largest and oldest EPZ in the country concerned. The Indonesian zone is less typical of EPZS than the other three. It is small and has a number of unusual characteristics but is worthy of examination because it began as an experimental project and, partly on the basis of its performance, the Indonesian government has decided to establish several more EPZS. Detailed case studies of these four zones have been conducted by the present author.4 Tables 1 to 4 summarize the economic performance of these four zones through 1982. Alto- gether, they employed roughly 90,000 people in 1982. A feature of the zones not revealed by thie tables is their industrial composition. Garment production initially dominates, then electronics assembly becomes more important. Indonesia and Malaysia are excep- tions to this pattern, in that garments have always been the dominant industry in the former and electronics in the latter. The two industries are quite different. Garment production is generally far more labor- intensive, and its technology has changed little in years. The data in tables 1 to 4 also fail to reveal the footloose character of EPZ firms. The case of the Philippines' Bataan EPZ provides a good example. In table 4, the number of firms barely changed between 1979 and 1982. But during 1979, four firms entered the zone and four others left. In 1980, five entered and four left; in 1981, three entered and three left; and in 1982, two entered and four left. Aggregate data on export volumes and employment also disguise annual volatility for individual EPZ firms. Table 4 shows that, between 1981 and 1982, total exports from the Bataan EPZ rose by 19 percent. 70 Research Observer 4, no. 1 (January 1989) Table 1. Indonesia: Aggregate Economic Performance of Jakarta EPZ Indicator 1977 1978 1979 1980 1981 1982 Number of firms 4 7 15 18 18 18 Number of persons employed 773 1,653 4,317 6,374 7,520 7,742 Value (millions of U.S. dollars) Exports 0.9 12.8 5.9 18.7 28.7 37.5 Imports of raw materials 1.2 11.8 6.4 13.0 13.5 13.8 Local raw materials 0 0.01 0.6 1.9 5.2 9.5 Imports of capital goods 0.1 1.0 1.0 1.2 0.8 0.3 - Local capital goods 0 0 0.03 0.01 0.03 0.01 Total official taxes 0.01 0.15 0.33 0.40 0.56 0.56 Estimated unofficial taxes 0.23 3.11 1.32 2.76 3.60 3.60 Percentage Local to total raw materials 0 0.80 9 13 28 41 Local to total capital goods 0 0 2.9 0.8 4.6 3.2 Note: All monetary quantities are in current prices. Source: Bonded Warehouses Indonesia, Jakarta; International Monetary Fund, Interna- tional Financial Statistics, various issues; and Warr 1983. For individual firms, however, exports rose in only twenty-nine of the fifty-two that were present at the beginning of 1981 and declined in twenty-six (including the three that left the zone during that year). In the first group, the average increase in firm-level exports, weighted by exports in 1981, was 42 percent; in the second group (excluding the three which left the zone) the weighted average decline was 29 percent. These large variations in output partly reflect the adjustments made by the headquarters of the large corporations to which EPZ firms belong, in response to perceived changes in market demand. They also reflect the way that such corporations relocate their activities when the prof- itability of their firms changes. Raw Materials and Technology Transfer Two of the anticipated benefits of EPZS were that firms would buy more local raw materials and that such links transfer technology to domestic firms. In reality, local raw materials make up no more than a third of the total purchases of raw materials. The exception is Indonesia, where local textiles are purchased significantly by the zone's garment producers. In Malaysia, local raw materials consti- tute only a small percentage of the total. Purchases of raw materials and intermediate goods produced by other EPZ firms are more than three times greater. In the Philippines, the share of local raw mate- rials had declined to less than 10 percent by 1982. Peter G. Warr 71 Table 2. Korea: Aggregate Economic Performance of Masan EPZ Indicator 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 Number of firms 70 115 110 105 99 99 97 94 88 89 83 Number of persons employed 7,072 21,240 20,822 22,248 29,615 28,401 30,960 31,153 28,532 28,016 26,012 Value (millions of U.S. dollars) Exports 23.9 145.5 298.0 257.1 441.0 496.5 579.2 621.7 577.3 664.4 601.3 Local sales 0 0 6.2 7.9 25.2 28.1 81.7 90.7 82.5 99.0 92.1 Imports of raw materials 16.5 91.7 176.7 137.8 216.7 239.3 270.7 293.0 266.2 295.9 281.7 Local raw materials 1.0 23.1 48.6 44.6 92.7 120.0 130.0 149.4 131.3 144.0 142.7 Total wages and equipment 5.9 17.9 18.9 23.2 36.2 41.4 47.5 51.5 49.4 59.0 59.6 Total electricity used 0.2 1.3 2.3 2.0 3.4 3.8 4.5 4.8 4.5 5.1 5.3 Total taxes 0 1.44 1.79 1.55 1.71 1.50 1.85 1.78 1.74 2.31 2.17 Percentage of local to total raw materials 6 20 22 24 30 33 32 34 33 33 34 Note: All monetary quantities are in current prices. O Source: Administration Office, Masan Free Export Zone, Masan; International Monetary Fund, International Financial Statistics, various issues; and Warr 1984. C 90 Table 3. Malaysia: Aggregate Economic Performance of Penang EPZ Indicator 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 Number of firms 10 21 31 32 33 34 35 35 41 49 50 Number of persons employed - 15,627 18,569 22,412 25,780 27,895 30,372 35,379 38,355 38,078 36,298 Value (millions of U.S. dollars) Exports 2.1 53.6 94.2 192.2 274.3 226.1 591.5 1,085.2 972.9 717.5 714.9 Local sales - 0.1 2.3 1.7 6.9 4.6 9.4 2.6 0.06 14.5 47.1 Imported raw materials 1.3 55.0 127.8 185.1 237.2 193.6 425.6 492.4 707.0 523.1 520.6 Local raw materials 0.07 0.9 2.8 7.1 6.7 10.5 13.3 14.5 14.5 16.9 22.8 Raw material from EPZS - - - 5.8 12.0 13.1 40.3 64.5 76.6 48.9 82.3 Imported capital goods 0.4 13.4 54.7 29.7 9.5 15.2 120.0 53.9 36.6 36.7 36.6 Local capital goods 0 1.8 18.9 27.0 2.2 3.6 2.6 21.7 3.3 4.0 3.9 Total wages paid 0.9 6.3 5.2 14.0 17.4 25.0 43.2 56.6 72.3 80.5 83.4 Total electricity used 0.4 0.7 1.7 5.7 6.9 .0 8.6 12.1 17.8 23.5 23.2 Total taxes paid 0 0 0 0 0 0 0.14 0.15 0.09 0.74 1.29 Percentage Local to total raw materials 5 2 2 4 3 5 3 3 2 3 4 Local to total capital equipment 0 12 26 48 19 19 18 29 8 10 10 - Not available. Note: All monetary quantities are in current prices. Source: Panang Development Corporation, Penang; International Monetary Fund, International Financial Statistics, various issues; and Warr 1987b. -4~~~~~~~~~~~~~~~~~~~~~~ -'4 Table 4. The Philippines: Aggregate Economic Performance of Bataan EPZ Indicator 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 Number of firms 1 5 14 16 39 38 47 51 51 52 S2 Number of persons employed - 1,298 3,321 5,502 8,962 12,821 17,495 18,877 19,204 19,858 19,410 Value (millions of U.S. dollars) Exports 0.4 0.9 2.1 7.3 22.4 39.7 73.1 98.2 122.7 134.0 159.6 Local sales - 3.9 6.8 4.3 11.7 13.6 14.8 16.5 13.3 8.2 5.0 Imports of raw materials 0.2 0.5 2.9 7.8 15.8 38.5 47.3 66.4 77.3 81.2 122.3 Local raw materials 0.07 0.2 0.3 0.8 4.2 9.9 3.8 7.9 9.5 7.4 8.5 Total wages paid - 0.6 1.5 2.5 4.3 6.6 9.3 14.4 20.4 22.4 21.8 Total electricity used - 0.1 0.3 0.5 0.7 0.9 1.2 1.6 1.5 1.7 1.6 Total taxes paid - - 0.07 0. 0.4 0.6 1.5 2.2 1.9 1.7 1.4 Total domestic borrowings 1.8 22.8 61.4 117.8 85.9 89.4 3.3 2.8 2.3 1.9 1.5 Percentage of local to total raw materials 30 30 8 10 21 20 7 11 14 9 6 - Not available. Note: All monetary quantities are in current prices. Source: Export Processing Zone Authority, Manila; International Monetary Fund, International Financial Statistics various issues; and Warr 1985. C Co Managers of EPZ firms report that the main obstacle to buying local raw materials is their low and unreliable quality. Entire ship- ments of finished goods may be rejected if the raw materials or intermediate goods used were inferior. The changing industrial com- position of the EPZS is also a factor: garment and footwear manu- facture uses a much higher proportion of local raw materials than electronics assembly. And a third factor is the global strategies of the corporations involved. Parent firms wish to preserve the inter- national mobility of their processing operations; developing long- term relations with local suppliers does not serve this goal. If the corporation wishes to retain the capacity to relocate its activities at short notice, it is better to buy these inputs from the cheapest reliable international source. As for the transfer of technology, the initial hopes have not been fulfilled. Many EPZ industries use technology that is universally available: labor-intensive garment production is a good example. Those that do have special information-electronics firms are the best example-guard it carefully, even from their own workers. To hand technical know-how to the locals is thought to be equivalent to handing it to one's competitors. It is hardly surprising that know- how is not readily given away; it has to be purchased. Working Conditions and Wages Working conditions in EPZS have been widely criticized by writers from industrial countries. This perspective is often combined with the claim that EPZ firms "exploit" their workers and enjoy big prof- its, at the expense of jobs back home in the industrial countries. Such arguments have usually reflected a lack of familiarity with the conditions and wages in developing countries; unless workers were better off being "exploited" in an EPZ, EPZ firms would find it impossible to hire. Useful information on the Philippines was provided by Castro (1982). In the Bataan EPZ, 74 percent of workers were female; two- thirds were with no previous factory experience; and most were between the ages of seventeen and twenty-four. Turnover rates were high; the average duration of zone employment was around three years. Most of the workers in Castro's sample were members of larger households (the average size was six members); incomes rep- resented roughly half the combined cash incomes of these house- holds. Almost half of all zone workers worked overtime. The aver- age working week was fifty-four hours. Of those who had previously had paid employment, their average earnings in the EPZ were 35 percent higher than these previous earnings. Castro concludes that there was a clear income gain from moving to the EPZ. Peter G. Warr 75 Data provided in a survey conducted by the Philippines' Ministry of Trade and Industry suggest that-allowing for differences in liv- ing costs-real wages of unskilled workers were roughly the same in the EPZ as in similar employment in the capital city (Warr 1985). Real wages for skilled workers were somewhat higher in the EPZ. Whereas unskilled workers may be drawn from any part of the country, including rural areas, skilled workers must be recruited from the capital city, requiring a premium to attract them. EPZ firms appear generally to adhere to minimum wage laws, where these exist. Firms operating within the domestic manufactur- ing sector may often avoid these regulations, but the greater visibil- ity of EPZS and their politically sensitive position make violations of minimum wage restrictions more difficult. The Welfare This section considers the benefits and costs of an EPZ, as experi- Economics enced by citizens of the host country by c omparing the observed of EPZs situation with the hypothetical results of not having a zone.5 The foreign ownership of firms and the "offshore" nature of the zones themselves suggest a simple framework for analyzing their impact on the domestic economy. This framework can be termed the "en- clave approach," following Corden (1974 and 1985). It is shown in figure 2. Figure 2 Consider (a) the flows of goods and services and the finan- cial flows between the EPZ and .4 ~Labor the rest- of the world and (b) the Intermediate goods Raw material flw between the EPZ and the Processed goods < Capital goods flows between the EPZ and the host country. The essence of the Rest Capital goods Processed goods Domestic of the Remitted profits EPZ Taxes ecoomy enclave approach is that the world Management Subsidies flows in (b) are relevant for eval- Technical knowledge Utilities uating the welfare impact of the External effects zone, but that the flows in (a) are not. EPZ firms purchase intermedi- ate and capital goods from abroad, which results in outflows of foreign currency.6 In vertically integrated firms these transactions occur within the firm, giving rise to questions of transfer pricing. The firm may also repatriate profits to its parent abroad. These transactions are irrelevant for an evaluation of the welfare effects of the zone, except insofar as they affect the domestic economy. The issue of transfer pricing provides a good illustration. Suppose that (as is often the case) there is no profits tax on EPZ firms. Transfer 76 Research Observer 4, no. 1 (January 1989) pricing influences whether a firm's profits will be recorded in the host country or elsewhere. But, so long as these profits are earned by the EPZ firm, whether they are realized in the host country or abroad and whether they are repatriated or retained by the EPZ firm are irrelevant for economic welfare in the host country. But if profits are taxed within the host country, transfer pricing affects the size of these taxes and becomes highly relevant. Economic conditions in an EPZ are generally less distorted than those elsewhere in the domestic economy. Nevertheless, this does not imply that the net outcome of the real and financial flows in figure 2 neces- sarily raises welfare in the host country. Only a detailed examination of the benefits and costs can resolve this question. The next section looks at each of the main links between EPZ firms and the domestic economy and its welfare significance. Components of a Benefit-Cost Analysis of EPZs PROFITS AND LOSSES. Most EPZ firms are foreign-owned. Their profits or losses, to the extent that they are retained or incurred by the firms themselves, do not enter our calculations directly. The domestically owned profits and losses (if any) properly belong in an evaluation of the zone, but they can seldom be estimated satisfacto- rily from the available data. To the extent that such data are col- lected, they are unreliable, but they do suggest that the profits of domestic firms are only a minuscule proportion of the overall bene- fits from EPZS. So, for the purposes of this study, the profits of domestically owned firms will be omitted. FOREIGN EXCHANGE EARNINGS. Public discussion of EPZS places considerable stress on the foreign exchange earnings derived from the zones, reflecting the presumption that these earnings have direct welfare relevance for the host country. In fact, however, the foreign exchange earnings of foreign-owned EPZ firms merely constitute transactions between these firms and firms abroad. They have no direct effects on the economic welfare of domestic nationals. Re- gardless of the difference between a firm's officially declared exports and imports, the corresponding amount of foreign exchange remains the property of the firm itself (leaving aside possible taxation for the moment). The money may be: a. held in liquid form in foreign exchange accounts, whether inside or outside the host country b. used to buy imported capital equipment c. converted into the domestic currency to be spent on wages and purchases from the local economy. Peter G. Warr 77 Item (a) is of little welfare importance and reduces to a decision as to where the firm chooses to do its banking. Item (b) can also be disregarded if the imported capital equipment is ultimately disposed of abroad or scrapped. Only item (c) has welfare importance, be- cause there may be a net benefit to the h,ost country from these purchases. To purchase raw materials and services from the domestic econ- omy and to hire local workers, EPZ firms must convert their foreign exchange into domestic currency. This is done through the central bank at the official exchange rate. The question is therefore whether the social value of the foreign exchange received by the host coun- try's central bank exceeds the value of the domestic currency the firms obtain in return. The value of the foreign exchange means the domestic value of the extra traded goods and services the host country may absorb as a result of its extra foreign exchange hold- ings. The value of the domestic currency given to EPZ firms means the domestic value (opportunity cost) of the domestic factors of production and intermediate goods and services purchased by EPZ firms with the money. When exchange controls and domestic pro- tection imply that the social value of foreign exchange in terms of the domestic currency exceeds the official exchange rate, the re- quirement that these conversions must be made through the central bank at the official exchange rate constitutes, in effect, a form of taxation. The firm's true foreign exchange earnings will presumably differ from their conversion of foreign exchange into domestic currency. Transfer pricing may be one mechanism by which this profit is realized, but to measure the host country's actual gains, the firm's actual foreign exchange conversion is the rel[evant statistic. EMPLOYMENT. The concern that host country governments have for the jobs created by an EPZ presumably reflects their view that the social benefits derived from generating an additional job out- weigh the costs. In other words, the wage received by a worker is considered to exceed the social opportunity cost of employment in the zone. However, it is difficult to measure the relevant opportu- nity cost. Wages in the zones are normally equal to, or slightly above, wages in comparable employment outside the EPZ. Neverthe- less, estimates of the social opportunity cost (the shadow price) of unskilled and semiskilled labor commonly suggest that it is less than wages paid in manufacturing. A difficulty in applying these estimates arises in relation to the transfer of skills to EPZ employees. The estimated value of such skills could in principle be incorporated either by reducing the pa- rameter of the estimated opportunity costs of labor or by increasing 78 Research Observer 4, no. 1 (January 1989) appropriately the parameter of the wage received. But, lacking de- tailed estimates of the value of these transfers, there is no solid basis for making such an adjustment. Consequently, some arbitrariness cannot be avoided. TECHNOLOGY TRANSFER. Administrators of EPZS agree that there have been few significant transfers of technology and skills from EPZ firms to the domestic economy. Those firms with the technical knowledge from which local firms could benefit (most notably elec- tronics and electrical companies) have been isolated from the do- mestic economy. Little of their raw materials and capital equipment has come from local suppliers. In retrospect, the early expectations that much technology would be transferred were naive. To the ex- tent that intermediate products are internationally traded, EPZ firms will buy from the cheapest reliable source. Managerial practices and notions of quality control are inevitably transferred to the local middle managers whom EPZ firms employ. These managers can eventually obtain significantly higher salaries in domestic industry than they could after a similar period of em- ployment elsewhere. This suggests that the training they receive confers a benefit to the domestic economy, which may not be fully captured in the wages they receive in the EPZS. One way of treating this issue is to say that the social opportunity cost of the employ- ment of these workers in the EPZ is lowered by such training. These externality effects can be incorporated in principle by lowering the parameter of the opportunity cost of labor. DOMESTIC SALES. Almost all of the output of EPZS must be sold abroad, but domestic sales are permitted when, for example, fin- ished consumer goods are rejected by foreign buyers. Such sales are typically treated as imports, and duty must be paid at the normal rate. The net value to the host country of the goods consumed is the value at c.i.f. prices of the imports which would otherwise have occurred, which is also the net price actually paid to the EPZ firm. Thus, as these sales have no net welfare effects, they can be ignored in the benefit-cost analysis. PURCHASE OF DOMESTIC RAW MATERIALS AND CAPITAL GOODS. Governments typically encourage EPZ firms to use domestic raw materials, intermediate inputs, and capital goods. This can be inter- preted to mean that governments believe that the prices paid by firms for these materials exceed the marginal social costs of supply- ing them. Local raw materials and capital goods generally compete with imported substitutes, and the duty applied to these imports provides the basis for estimating the difference between the social Peter G. Warr 79 opportunity cost of providing these imports (their border c.i.f. prices) and the prices paid (tariff inclusive). When EPZ firms receive a rebate from the host government equivalent to the duty that would have been paid on these imported inputs, there is no net welfare effect from their purchase by EPZ firms. USE OF ELECTRICITY. EPZ firms, especially garment and textile pro- ducers, are big users of electricity. The benefit-cost analysis must compare the tariff rates paid with estimates of the long-run marginal cost (LRMC) of supplying extra power. If the average tariff exceeded the LRMC, the electricity used by EPZ firms would entail a net tax- or, in the reverse case, a net subsidy. DOMESTIC BORROWING. Foreign investors are sometimes allowed to borrow on local capital market, perhaps with a government guarantee. This arrangement would be unimportant if the local capital markets was open to international capital flows: borrowing by EPZ firms would then simply induce inflows of private capital from abroad and would not displace local investment. However, when local capital markets are closed and interest rates sup- pressed-a combination present in Latin America (Diaz-Alejandro 1970) and the Philippines-the analysis is different. The implication is that the domestic output forgone as a result of additional borrow- ings by (foreign) EPZ firms exceeds the compensation received from them in interest and principal repayments. To put it another way, the shadow price of capital exceeds its market price. TAxEs. Although taxes raised from EPZ firms are generally small, they are a clear benefit for the domestic economy: without the zone, there would be no taxes. Firms that move to a zone from elsewhere in the host country or foreign firms that would have entered even without a zone are exceptions, but unimportant ones. Most firms are foreign and, according to managers, few would have invested in the host countries without the EPZ incentives. Taxes are therefore counted as a net benefit to the host country., The low rates of company income tax offered by host country governments to attract foreign firms into the EPZS sometimes achieve this goal. Some foreign investors legally reside in countries that allow their firms to credit taxes paid abroad against taxes due at home. The United States is such a home country. In these cases, a tax holiday for firms investing in the EPZ may merely transfer reve- nue from the treasury of the EPZ country to that of the investor's home country. 80 Research Observer 4, no. 1 (January 1989) DEVELOPMENT AND RECURRENT COSTS. The establishment of the zone site, its maintenance, and administration all represent eco- nomic costs-and in principle should be evaluated at shadow prices. In the absence of disaggregated data, however, it is necessary to rely on financial costs. Against these costs are the rents and other charges received from EPZ firms, not counted elsewhere in the analysis. Estimates of the shadow prices of labor, foreign exchange, capi- Evidence from tal, and so forth are available for most developing counties. Their Four Asian quality varies widely, but the best estimates for each country were: Countries * Indonesia: Hughes (1983), Pitt (1981), and Munasinghe (1980) * The Republic of Korea: Koo (1981) and Nam (1981a and 1981b) * Malaysia: Veitch (1977, 1979, and 1984) * The Philippines: Medalla and Power (1984) and Manalaysay (1979). These studies provided the basis for the shadow prices, but they were sometimes updated, corrected, or amended to a form more suit- able for evaluating EPZS. Table 5 summarizes the information as ratios of the estimated shadow prices to market prices. Table 6 shows the contributions of each of the major benefit cost categories to the aggregate net present value (NPV) of the EPZS. Costs appear as negative items. For consistency, the calculations assume a real discount rate of 7.5 percent and a life for the EPZ of twenty-five Table 5. Estimated Ratios of Shadow Prices to Market Prices Category Indonesia Korea Malaysia Philippines Labor 0.75 0.91 0.83 0.64 Foreign exchange 1.O00 1.08 1.11 1.25 Domestic raw material 0.85 0.92 0.90 0.96 Domestic capital equipment 0.85 0.98 0.91 0.96 Electricity 1.05 1.33 0.93 1.30 Domestic financial capital n.a. n.a. n.a. 1.58 n.a. Not applicable. a. Hughes 1983 concluded that the efiects of Indonesia's import barriers (tariffs and quotas), which raise domestic prices above border prices, and subsidies on the consumption of traded goods (such as rice and petroleum products) roughly canceled, implying that the shadow price of foreign exchange was approximately equal to the official rate. Source: Indonesia: Hughes 1983, Pitt 1981 and Munasinghe 1980. Korea: Koo 1981 and Nam 1981a and 1981b. Malaysia: Veitch 1977, 1979, and 1984. Philippines: Medalla and Power 1984 and Manalaysay 1979. Peter G. Warr 81 Table 6. Welfare Impact of EPZs: Net Present Value (millions of 1982 U.S. dollars) Category Indonesia Korea Malaysia Philippines Employment 4 39 111 59 Foreign exchange earnings 0 65 94 72 Local raw materials 5 16 18 3 Local capital equipment 0 0 10 0 Taxes and other revenue 23 18 10 11 Electricity use -1 -13 -53 -4 Administrative costs -13 -17 -4 -23 Infrastructure costs and subsidies -3 -68 -43 -196 Domestic borrowing 0 0 0 -147 Total net present value 15 40 143 -225 Internal rate of return (percent) 26 15 28 - 3 years. The final row of table 6 displays the calculated internal rate of return for each of the EPZS. Table 7 presents the NPV computations in more convenient form, by expressing the various components as a percentage of the gross benefits of the EPZ (the sum of all positive NPV items appearing in table 6). Before discussing the results in detail, it is necessary to focus on a methodological point: the distinction between the benefits from "for- eign exchange earnings" and those from other sources. As explained earlier, the benefits attributed to foreign exchange earnings arise be- cause EPZ firms must convert foreign exchange into domestic currency Table 7. Composition of Net Present Value (percent of gross benefits) Category Indonesia Korea Malaysia Philippines Employment 13 28 46 41 Foreign exchange earnings 0 47 39 50 Local raw materials 16 12 7 2 Local capital equipment 0 0 4 0 Taxes and other revenue 72 13 4 8 Electricity use -3 -9 -22 -3 Administrative costs -41 -12 -2 -16 Infrastructure costs and subsidies -9 -49 -18 -135 Domestic borrowing 0 0 0 -101 Total 47 29 59 -155 82 Research ODbserver 4, no. 1 (January 1989) to meet their domestic costs. It is analytically possible to separate the net gains from the currency conversion from those arising from the subsequent domestic payments, as reflected in tables 6 and 7. Alterna- tively, the two can be combined-and it makes economic sense to do so. Indirectly, foreign exchange is being paid to local workers, sup- pliers, and so forth. Consider a hypothetical example: the conversion of $1,000 into Philippine pesos at the official 1982 exchange rate of P9.17 = US$1 for the payment of local wages. When the $1,000 is converted into pesos, there is a net gain to the Philippines arising from the difference between the official exchange rate and the shadow price of foreign exchange. Since the ratio of the shadow price to the official rate was an estimated 1.25, this implies a net gain of P2,290. When the P9,170 is paid to Philippine workers, there is a second net gain-from the difference between the social opportunity cost of labor and the market wage. The estimated value of 0.64 for the ratio of these two sources of gain arises from the way our shadow prices have been defined. But the two are aspects of the same phenomenon: the (indirect) payment of $1,000 to hire domestic workers. Philippine workers are indirectly earning for the Philippines $1,000 in foreign exchange, generating a net gain to the Philippines of P4,590.7 Table 8 incorporates this analysis and shows the re-estimated distri- bution of net benefits, substituting for the first five rows of table 7. The gains from "foreign exchange earnings" have been redistributed among the other benefit-cost categories. The results for Indonesia are unchanged from table 7, because the estimated net gains from foreign exchange earnings were zero (see note a to table 5). The percentage totals do not add to 100 because only part of the firms' foreign ex- change conversions can be attributed to the four categories in the table. Benefits Table 7 shows that the big gains in Korea, Malaysia, and the Philippines come from employment and foreign exchange earnings. Table 8. Composition of Net Present Value with Foreign Exchange Earnings Distributed (percent of gross benefits) Category Indonesia Korea Malaysia Philippines Employment 13 55 68 69 Local raw materials 16 14 15 3 Local capital equipment 0 0 8 0 Taxes and other revenue 72 14 5 9 Peter G. Warr 83 With the gain from foreign exchange earnings distributed as in table 8, employment accounts for more than half the gross benefits. Local suppliers and tax revenue are much less important. For these three countries, the EPZS are in effect a form of indirect labor export. For Indonesia, two unusual features must be stressed. First, an unusually high proportion of raw materials is obtained within In- donesia: primarily textiles used in garments.. By 1982 more than 40 percent of all raw materials used were bought in Indonesia. The estimated net gains from this source outvweigh the estimated net gains from job creation. The second unusual feature is the impor- tance of the "taxes and other revenue" category. Of the $22.6 mil- lion shown in table 6, property tax accounted for $2.9 million; other official taxes $0.9 million; "unofficial" taxes $25.9 million; and expenditure on the drawback scheme - $7,100.8 The "unofficial" tax item, discussed in detail in Warr (1983) and Gray (1979), represents the outcome of rent-seeking behavior by government officials. This reveals much about the way the net ben- efits from the zone are distributed among individuals and also shows that these are collected at considerable social cost. If these revenues are excluded from the benefit-cost analysis, the NPV of $15,000 shown in table 6 becomes -$11,000, and the internal rate of return also turns negative (Warr 1983). The $7,100 spent on the drawback scheme is a subsidy to the use of domestic raw materials. It is intended to counteract the effects of protection on the costs of the imports used in producing these raw materials. Since the estimated net gain from the use of these raw materials is only $4,900, the drawback provisions are costing In- donesia more than they are worth. Costs The costs of achieving the benefits are summarized by the negative items in tables 6 and 7. In table 7 they are expressed as a percentage of the sum of all net benefits. The striking features of this table both involve the Philippines: (a) the enormous infrastructure cost of the Bataan EPZ, and (b) the heavy cost of giving EPZ firms (subsidized) access to the local capital market. Each of these items is itself large enough to outweigh the sum of all benefits derived by the Philip- pines from its EPZ. Another feature is the low administrative and infrastructure cost of Malaysia's Penang Free Trade Zone. How.ever, the cost of Malay- sia's subsidization of electricity outweighs the combined benefits from the use of local raw materials and local capital equipment and all tax revenues raised from EPZ firms. 84 Research Observer 4, no. 1 (January 1989) Any cost-benefit analysis of EPZS is bound to ignore a deeper The Policy question: would it be possible to achieve the benefits available from Implications EPZS in another, more cost-effective way? For governments consid- of EPZs ering the merits of EPZS, this fundamental issue needs to be ad- dressed directly. In recent years, several of the countries that established EPZS in the 1970s have extended the right to import free of duty to firms producing for export but located outside EPZS. The duty-free raw materials are held in bond on the factory site until required for production. This change of policy-in the Philippines, Malaysia, and Korea-undermined the advantages of EPZS and showed that expensive special zones were not really necessary. The same applies to other attractions of EPZS: the simplification of customs procedures, the clarification or elimination of regulations, and the upgrading of industrial infrastructure-each could be achieved for the whole economy. And, as foreign firms frequently attest, countries need stable and clear policies to attract foreign investment. This obvi- ously applies as much outside the EPZS as within. Most of the features that have enabled EPZS to attract foreign investment could be applied outside the zones, with similar effectiveness, and without establishing special enclaves. The features of the domestic economy that impede foreign invest- ment and that EPZs are intended partly to counteract also impede the development of efficient domestic industries. If a liberalized environ- ment within the EPZS deflects attention from these matters, the net outcome could be worse than what would have occurred in the absence of the zones. The benefits from EPZS are limited. They are definitely not "engines of development." For countries in the early stages of development, zones can be an efficient and productive means of absorbing surplus labor. Even then, they will never be more than a modest part of the solution to the vast employment problems of these countries. EPZS also expose domestic businesses to examples of internationally competitive enterprises; this demonstration effect is undoubtedly valuable, espe- cially in the early stages of industrialization, as is the on-the-job train- ing of local managers. Even so, such benefits should not be exagger- ated. As industrial development proceeds, interest in EPZS tends to wane. Taiwan and Korea, having been pioneers in the establishment of EPZS in the late 1960s and early 1970s, are now much less interested in this type of enclave development. In the next couple of decades a similar change of attitude may occur in many of the countries now actively promoting EPZS. Peter G. Warr 85 Abstract Export processing zones (EPzs) are economic enclaves within which manufactur- ing for export occurs under virtual free trade conditions. Many developing coun- tries have established EPZS in hopes of reaping economic gains through employ- ment, foreign exchange earnings, and technology transfer. This article studies the benefits and costs of EPZS in Indonesia, the Republic of Korea, Malaysia, and the Philippines and reviews the relationship between the wvelfare effects of EPZs and the host country's economic policies. When the domestic economy is distorted, the EPZ confers limited welfare gains. Nevertheless, EPZS are far from the "engines of development" that some countries had initially hoped they would become. Notes This paper has benefited from the comments of W.M. Corden, Demetrios Papa- georgiou, and Marcelo Selowsky. The author is responsible for the views presented and any errors. 1. See Hamada 1974, Rodriguez 1976, and Hamilton and Svensson 1982. Ham- ilton and Svensson 1983 is a partial exception to this description. See also Balasu- bramanyam 1988 for a useful discussion of this literature. 2. Examples in East and Southeast Asia include the Republic of Korea, the Philippines, Thailand, and Indonesia. 3. For example, the proportions of firms in the Philippines' Bataan EPZ (dis- cussed later) that declared overall trading losses in their annual financial statements were: 1980, 58 percent; 1981, 81 percent; 1982, 75 percent; and 1983, 64 percent (Warr 1985, p. 12). 4. These case studies are: Indonesia, Warr 1983; Korea, Warr 1984; Malaysia, Warr 1987b; and the Philippines, Warr 1985 and 1987a. S. Our discussion will disregard income distribution within the host country. 6. To keep figure 2 simple these financial flows are not indicated in the diagram. Most of the flows shown in the diagram are accompanied by financial flows in the opposite direction, but exceptions are taxes and subsidies and external effects such as transfers of managerial and technical knowledge. 7. The aggregate welfare outcome for the Philippines would have been essen- tially no different if the $1,000 had been paid directly to Philippine workers who then converted it into the domestic currency through the central bank. 8. The negative sign draws attention to the fact that this item is a revenue outlay-a subsidy-rather than a tax.receipt. References Balasubramanyam, V.N. 1988. "Export Processing Zones in Developing Countries: Theory and Empirical Evidence." In D. Greenaway, ed. 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