The Hindu Business Line : Special Economic Zones — An idea whose time has lapsed

AMIDST the general discussion on foreign direct investment (FDI) in India and the concern about its smaller size compared to China's, comes the news that Nokia, the world's largest mobile company, has been permitted to set up a Special Economic Zone (SEZ) in Tamil Nadu to manufacture telecom equipment and mobile handsets.

The company, according to a report in this paper, expects to pump in more than Rs 650 crore into this SEZ. As far as FDI goes, that is not a big investment but it deserves mention because it is an example of a type of foreign investment, the gains from which could well turn to be less than they are cracked up to be.

Begun as a bold expedient 40 years ago in the high noon of the licence regime and fiscal controls, the EPZs (export promotion zones) in India are poor cousins of their counterparts in some Asean (Association of South-East Asian Nations) countries, such as Indonesia, Korea and Taiwan and, of course China. Mention SEZs and one is put in mind the eastern, coastal provinces of China, such as Guangdong, that have sent the country of peasants, more precisely parts of it, spinning into unfettered capitalism with dizzying speed. The SEZ was the rocket that took the Chinese to stratospheric growth.

Five years ago, the late Murasoli Maran, as Commerce Minister, returned from Guangdong with a dream that he put into the Exim Policy of 2000. Since the idea of SEZ came to this country on the back of its phenomenal success in China it seemed appropriate to morph the EPZ into the SEZ and stay tuned to a more fashionable and, successful version of the vehicle for export oriented growth. So far eight EPZs have so morphed, with the simple, crystal clear objective spelt out in the SEZ Act of 2005.

No more the woolly-headed aims of value addition, employment generation and all such remnants of the control regime. Now, the sole purpose of the SEZs is to export goods and services and earn foreign exchange. And to make it easier, an SEZ developer and enterprise can export goods or services or, simply, trade. The word `processing' that bound `export' and `zone' is now unnecessary. Small wonder then, the Commerce ministry is flooded with applications from domestic and foreign companies.

So what do blue chip Indian and foreign companies hope to get when they apply to the Commerce Ministry for an SEZ? The SEZ Act 2005 provides tax exemptions to SEZ units and SEZ developers from all indirect taxes including basic Customs duty, countervailing duty education cess and, direct taxes.

As the Act lays emphasis on providing good infrastructure at low cost for SEZ units and developers, basic inputs needed to achieve that end will attract lower duties. The Act is also mindful of the need for uninterrupted and cheap power. So power plants can be imported or procured from domestic producers without attracting any duty. Transaction costs, the nightmare of every enterprise, will also be minimised for the SEZ participants by the single window clearance at the zone level via the good offices of the Development Commissioner.

SEZs, like the EPZs before them, are supposed to develop backward and forward linkages. Presumably, that means ripple effects on job work and technology transfer to non-SEZ areas, the hinterland. But one of the prominently highlighted attractions is the complete freedom to subcontract, even abroad.

And unlike the EPZs of the caution and control era, SEZs today can engage in manufacturing, trading or service activities. Foreign investors (Nokia, for instance) will be permitted to develop townships within the SEZs with residential areas, markets, play-grounds, clubs, recreation spaces and the like. The incentives are all summed up in a single line that comes up on the flash intro on the Web site of the Commerce Ministry on SEZs. "A designated duty free enclave to be treated as foreign territory for trade operations and duties and tariffs" (http://sezindia.nic.in).

The case for the SEZs rests on the same assumptions that inspired the enclaves in the eastern provinces of mainland China and those in the newer and, poorer Asean countries such as Laos and Indonesia. The premise was that in a country bogged down by various forms of backwardness that are basically inimical to market-driven growth, the best bet is to create small islands of free enterprise for exports using cheap local labour, with a liberal tax regime and allowing unfettered entry and exit of capital to attract multinationals.

In China, the idea was a runaway success, though only parts of it — the SEZs — reaped benefits. The rest of the country became all the more poor in comparison with the self-perpetuating wealth creators of the eastern provinces.Will it work for India?

In 2000 when the SEZ took roots, India was being liberalised with the goal being to make economic activity more efficient, cost effective and profitable. Data on economic growth bear testimony to the success of policy, half-baked, reluctant or even accidental as it may have been.

With two successive quarters posting 8 per cent growth in GDP, and a strong export growth despite sluggish G7 growth rates, what magic can the SEZs pull off that the rest of the economy, without those special order privileges, cannot?

A study of EPZs/SEZs by Aradhana Aggarwal of ICRIER in New Delhi highlights the failures of the special enclave to meet any of its objectives.

Titled "Export Processing Zones in India: Analysis of the export performance" the report — a timely intervention in the rather thin debate on SEZs as a vehicle of export led growth — focuses on the interplay of exports, employment, imports and value addition, and examines data for the period between 1966, when the first EPZ was set up, and 2003, a year after the Exim Policy introduced the notion of SEZ and a year before the draft SEZ Bill was written.

The results are interesting to say the least. Exports grew over the period under review, but in absolute terms. A look at the share of EPZ exports in total manufactured exports presents a different picture. The average annual growth rates of EPZ exports declined continuously over the years, falling steeply over the period from 77 per cent in the first phase (1966-1980) to 7 per cent by 2001-2003, the fourth phase. Ms Aggarwal attributes the decline to a possible slow growth in the size of the EPZs.

Employment, as a measure of expansion, she says, grew absolutely. But the average annual growth rate shrank continuously. "This was despite the fact that four new EPZs became operational in the late 1980s and another EPZ at Vizag came up in 1994." So, after an initial expansion, the momentum slowed.

Productive efficiency is a better indicator of export growth than simple employment size. The results were equally disappointing for efficiency, which measured as rate of exports per unit of employment especially after 1980, also declined despite the addition of new EPZs during the 1980s.

Foreign exchange earnings, as Ms Aggarwal reminds the reader, are the most important benefits to be expected from the EPZs. In absolute terms, the export earnings look very impressive. It is when you look at the rate of growth that the picture gets bleaker with the figure actually declining. But in the study,value addition, that ratio of net foreign exchange to exports, did not record any appreciable increase.

While the new Act confers a more liberal dispensation on the SEZs than what the old EPZs have enjoyed, the overall advantages of preferential treatment may be illusory. More pertinently, after four decades of preferential treatment and two decades of economic reform, the record of the EPZs stands in contrast to the performance of the general economy.

For one, the rest of the country has always done better than EPZs without the privileges that the zones enjoyed. For another, economic reforms are turning fiscal incentives more universal in their application. SEZs, therefore, may not enjoy those advantages for too long.

In any case, preferential taxes may be actionable under World Trading Organisation laws. WTO rules permit border tax adjustments, some duty drawbacks and exemptions but the management of these may prove difficult; lapses in bookkeeping, for instance, may attract countervailing duties under WTO rules.

Ms Aggarwal draws the conclusion that a system of tax incentives contingent on export performance may prove to be "unsustainable" in fact and law. She attempts to hold up the SEZ as a workable proposition and suggests some changes that appear at odds with her research on their working.

Far better to turn the entire country into a SEZ.