The overall business environment – including factors such as finance (access and cost), infrastructure (cost, availability and reliability), labour (cost and quality), the regulatory environment, taxation, corruption and the broader economic policies – is a critical determinant of the location of a foreign direct investment (FDI) project.
In countries where the overall business environment poses challenges for attracting FDI, economic zones (EZs) are seen as an important instrument for overcoming these constraints. But what exactly are they, how do they work, how have they evolved over time, and what benefits might be found in locating in EZs? Here, we provide some explanations.
What is an economic zone?
Today there are an estimated 3,500 free zones around the world, with the number increasing rapidly. There is a lack of consensus on the exact definition and different terminology is used to describe a free zone, such as export processing zones (EPZs), free trade zones or special economic zones. Today the most commonly used terminology is ‘special economic zones’ or, simply, ‘economic zones’.
Today EZs increasingly offer an attractive and competitive business environment combined with fiscal incentives and many investor support services.
Many EZs started up in the 1980s and 1990s offering a conducive and attractive environment for doing business complemented with generous (often fiscal) incentives, and combined with exemptions from export or import duties and preferential market access to large consumer markets through trade agreements.
The first EZs, which were often located close to major ports, were largely focused on the export activities of assembled and manufactured goods in industries such as automotive, electrical goods, electronics, garment, textiles and apparel. Examples of this include many of the EPZs in China, textiles and garment manufacturing in Bangladesh, electronics assembly in Malaysia and automotive assembly in Mexico. Gradually, EZs became more diversified in terms of industry focus (for example, logistics, mining and services).
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Why do economic zones exist?
The reasons why governments facilitate EZs and the role they can play in generating economic growth are many:
- EZs are seen as a tool for achieving one or several specific policy objectives: increasing employment, attracting FDI and/or increasing foreign exchange earnings.
- EZs have been initiated as a policy instrument to transform or diversify the economy of a country.
- EZs are often seen as laboratories for experimentation of economy-wide reforms. In such a case EZs are considered as a stepping stone that allows a country to gradually liberalise its trade and investment regime.
- (Fiscal) incentives – the raisons d’être of free zones often serve to compensate for the weaknesses in the overall business environment of a country.
- Governments see EZs, especially in emerging markets, as an important policy tool to support their economic development objectives, even though the concept of EZs has received criticism focused on the absence of comprehensive and reliable data showing their real benefits.
- EZs are seen as a distortive policy toolset to correct the effects of another distortive policy tool (i.e. high tariffs, import restrictions and quotas implemented by governments). From this perspective, in a free-trade environment, EZs would have no raison d’être, as there would be no need for this ‘counter-subsidisation’ policy instrument. Others argue that free zones create economic distortions by attracting investments that may otherwise have little or no economic justification, prevent or delay more widespread economic reforms, and give generous tax breaks to companies that would have invested in the country anyway.
- Free zones, especially when they segregate export-oriented companies in an enclave, separate from the domestic economy, may create excessive dependence on imports, reduce domestic value-added, and eliminate many of the potential domestic benefits from technology transfer, skills development and market access.
- EZs have remained isolated enclaves where ‘footloose’ multinationals exploit generous incentive packages without generating significant employment opportunities nor exchange technologies, expertise, knowledge, innovation and skills to the local economy. In all these views economic zones are seen as ‘second best’ and a less optimal solution, to be used only when countrywide liberalisation or countrywide duty-free import systems are not available. In this view, free zones should be transitory, and abolished as soon as their reforms spill over to the wider national economy.
Over the past ten years, as the benefits of EZs become more visible and the zones have become more diversified and embedded in a country’s economic development strategy, much of the criticism has diminished. Today EZs increasingly offer an attractive and competitive business environment combined with fiscal incentives and many investor support services. EZs differ, however, in size, economic development purposes, physical characteristics, government incentives and industry focus.
What are the benefits of an economic zone for investors?
As mentioned, EZs may offset some aspects of an adverse investment climate by offering world-class facilities and best practice policies. EZs can mitigate these risks by offering a range of advantages and services that equal or surpass the competitiveness of those offered by other locations within the country, which typically include:
- Fiscal incentives: EZs generally offer fiscal incentives, which may include permanent or temporary exemptions from income taxes, property taxes, and duties and VAT on imports. These incentives can reduce the cost of doing business and increase returns on investment. Based on research by the World Free Zone Organisation, the overwhelming majority of incentives awarded in free zones are fiscal, or fiscal in combination with non-fiscal incentives such as cash grants, subsidies, credits, loans or non-financial types of incentives. Out of the 2,071 incentives found in the research, 2,002 (or 96.7%) were purely fiscal incentives.
- Other incentives: In some cases, EZs offer free or below-market rental of land, subsidised energy, and free or low-cost services, all of which can increase investment returns and shorten payback periods.
- Reliable and predictable policy, legal and regulatory framework: When a country has an EZ policy framework, many of the policies will be part of the broader economic development policy of the country and more stable and predictable.
- Infrastructure: EZs typically offer high-quality and reliable physical and digital infrastructure, including internal roads, water and sewerage, electricity, and telecommunications networks, as well as easy access to external transport, power, water and sewerage.
- Help with approvals and administrative procedures: Most successful EZs offer some form of facilitation services, which reduce the difficulty that investors – especially foreign investors – might otherwise encounter in obtaining all necessary licences and approvals. The zone regime may often offer other advantages, such as simplified administrative procedures, often through a digital one-stop shop.
- Security of land tenure: Many countries have poorly developed land registry or cadastral systems as well as overlapping and competing systems of tribal, customary and formal occupancy and ownership of land, which can make it hard for a company, especially a foreign one, to buy or lease land with certainty that the lessor or seller actually owns it. An EZ can reduce this risk by being established on government-owned land and offering occupants secure long-term leases.
- Physical security: In areas with high crime and/or civil disturbance, EZs can offer investors a secure and safe environment with controlled access.
- Mitigation of commercial risks: Most EZs provide pre-built factory shells, warehouse space and offices to accommodate investors. This substantially lowers the capital cost to investors, who otherwise would have to build their own facilities, and also reduces the time needed to begin operations. It also can eliminate the need for an investor to conduct environmental impact assessments and obtain building permits.
- Matchmaking services: By maintaining a database of local suppliers, EZ operators can help tenants increase the efficiency of their supply chains through local sourcing and subcontracting. These linkages help maximise the benefits – employment, income, skills, market access, higher domestic value-added – that accrue to the domestic economy and local enterprises from EZs.
- Efficient supply chain operations: A good EZ will have a dedicated on-site customs post, open 24/7, to allow tenants to load and ship or receive cargoes with minimal delays. This reduces transaction costs and minimises the time and cost of logistics operations.
- Provision of ancillary services: Some EZs can accommodate a wide range of services and facilities that may include banks, restaurants and cafes, hotels, worker housing, and so on.
A word of caution
The international context under which successful EZs have been established has changed drastically over the past two decades. First, the Covid-19 pandemic and the further intensification of protectionism and regional trade blocks will collectively affect the volume of investment directed towards EZs. Second, the World Trade Organisation’s agreement on subsidies and countervailing measures has been designed to phase out incentives on export performance and use of local contents. The implication is that the options to differentiate by providing fiscal incentives within an EZ has become limited.
The classical foundation upon which the competitiveness of EZs rests – i.e. the combination of an appealing incentive package and a real estate solution for investors – has become obsolete. More and more, free zones award a standardised package of incentives that consists of a corporate income tax holiday in combination with preferential import and export duty treatment and other tax exemptions. When seeking to diversify their business environment and create unique competitive advantages, free zones need to move away from overgenerous fiscal incentives that exclusively focus on increasing the profit margins. These low-cost and low-tax business environment strategies are easy to copy and replicate and do not equip EZs with a distinctive source of competitiveness.
EZs should start to rethink the role they can play in global value chains, and focus more on new industries that have become the drivers of economic globalisation, FDI in sustainable industries, and on digital or more broad service activities. The requirements of these investors are fundamentally different to the traditional manufacturing firms exploring low wages, export platforms and a tailored incentive package. EZs of the future should become more sustainable, make themselves digital, and offer the advantages of being well-equipped industrial or technoparks, which can facilitate the development of competitive clusters. EZs should also be integrated into national economies and better showcase the economic benefits they can offer to an economy.