Special Economic Zones and prospects for Sri Lanka

Port City Colombo

The motivation for Special Economic Zones, also commonly referred to as SEZs, stems from an innovative idea: to overcome distortions in policy and infrastructure constraints in domestic economies. 

Of course, it would have been a tedious job to sort out all the issues which hindered the way forward of an economy., These concerns gave rise to the idea that creating “islands of excellence” would beone way to achieve the desired economic goals. 

These islands of excellence create a closed system wherein investors can feel secure in the absence of an adequately functioning market. To maintain investor confidence, property protection isa key element, particularly in an environment of unstable and shifting politics.

Although most would say that Special Economic Zones, as a tool to boost economic growth in countries the world over,isa novel idea which came into being in the 50’s, a deeper look indicates that the concepts date back to 1937, with the first such Special Economic Zone being launched in New York.

Once the idea took hold, there have been a host of other countries that experimented with this idea; Puerto Rico being the second, followed by Ireland (Shannon) and so on as many countries followed suit immediately after the Second World War.

However, countries must seriously contemplate the risks involved in the operation of these zones. Many economists and experts have cautioned governments of potential dangers associated with governance in 
the zones. 

“Our thinking is that SEZs can be major engines for national development but they must be structured very carefully as they cannot be islands unto themselves – you have to consider them in a more holistic way as to how they would be integrated into the national economy

There is the potential for unforeseen problems cropping up from time to time over issues relating to under-invoicing and over-invoicing linked to money laundering. 

Although it is rather difficult to determine how funds obtained through money laundering are being utilized, it is the unequivocal responsibility of the government to set up monitoring mechanisms to investigate potential money laundering aspects of SEZs. As corruption has led to the downfall ofmany SEZs around the world, controlling bureaucracy and corruption is vital to achieving success.

The Pathfinder Foundation in its quest to examine pertinent issues with multitudes of advantages and disadvantages as well as other issues associated with the Special Economic Zones spoke to two specialists from the Centennial Group International Team: Dr. Rajat Nag and Dr. Anthony J. Pellegrini. Both these experts answered many pressing questions relating to the development of SEZs and to shed some light on the pros and cons ofsuchdevelopment, with a special emphasis on the Colombo Port City. The interview follows.

Special Economic Zones first came into being in the 1950s in Ireland. Can we talk about the historical aspects of its development as well as risks involved in SEZ policies with special emphasis on low-income countries?
Dr. Rajat Nag first outlined the historical aspects of SEZs by describing how the first Special Economic Zone was actually set up in 1937 in New York. Shannon in Ireland followed in 1958.After that, a host of developing nations joined with the motivation of improving their economies through Special Economic Zones in their respective countries. 

“It is not good enough to only have laws. They need to be satisfactorily implemented and that is where many countries have fallen well short and the SEZs have thus not been very effective

Dr. Nag states that the basic questions these nations asked themselves were: “can we get an increase in FDI (Foreign Direct Investment) into our country? Can we get our exports going? And the SEZs were a means to do so”
RN: “India was one of the first developing countries to start a SEZ at Kandla Port back in 1965. Many others followed and now, I believe, there are about five thousand Export Processing Zones in more than 130 countries around the world. 

Of course, none is a bigger success story than China’s first Special Economic Zone: the ‘miracle of Shenzhen’. This was a very wise way of experimenting with some fundamental economic reforms that the Chinese leaders wanted to bring in. It was almost alaboratory setting to test out how the new policies of market liberalisations would work before they tried them out on a larger scale around the country. The rest, as they say, is history. The Shenzen experiment was a huge success and was at the root of Chairman Deng Xiaoping’s gradually opening up of the Chinese economy and the dramatic Chinese growth story. 

Besides China, Korea was yet another early success story. 

When talking about the successes of SEZs, Dr. Nag said yes,there have been many success stories – China, Korea, and Malaysia, for example –but he cautioned that there have beenmany SEZs which have not been verysuccessful. Certainly, a very mixed bag, he said. 

He noted that while it is easy (and tempting) to be swayed by these successes, there are literally hundredsaround the world that failed to make their mark. The SEZs are not cost free: Governments offer incentives (tax breaks, free and easy access to land etc) thus foregoing tax revenues and simultaneously creating distortions within the domestic economies. 

“The masterplan done by Skidmore, Owings & Merrill characterizes Port City as an extension of the Central Business District (CBD).The plan sees Port City as a place with a high standard of urban amenities, with a focus on commerce, finance and tourism.There is no special focus in the plan on its link to the port, nor any discussion of Port City as a trading hub

There are several governance issues, such as money laundering through the SEZs. Labour laws are yet another area of concern.You try to ring-fence companies from domestic labour laws to attract foreign investorsandwhile they might create employment opportunities, the labourers working within these enclaves might not enjoy the same protections as those working in the local economies. 

RN: “Our thinking is that SEZs can be major engines for national development but they must be structured very carefully as they cannot be islands unto themselves – you have to consider them in a more holistic way as to how they would be integrated into the national economy.

“The principal motivation in development of SEZs since‘50’s was to somehow get around the domestic economic distortions and severe infrastructure deficiencies by creating ring fenced islands where such constraints would be alleviated. 

“This worked for a while, particularly in attracting manufacturing options. China, Korea, Taiwan all followed this model quite successfully. However, as countries moved up the economic growth path and ventured more into services and other sectors of the economy, such a model didnot work as well. 

Many countries in the world have set up SEZs to ensure rapid economic growth. What are the most prominent countries that have been successful in achieving their desired economic goals and what are the risks of SEZ policies in low-income countries?

Dr. Anthony Pellegrini, the other expert on SEZs, volunteered to answer the question.

AP: “Let me start with South Korea. The thing I would say about South Korea that distinguishes it from other countries is that Special Economic Zones in S. Korea are very tightly connected to local businesses surrounding the SEZs and in fact connected to local business throughout the country. As a matter of policy, the government very actively encouraged backward linkages from foreign companies that were located in SEZs to local Korean suppliers.Policy support was provided to facilitate such linkages, including technical assistance to helpdomestic businesses to take advantage oftechnologytransfers and facilitate Korean workers to learn new skills.

“Some other countries that had been successful include China, Vietnam, Taiwan, Mauritius, the Dominican Republic, El-Salvador, and UAE .

“There is no single approach utilized by all successful SEZs, but there are patterns. I will identify some of the distinguishing factors that had been utilized by individual countries that made their SEZs successful.

“Dr. Nag already noted that in China, the first SEZ was opened in Shenzhen in 1980. At the time Shenzhen was a small village.Forty years later, it has becomea huge city with a population of 12 million people.Shenzhen is more than just a manufacturing zone.It is more than just an export-processing zone. It is an example of how China used SEZs as a way of testing new economic policy. You will remember that back in eighties, China was opening to the world and testing the concept of the market approach. Creating Special Economic Zones was the way that Premier Deng Xioping was able to do that without opening the entire country to this new approach, which would have been very risky.

“China even now uses SEZs as test beds.When they are considering a new policy and they are not yet prepared to try it around the country, they will establish a new SEZ . There are many SEZs in China with different characteristics, which have tested different policies. As just an indication of the success in China, the World Bank has estimated that SEZs have been able to contribute 22 percent of Chinese GDP, 45 percent of total national Foreign Direct Investment and 60 percent of Chinese exports.

“Some estimates show that China currentlyhas over two thousand SEZs. 

Mauritius is another example often mentioned as being successful; Their focus is not exclusively on attracting foreign businesses.Their focus is mainly on stimulating local businesses. Domestic businesses are an important component of the companies that are part of the Special Economic Zones.

Employment in Mauritius’ SEZs reached nearly 90,000 people in 1989, helping to reduce unemployment to less than 3 percent as against more than 14 percent in 1984. 

“The Dominican Republic in Latin America is another example. They have some 600 firms working across 60 industrial parks employing 140,000 workers.The SEZs started with textiles, but were successful in shifting to higher-tech products. 

The SEZs in the past accounted for 80 percent of all exports. That is now down to 50 percent, which is a positive development because it reflects the positive effects of shifting regulations in favour of the domestic economy. They applied the lessons they learnt from the SEZs to the rest of the economy and that benefited the domestic firms outside the SEZ so that the percentage of total exports attributable to SEZs declined.”

What risks do countries face in initiating SEZs? 
Speaking on the risks involved in SEZs, Dr. Pellegrini said one of the most common risks is the assumption that any location can be turned into a successful SEZ by offering good infrastructure along with tax holidays and other financial benefits–This is really not the case.

AP: “Each SEZ proposal involves a location with its own special advantages and disadvantages. Each location requires a different set of policies. The challenges are not onlyphysical and financial but also social. It is necessary to determine what you are trying to do, and whether what you are trying to do is manageable with the resources at hand. 

“Another point, the importance of which was highlighted in the successful examples S. Korea, Mauritius and Dominican Republic, is that many unsuccessful countries have not taken steps to promote forward and backward linkages to the rest of the economy. In the end, those linkages are critical to the national economy, and it is important for the success of SEZs that planning for linkages takes place in advance. 

As part of that, many countries give formal thought to SEZ as ‘learning laboratories’ –especially learning laboratories for new policies. In order to derive full benefits from the SEZs you must learn from your experiences and try to apply the lessons learned to the rest of the economy; it will not happen by chance. .

“Another issue involves tax holidays.When these are only available for foreign investors, the domestic investors invariably face a disadvantage.This can be both a political and an economic problem.. It is important to keep in mind that, , whatever you are doing in terms of financial benefits you have to consider how they comport with WTO (World Trade Organization) rules. The WTO discourages various types of discrimination and countries do have to respect the WTO rules.

“Another risk is planning infrastructure without being realistic about the magnitude of the infrastructure need, There have been many SEZs especially in Africa where infrastructure was promised but where there was lack of realism between the infrastructure promise and the costs of providing the infrastructure.. There needs to be a careful assessment of the infrastructure plans and a realistic review of financing needs.

“Another serious risk is the inability to monitor and control bureaucracy and corruption.This had been the reason for downfall of SEZs in several countries, where the selection of businesses was not very transparent.

“The experience is that where corruption had been rampant, many good companies have decided to keep away from investing in the SEZs. Hence, SEZs really do need competent management that can handle challenges.Investment promotion is a major responsibility of the SEZ management, and this requires leadership skills.”

RN: “Another very sensitive and challenging area for the development of SEZs is land acquisition.Huge tracts of land (usually in prime locations close to a port) need to be acquired by the national and sub national governments and made available to the SEZs. 

“There are the immediate challenges of acquiring such lands and often in the excitement of announcing the establishment of SEZs, these are downplayed or left for later causing significant delays in implementation and increased costs. Land acquisiton has been a very politically difficult and sensitive issues for many SEZs in India and many other countries. There are also very complicated governance issues of ownership of such land: either freehold or long term leases. 

“As I noted earlier, SEZs haveoften been a lucrative conduit for money laundering. In their desire to attract foreign investors to their SEZs, many countries make significant concessions not only on taxes but also on the labour side. They might, for example not insist that minimum wage lawsor safety regulations would apply in the SEZs .The stunning success of thegarment industry in Bangladeshhas suffered from this wherethe SEZs shielded the investors from trade union activists.

“SEZs are sometimes considered or portrayed as ‘Islands of Excellence’. However, I believe the only way that SEZs can ultimately be judged successful ( andthus meaningfully contribute tonational development)is when theybecome integrated with the economy of the host country and are not an island unto themselves.

“Ultimately, the ideal situation is that the whole country becomes an SEZ,with the right policy and adequate infrastructure etc. The SEZ’s are created ascarve- outs but ultimately SEZs must be integrated with the host country. In many countries, as we have noted, SEZs have remained as islands, and that is not a marker of success.”

In your opinion are SEZs effective in driving private-sector development?
AP: “Under the right conditions SEZs have been successful in attracting private sector investments.They have brought specialized skills, along with new technology.

“South Korea and China haveused SEZs to stimulate the domestic private sector, paving the way for skills to be transferred to domestic employees. When domestic employees of foreign firms change jobs to join domestic companies, the process of skills transfer is accelerated.

“The success of SEZs is not automatic. Governments need to be strategic as to how the policies and incentives are designed so that the domestic private sector is a beneficiary.”

Prime Minister Mahinda Rajapaksa, during his budget address, told parliament (November 18) that he expects to present to parliament a new legal framework conducive to promote commercial services and investment in the Special Economic Zone in January 2021. What are your views on how useful this would be for Sri Lanka?And Should the proposed SEZ be treated as a foreign entity within the Sri Lankan legal framework or should it be modelled under a different set of laws with administrative structure free from constitutional control in a bid to espouse economic growth?

“Without a doubt an adequately robust legal and regulatory framework is needed for Special Economic Zones.That is the starting point, but these are only necessary conditions and not sufficient. We have earlier discussed those sufficient conditions,’ in terms of infrastructure, good governance, implementation designing etc.

“However, it is not good enough to only have laws. They need to be satisfactorily implemented and that is where many countries have fallen well short and the SEZs have thus not been very effective. 

“Dispute resolution is particularly relevant in this context. SEZs need to havea clearly laid out dispute resolution mechanisms and of course, in the end this becomes a question of trust and confidence in those. 

“We feel that SEZs should not become islands unto themselves, they should be ultimately a part of the whole economy, and therefore we feel that SEZs should not be modelled under a different set of laws, with an administrative structure free from the country’s constitutional control, etc. It should not be extra-territorial.

“When you relax your labour laws to make them more attractive or when you dilute your environmental compliance requirement or when you give access to credit at less than market rates,these distort the domestic economy andcan be counterproductive. 

In summary, a country should be governed by only oneset of laws and an SEZ should be part of that country’s legal and economic framework and not outside it.”

Would Sri Lanka’s exclusive geographical location be an added advantage to attracting Foreign Direct Investments to the proposed SEZ?
RN: “Obviously Sri Lanka’s geographical location is helpful as it islocated at the intersection ofvery important sea routes. However, I believe thatinvestors would decide based on the merits of the SEZ in Sri Lanka as a whole: the incentives, site readiness, infrastructure facilities, labour availability both in terms of quantity and quality.Location is just another factor, important as it might be.The applicable laws, rules and regulations, the confidence in their fair and speedy implementation and the dispute resolution mechanisms which will be in placewillobviously also be important considerations.

What could be the role of the Stock Exchange to give a new impetus to investments?
AP: “Stock Exchanges are an essential building block for facilitating business investment. Robust financial markets depend on the stock exchange. In Sri Lanka’s case, the stock exchange is currently the smallest exchange in the region, at least in absolute terms.

“The limited size and the limited liquidity of the Stock Exchange could be a constraint for some of the development that is expected to take place in the Port City. However,the Port City is a very big development where a number of big developers are proposing to come in and most large foreign investors would come with their own financing.In fact just a few days ago,Browns Investments came in with a proposed financing for the development of the International Financial Centre within the Port City.

“Given that, I think the Stock Exchange would be most useful fordomestic investors, who have potential projects either inside the SEZ or outside and related to the SEZ or those who would partner with foreign companies. 

“I should mention,with regard to access to capital, that the World Bank prepares a report called ‘Doing Business.’It is a report that rankscountries on a number of different factors that indicateshow open the countries are to private sector business. For Sri Lanka, one of the areas where it is significantly behind other countries is access to capital.Under these circumstances it makes sense to give priority and importance to the development of the Stock Exchange.”

What are the global good practices of SEZ development that Sri Lanka could learn from?
Dr. Pellegrini mentioned that both he and Dr. Rajat Nag earlier outlined the risks involved in SEZs.The global good practices arefor the most part the opposite of the risks.

AP: “At the risk of being repetitive, I would mention several global good practices.

“First, there should be clarity of purpose and focus. Every SEZ is different. The proponents of an SEZ need to be able to explain what the need is, that the SEZ is intended to fill. How will the SEZ respond to that need? What is the synergy with the local surrounding environment? What is the synergy with national plans and regional plans?
“Second, successful countries treat SEZs as an opportunity to test innovation, to test new policies to see what policies may work, and, if they are successful, to apply them outside the SEZ for the benefit of the domestic economy. 

“Third, the need for good infrastructure is widely recognized, but despite this recognition, it is sometimes a stumbling block. Good infrastructure is needed both within the SEZ zone and outside to connect the SEZ with its surrounding business environment and to connect it to an airport or port. Good infrastructure also requires that the financing of infrastructure be addressed professionally. 

“Fourth, Financial incentives to investors need to be carefully designed. A cost benefit analysis that balances the potential gains against the foregone revenue can be useful.

“Finally, I will mention good governance and management that is free from bureaucracy and corruption.”

Does Sri Lanka need foreign policy adjustments to strike a balance between the regional superpowers or can it remain a neutral entity as a nonaligned nation under the given political context?
RN: “This is always a challenge for all countries and Sri Lanka’s situation is no exception. Countries need to have a nuanced, balanced policy determined from the perspective oftheir own national interests.”

What are the chances of converting the Colombo Port City into an exclusive trading hub covering a large swathe of the Indian Ocean under the current geopolitical environment where the regional superpowers are competing for economic and strategic presence in the region?
According to Dr. Pellegrini this is an interesting and pertinent question given the present global environment in relation to trading and business competitiveness.

AP: “A proper analysis requiresa comprehensive study of the expected development of the Portas well as an assessment of the planned development of Port City.Of course, we did not have a chance to do that. So my response will focus on outstanding questions rather than definitive answers.

“The question of Port City becoming a trading hub depends in part on how the growth of the Port itself will continue.I think that everybody knows that the Port has done very well,that it has a unique regional position,and that it was ranked in 2018, as the fastest growing port in the world–for at least part of that year. 

“But the question that is posed recognizes that the regional powers are competing.It is well known that India is seeking to increase its own capacity to handle transshipment and they are working with the Dubai Port on that.
“I have also read that internally there are discussions within Sri Lanka about the slow pace of infrastructure development within the port, especially in respect of needed new terminals. These two factors, i.e. competition and management of port development, will affect port growthand its role in the Region. But many variables are at play.
“Assuming that the Port continues its growth, the question then becomeswhether the adjacent Port City development zone will become a trading hub. Now when I look at the master plan, the link to the Port is a key question. 

“The masterplan done by Skidmore, Owings & Merrill characterizes Port City as an extension of the Central Business District (CBD).The plan sees Port City as a place with a high standard of urban amenities, with a focus on commerce, finance and tourism.There is no special focus in the plan on its link to the port, nor any discussion of Port City as a trading hub. 

Some developers will see in the Port City plan, its potential to be a successful commercial and financial center. This begs the question of the extent to which commerce in the Port City would be linked to development in the port and to trading. To-date I have seen no study of this question.