International Experience with Special Economic Zones (sezs): Using sezs to Drive Development in Countries around the World

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International Experience with Special Economic Zones (SEZs): Using SEZs to Drive Development in Countries around the World

Theodore H. Moran

October 2011

Report Commissioned by CDE

October 25, 2011

International Experience with Special Economic Zones (SEZs): Using SEZs to Drive Development in Countries around the World

Theodore H. Moran

Marcus Wallenberg Professor of International Business and Finance

Georgetown University

Non-Resident Senior Fellow, Peterson Institute for International Economics

Non-Resident Senior Fellow, Center for Global Development

Executive Summary

The purpose of this paper is to provide a broad comparative perspective about developing country efforts to use Special Economic Zones (SEZs) to enhance various economic and social objectives, covering the period from the earliest use of SEZs in the 1970s to the most current best-practices in 2011. This paper uses the term Special Economic Zones (SEZs) interchangeably with Free Trade Zones (FTZs) and Economic Processing Zones (EPZs). Throughout the comparative analysis presented here, the term SEZ, or FTZ, or EPZ refers to sites in which there is duty-free access to inputs, a distinction that will assume particular importance in the larger discussion of South Africa’s Industrial Development Zones (IDZs) at this CDE Conference.

The paper provides short country narratives that include the Philippines, Mauritius, the Dominican Republic, Costa Rica, and Malaysia (Penang), with brief insights that range from Kenya and Egypt to contemporary Morocco, Thailand, and Singapore. The country narratives are not simply repetition of the same story of success or failure over and over again – each one adds a new dimension of analysis and/or new kinds of evidence to the discussion of how SEZs might fit into development policy.

It soon becomes apparent that analyzing the potential contribution of SEZs to a developing country’s growth and welfare cannot be done in isolation. The development of an effective SEZ strategy – or what will be later called an FDI-SEZ-export strategy – requires a detailed look at multiple overlapping challenges. Five will receive special treatment here: 1) Meshing SEZs with More Effective Investment Promotion Agencies; 2) Safeguarding and Improving Treatment of Workers in SEZs; 3) Reinforcing an FDI-SEZ-export strategy with vocational training partnerships; 4) Using SEZs to Diversify and Upgrade the Host Export Base; 5) Creating Backward Linkages from Foreign Investors in SEZs to Indigenous Firms in the Host Economy.

The goal is to outline an FDI-SEZ-export strategy that embodies best practices from around the world in the contemporary period.

At the end of the day the hope is to the provoke discussion and reappraisal of the potential benefits of such an FDI-SEZ-export strategy for South Africa, while showing how South Africa can avoid dangers and adverse side-effects from such a strategy.

The Rationale for SEZs and Reasons for Success or Failure

The rationale for creating SEZs springs from the idea of setting up special investor-friendly sites where foreign investors can import inputs duty-free and assemble final goods for sale in international markets. Underlying this rationale is the conviction that the comparative advantage of the host economy is cheap labor. The benefit for the host comes in the form of lowest-skill job creation in manufacturing and assembly, pulling labor out of primary production (agriculture and extractive industries) and/or urban unemployment, with the added advantage of strengthening of the balance of payments via increased exports. The paper shows that this initial conception of the role of SEZs has undergone significant change as individual countries have tried to enhance the contributions and avoid damages from incorporating SEZs into development strategy, over time.

The ingredients for disappointing SEZ outcomes, as illustrated in the country narratives, include lack of infrastructure and extremely poor treatment of workers by quasi-monopolistic employers, overvalued exchange rates, high SEZ wage regulations in comparison to relative productivity, weak and ineffective investment promotion agencies, lack of a favorable doing-business setting within SEZs, lack of a favorable doing-business setting surrounding SEZs (leading to feeble backward integration into the local economy), and lax environmental standards and weak enforcement of environmental regulations.

To a certain extent, individual country cases with more positive SEZ outcomes show mirror-image characteristics in comparison to less-successful SEZs, but each experience offers instructive new features. The country narratives included here show moreover that countries can gain benefits from SEZs without having to get-everything-right all at once; they can use SEZs to make contributions to host country growth and welfare through various policy improvements at the margin. The country narratives demonstrate that it is not impossible for countries to replicate the success of others if they are ready to commit themselves to start down what will be called an FDI-SEZ-export path.

The ingredients for success include macroeconomic reform, steady improvement in doing-business indicators (both within and surrounding the SEZs), and access to reliable infrastructure and semi-skilled labor. Some success stories feature private SEZ developers (who have a self-interest in seeking out investors to populate their SEZs) and investor-developers. The country narratives show a potentially powerful signaling-effect or demonstration-effect from a first-mover anchor investor. They also provide evidence of substantial on-the-job training and skill-acquisition for SEZ workers, with large productivity gains that benefit both labor and investors. Rising demand for labor and increasing sophistication of plant operations lead to higher wages and better treatment of workers. Countries with successful SEZ strategies examined in some detail here (the Philippines, Dominican Republic, and Costa Rica) allow union-organizing within SEZs. Survey data from SEZ economies reveal horizontal spillovers as indigenous workers and managers gain experience in foreign-owned SEZ plants and then use their know-how to set up their own companies. Under some conditions (examined herein) there are strong vertical linkages from SEZ investors to indigenous supplier networks.

Important On-Going Issues and Controversies about SEZs

Countries that want to consider using SEZs as a central component of development strategy will rightly be concerned about safeguarding and improving treatment of workers in SEZs. Violation of worker rights, unacceptable health and safety conditions, and failure to abide by official labor regulations remain a feature of many SEZs around the world today. When labor regulations are properly enforced, however, the expansion of low-wage investment in SEZs has a quite notable impact on poverty reduction. The evidence shows that foreign firms and subcontractors in SEZs pay a wage premium in comparison to alternative employment in the economy. This wage premium is not the only positive benefit. For women, expansion of SEZ opportunities represent expanded formal employment opportunities, better conditions of work, less hazardous employment, lower accident rates, greater job security, and higher educational attainment (particularly for young women). Gender research shows social outcomes for women that include greater economic independence, respect, social standing, “agency”, and “voice”. Social spillovers are common. In Bangladesh, the enrollment rate of girls aged 5 to 18 is approximately seven percentage points higher in villages with a garment factory than in other villages. The introduction of a call center in India raises the number of children in school in the local community by six percentage points.

Once foreign investment in SEZs begins to rise above the least-skilled operations – as documented in the country narratives – both the level of wages and the treatment of workers changes dramatically. The wage premium on the part of foreign investors in SEZs becomes even more pronounced. Survey data from industry sectors such as autos and auto equipment, electronics, chemicals, and industrial equipment -- in comparison to garments and footwear -- show that foreign investors in higher-skilled activities pay their workers two to three times as much for basic production jobs, and perhaps ten times as much for technical and supervisor positions, in comparison to what is earned by employees in comparable positions in lower-skilled MNC operations.

Moreover, there is interesting new evidence – potentially very valuable new evidence -- showing institutional spillovers in labor markets when the skill-intensity of FDI activities rises. As the operations of foreign investors grow more sophisticated – as electronics and auto parts investors build plants in SEZs and industrial parks alongside garment and footwear assemblers – the former promote better worker facilities, security, transport, health and safety standards (even daycare) that apply to all firms. Although the evidence comes from a small sample that includes three of the countries surveyed here the evolution of labor relations in SEZs shows that the more skill-intensive foreign firms led the way for passage of ILO-consistent regulations on the national level (and more effective enforcement of the resulting regulations on the local level, including communal disciplining of violators) in the interest of promoting “labor peace”. The dynamics of this process exhibit a race-to-the-top phenomenon quite at variance with the race-to-the-bottom assumptions in much of the sweatshop literature.

Much popular discussion assumes that relatively unsophisticated activities – like production of garments, footwear, toys, and the like – constitute the predominant thrust of multinational manufacturing corporate operations around the world today. But this far from accurate. The flow of manufacturing foreign direct investment to medium-skilled activities such as industrial machinery, electronics and electrical products, auto parts and other transportation equipment, scientific instruments, medical devices, chemicals, rubber, and plastic products is nearly ten times larger each year than the flow to low-skilled, labor-intensive operations such as garments and footwear, and has been speeding up over time.

This outcome is particularly important in light of the discovery that is summarized in the phrase “What You Export Matters!”. Movement toward higher levels of domestic productivity and rising standards of living come about not simply by producing and exporting more of the same goods and services, but by upgrading and diversifying the production and export base of the country. This provides the setting within which an FDI-SEZ strategy can become a central element in recasting a developing country’s development trajectory.

To tap into the vast flows of middle- and higher-skill intensive FDI operations, developing countries have to combine the creation of attractive SEZs with an effective foreign investment promotion effort. In place of cumbersome, highly discretionary “screening” of investment proposals, the most effective Investment Promotion Agencies are a “one-stop-shop”, empowered to make the approval of investment projects as rapid, automatic, and transparent as possible. A central element of attracting middle-and-higher skilled FDI is to set up partnerships between foreign investors and local universities and vocational training institutes. These skill-building partnerships constitute an important magnet in attracting anchor investors, and stimulating follow-the-leader behavior on the part of other companies.

At the same time, an aggressive FDI-SEZ-export strategy opens the door to developing links between foreign investors and local companies. Contemporary survey data show that SEZ foreign investors provide potential indigenous suppliers with help with setting up production lines, training in quality control, coaching in management strategy and financial planning, advance payment and others kinds of financing, and introduction to export markets. The spread of backward linkages depends upon a host country business-friendly climate that allows local firms to grow and prosper. Indigenous companies need contract enforcement, reliable infrastructure, lack of red tape, and access to duty-free inputs no less than the foreigners if they are to become certified as suppliers to foreign exporter in the SEZs.

Implications for South Africa: Grand Debates and Strategic Choices

The concluding section of this paper offers the perspective not of an expert on South African development policy, but of a studious outside observer trying to suggest how comparative evidence might apply to decisions facing South Africa in the contemporary period.

The first impression of such an observer may be surprising: namely, that South Africa is relatively well-positioned to use an FDI-SEZ-export strategy as a central component of development policy as the world emerges from the contemporary international economic downturn. South Africa has the resource base, industrial base, labor base, and educational institutions necessary to transform the current IDZ arrangements into a highly dynamic FDI-SEZ-export program that can make important contributions to South African growth and welfare. But to do so successfully will require high level national commitment and policy coherence. To be sure, contemporary debates at senior levels in today’s South Africa show quite a lot of suspicion about SEZs. Such suspicion is not unique to South Africa: countries included in this comparative survey have had deep political debates about aligning national development along lines congruent with the forces of globalization. But a clear-eyed appreciation of the potential benefits for South Africa that may emerge from the data on job creation, poverty reduction, and enhanced growth compiled here may help reoriented domestic debate and stimulate domestic support for moving in a dedicated FDI-SEZ-export direction.

The second observation is that a sophisticated FDI-SEZ-export strategy does not require South Africa to abandon concerns about worker rights or environmental damage, nor to adopt what might be characterized as a neo-liberal Washington Consensus-like ideology of relying solely on markets without public sector involvement. As elaborated here, a successful FDI-SEZ-export strategy requires strong and focused government regulations and interventions. The text offers a novel perspective on the debate about what kind of “industrial policy” is appropriate to accompany an FDI-SEZ-export strategy.

The third observation is to repeat what many others have also noted, that the FDI-SEZ-export approach will not be a panacea for all South African development problems, and specifically not a magic cure for the nation’s unemployment crisis. But when job creation is measured in an appropriate manner against a counterfactual of what national employment would look like in the absence of SEZs, net new jobs can easily reach 100,000, and over time several multiples of that.

To the outside observer, the potential competitiveness of South Africa as a site for manufacturing exports holds some interesting possibilities. Currently South African manufacturing firms face a wage cost disadvantage relative to China and India, for example, but much of this disappears once productivity differences are taken into account. Careful estimates suggest that South Africa’s productivity adjusted wages (unit labor-costs) are actually lower than India (due to the latter’s low productivity rates) and only about 24 percent greater than those in China. A gradual depreciation of the Rand and appreciation of the RMB would act to make South African manufacturing quite competitive with China, while remaining superior to India. Reinforcing South Africa’s relative competitiveness looking forward, China’s five-year economic plan calls for an increase in domestic wages on the order of 10-15 percent per year. Sector level estimates for labor-intensive manufacturing calculated indicate that each one percent improvement in South African labor-cost competitiveness will lead to a 2.7 percent increase in exports. For more capital-intensive machinery and metal products, a one percent improvement in South African labor-cost competitiveness leads to a 1.5 percent increase in exports.

Looking at South African wages outside of the manufacturing sector, data reported in the New Growth Path shows that half of all those employed in 2008 earned less than R2500 a month ($2.10 per hour), one- third earned under R1000 a month ($0.80 per hour), and one quarter was unemployed (at a Rand of 7.5 to the dollar, and a forty hour workweek, R1000 a month is R6 per hour or 80 US cents.) This means that almost half of the South African labor force earned less than $1 per hour (in China, by comparison wages in rural areas averaged $0.83 per hour and in urban areas $2.38 per hour, in 2008, and have been rising rapidly since then). If investors in South African SEZs were allowed to pay wages approximating these levels – probably with a wage-premium to entice the more attractive workers – the country would find itself highly competitive in low-skilled export activities such as clothing, footwear, and standardized electronics assembly (now noticeably absent from South Africa’s export basket). The comparative perspective introduced in this paper helps make this low-wage approach more palatable since data from SEZs elsewhere suggest high labor productivity gains from learning-by-doing and on-the-job-training within SEZ plants, leading to differentiated and rising compensation levels.

A national development strategy whose purpose is to provide employment in parts of the economy where there is high informal employment and/or high unemployment in general will want to provide labor regulations that allow compensation closer to real productivity levels, and not be bound by national regulations that dictate a high minimum wage. This would be especially true in export-oriented SEZs that aim to attract FDI in lowest-skilled sectors. The data provided in the New Growth Path -- showing that a very large portion of the South African workforce earns less than half as much as urban Chinese workers -- suggests that this would be an appropriate approach for South African strategy toward low-skilled SEZs. It is important to note that this below-minimum wage carve-out would nonetheless be likely to increase worker earnings, family living standards, and overall social welfare – as well as worker employment -- in the regions and communities where such a low-skill intensive SEZ program were launched in the South African context. South Africa might want to examine the experience of the Dominican Republic where the minimum wage in SEZs is lower than the minimum wage in the domestic economy, and indeed there are different SEZ minimum wages depending upon the sector that predominates in the zone.

South Africa faces a pleasant dilemma that many other countries could only wish to enjoy. The South Africa economy is already home to many high productivity, relatively sophisticated activities both foreign- and locally-owned. Superior infrastructure and strong educational institutions – in comparison to many other countries – allow South African authorities to choose to continue along a skill-intensive FDI-SEZ-export path. The challenge in the contemporary period is to “fill in” lower-skill-intensive FDI-SEZ-exports with the explicit purpose of lower-productivity job creation. As noted later in the text, South Africa should be able to follow the path of a select few other countries in pursuing a high-skill SEZ and low-skill SEZ combination simultaneously by applying differential wage levels and hiring flexibility to each.

At the end of the day, an FDI-SEZ-export strategy for South Africa would want to target investors both in lower skill-intensive activities and in middle and higher skill-intensive activities. As South Africa becomes more pro-active in attracting new FDI, it seems inadvisable to deliberately to try to dumb-down the country’s potential production and export profile. Comparative analytics – as discussed earlier in the What-You-Export-Matters! debate – strongly suggest that a growth-boost can be generated from diversifying and upgrading the production and export base of any given country. Granted that the growth-job-creation relationship has been disappointing in South Africa in recent years, but the country will not want to give up on trying to enhance growth prospects. A genuine FDI-SEZ-export strategy for South Africa would want to target the advanced manufacturing and medium technology sectors such as those identified in the National Industrial Policy Framework/Industrial Policy Action Plan (IBAP), including automotive assembly and components, chemicals, plastic fabrication, ITC products and services, advanced materials, aerospace, and pharmaceuticals, as well as the labor intensive sectors, including clothing, textiles, and agriculture/agro-processing.

A strategy that offers SEZ status to an investor as a legal category rather than as associated with a particular geographical site allows the investor to set up shop according to the investor’s own calculations about reliability of infrastructure, access skilled labor and managers, ability to connect with vocational training institutes, and so forth. From a comparative perspective, since SA has many areas with superior infrastructure and strong educational and vocational training resources, this might be a favorable approach for an FSI-SEZ-export strategy for SA. This might be attractive for setting up plants in more skill-intensive FDI activities.

Inflows of FDI into South Africa have been rising in the period prior to the international economic crisis of 2008, going from an average of less than 1 percent of GDP throughout the second half of the 1990s to an average of 1.7 percent of GDP 2000-2006. But this performance remains significantly lower than the 3 percent to 6 percent average annual rates for comparable countries such as Chile, Thailand, and Malaysia. This is all the more surprising since enterprise survey data indicate that the expected rate of return to investment is higher in South Africa than in most of the comparators, and South Africa scores relatively well on a number of the World Bank Doing Business indicators. The principal impediments appear to be costs and risks associated with crime and with shortages of electricity, plus relative lack of access to skilled labor. The comparative perspective introduced in this paper suggests that a dedicated FDI-SEZ-export strategy for South Africa would want to be designed around providing assurances across all these fronts to targeted international companies.

To underpin an aggressive FDI-SEZ-export strategy, South Africa will want to pursue a vigorous effort to obtain duty-free entry into external markets. This will require reciprocal liberalization of access into the South African domestic market. Openness to trade is not just a policy issue, of course: Of all doing business indicators for South Africa, the “trading across borders” indicator stands out as a major impediment, and the “cost of importing (per container)” and “cost of exporting (per container)” measurements have been deteriorating (2008-2011). South Africa features an impressive rank of 10 in “protecting investors”, and a respectable 34 in overall “ease of doing business”, whereas the country suffers a discouraging 149 in “trading across borders”.

The comparative perspective introduced here shows that the creation of a reasonably effective and highly valuable FDI-SEZ-export strategy is quite do-able, without threat of harsh unwanted side effects. But launching an FDI-SEZ-export strategy that has a chance of success requires a clear decision at the highest levels to make such an effort the centerpiece of development policy for the future. For South Africa this will mean a decisive effort to move beyond the current Industrial Development Zone framework and agenda.

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