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Special Economic Zones: Opportunities and Pitfalls

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What are Special Economic Zones?

Special economic zones (SEZs) are areas in which governments offer fiscal and regulatory incentives to businesses to drive economic growth, often creating win-win scenarios for investors and economies at large.

When a government creates an SEZ, it differentiates the rules within the zone from the rest of the country. These rules often include reduced tariffs, lower taxes, and regulatory exemptions. A country with strict labor laws, for example, might loosen those laws in a specified area and designate it as an SEZ.

There are various types and sizes of SEZs. Some are so small they occupy but a single floor of a building; others span entire cities. The most ubiquitous zones are industrial parks, called “export processing zones,” where most, if not all, of what is produced within the zone is exported.

From an investment perspective, SEZs are important because they affect the business climate in which companies operate.

Smaller zones tend to not have residents living within their confines. Others can comprise entire populated communities. China may be the best example of a country with expansive SEZs. Shenzhen, previously a small fishing village, has grown its population to more than 10 million since being designated an SEZ in 1980.

The first zone may have been established in 166 BC on the Greek island of Delos. The island drew many visitors as a holy sanctuary, but its natural resources could not support its growing popularity. As a result, Delos was designated a free port, allowing goods to be imported tariff-free.

The modern SEZ model has evolved since Delos, emphasizing manufacturing and exports rather than tariff-free imports. The first of these modern zones was introduced in 1959 when Ireland's Shannon Free Zone, a 600-acre international business park, was opened adjacent to the Shannon Airport. Growth of SEZs was initially sluggish, but the success of zones in China sparked an increase in the 1990s. Today, there are more than 3,000 zones worldwide.

What Are the Benefits?

Typically, SEZs are designed to attract foreign investors, which in turn should lead to increased employment, production, and exports within the SEZ. Residents may benefit from employment opportunities and more economic activity overall. The government can benefit too, since more economic activity can increase government revenue despite business-friendly incentives such as lower tax rates.

In addition to fiscal incentives, investors who participate in an SEZ may also benefit from a reduction in administrative red tape as governments often attempt to streamline bureaucratic processes, such as applications and approvals for doing business.

What Are the Risks?

Critics of SEZs rightly point out that they are discriminatory by nature and may be susceptible to corruption. SEZs allow governments to extend privileges to certain investors and potentially to friends and family or companies that offer bribes. The smaller a zone is, the easier it is to engage in this kind of corruption. If, for example, a company on one floor of a building is designated an SEZ, it is difficult to tell whether this arrangement is in fact an SEZ or simply a targeted tax benefit.

What Makes an SEZ Successful?

While growth within SEZs is visible, the true success of the SEZ can be hard to gauge. When comparing an SEZ to its adjacent area, it may be easy to conclude that the SEZ is successful because it has more employment and investment. But in reality, the zone might actually be diverting resources from the rest of the country. While investment and people move into the zone, the creation of the zone itself may not have generated more economic activity in aggregate.

The most relevant factor in an SEZ's success may be its size. Larger zones where people actually live create communities that can integrate with the surrounding economy, often facilitating a transfer of technology. Korea's Songdo International Business District is a good example of this.

Besides being designated a “smart city,” it hosts a university campus hub. Korea is thus using the SEZ model to drive innovation and the transfer of human capital. This is very different from the industrial parks found in many developing countries that attract investors on the basis of cheap labor.

Economic Reforms vs. Politics

If SEZs really are beneficial, why do governments limit zones to a specific city or region? The answer, quite simply, is politics. In essence, SEZs may allow a government to look as though it is open to trade and thus gain political clout internationally. Meanwhile, it can maintain protectionism in the rest of the country, and thus benefit through the non-productive practice of trading exemptions from protectionism for favors and bribes.

Yet SEZs can also be a tool for political minorities to promote true liberalization. An example of this can be seen in China. In the 1970s, China had an extremely restrictive investment climate, which a group of Hong Kong businessmen with interests in China were seeking to change. While their interests of country-wide liberalization were not plausible, they did succeed in obtaining a liberalized zone where they could conduct business.

Once an SEZ starts growing, even its critics may realize the opportunities that zones can offer and choose to initiate more of them. As more SEZs are created, it may become obvious that reforms are beneficial and should be implemented countrywide. In China, as SEZs proved that foreign capital was more beneficial than harmful, the authorities moved to implement more liberal policies in the rest of the country.

Investment Implications

SEZs affect the business climate in which companies operate. When analyzing a company, analysts should not only study indicators like the level of economic freedom in the country as a whole but also note whether the company operates in an SEZ, where the business environment may be very different from that of the rest of the country or region. Additionally, countries that initiate promising SEZs have the potential for faster future growth.

Thus far, SEZs have relied primarily on fiscal incentives, but in the future their development may be driven more by regulatory incentives. Instead of simply lowering production costs, reduced or improved regulations may provide new opportunities for innovation and high-tech development.

Interestingly, populism, which is widely spread in the world today, may also drive the growth of SEZs. One feature of populism is nationalism, which leads to protectionism. And with increased protectionism, investors tend to demand more exemptions like those offered in SEZs.

That is actually how SEZs emerged in the United States. During the Great Depression, the Smoot-Hawley Tariff Act of 1930 discouraged shipping into and out of the country. In response, companies lobbied for zones that could function as if they were outside the customs borders, thereby allowing merchandise to be loaded and unloaded in certain areas without incurring tariffs.

SEZs offer opportunities for manufacturing, innovation, and real estate investments. Any investor studying a country, industry, or company may want to consider the impact of SEZs and the fiscal and regulatory benefits they have to offer.