Rationale/Benefits for Free Zone Development



Why Develop Free Zones?

Zone development is one of the many trade policy tools at the disposal of a developing country government.  Typically, they are created as open market cases within an economy that is dominated by distortion trade, macroeconomic and exchange rate regulations, and other government controls.

The rationale for the development of Free Zones differs between developing and developed countries.  For developing countries, free zones have traditionally had both a policy and infrastructure rationale.  The typical free zone policy package of import and export duty exemptions; streamlined customs and administrative controls and procedures, liberal foreign exchange policies, income tax incentive – meant to boost an investor’s competitiveness and reduce business entry and operating cost.  Export oriented Free Zones (EPZs) are intended to convey ‘free trade status’ to export manufacturers to enable them to compete in global markets, and counter- balance the anti-export bias of trade policies.

Madani (1999), Cling & Letilly (2002) and Gauthier (2004) outlined four broader policy reasons for the development of Zones, especially Export Processing Zones, in developing countries as follows;

(i)         To support a wider economic reform strategy.  In this view EPZs are a simple tool permitting a country to develop and to diversify exports.  Zones are ways of reducing anti-export bias while keeping protective barriers intact.  The EPZs of Taiwan and South Korea followed this pattern.

(ii)         To serve as ‘pressure values’ to alleviate growing unemployment.  A lot of the Free Zone are associated with this and are examples of robust, job creating programme that have remained enclaves with little linkages to the host economies.

(iii)       To serve as experimental laboratories for the application of new polices and approaches.  China’s Special Economic Zones are classical examples of this category.  Financial, legal, labour and other policies were introduced and tested first within the Special Economic Zones before being extended to the rest of the economy.

(iv)       To attract Foreign Direct Investment into the countries: Foreign Direct Investment (FDI) is one of the corner stones of the modern-day economy and is central to the process of long-term economic development and sustainability for both transition and developing markets world-wide. In recent years, policy makers, especially in the developing nations, have come to the conclusion that Foreign Direct Investment is needed to boost the growth in their economy.

The ‘hardware’ of the Free Zones are fully serviced sites with purpose built facilities for sale or lease –  aimed at enhancing the competitiveness of manufacturers and service providers, and realising agglomeration benefits from concentrating industries in one geographical area.  These include efficiencies in government supervision of enterprises and provision of off-site infrastructure facilities, improved environmental controls, and increased supply and subcontracting relationships among industries, amongst others.  This infrastructure rationale is one of the most important driving forces behind Zone development in countries that are poor in infrastructure like Nigeria.

The rationale for Free Zone development in industrialised countries is more varied.  The new Special Economic Zones programme in South Korea and above two dozen Foreign Access Zones in Japan, for example, are explicitly intended to promote foreign investment.  In contrast the main rationale for Shannon Free Zone in Ireland was to establish a ‘growth pole’ in economically distressed southern part of the country.

Revitalisation in the economically distressed urban and rural areas is the motivation behind the many enterprise Zone-style programmes in UK, France and the USA.  But enhancing trade efficiency and manufacturing competitiveness is the principal rationale behind Free Zone programmes in most industrialised countries.  Many Companies choose a Free Zone location because of the important advantage of operating in a flexible, duty-free environment.

Operating costs are lower as a result of reduced overhead, insurance and security cost, cash flow is enhanced by the ability to postpone duty payments only upon entry into the domestic Customs Territory.  The Foreign Trade Zones in the US have been critical in enabling manufacturers to operate ‘just-in-time’ systems.  The efficiency advantages provided by Free Zones are even more important for industrialised countries and approaches and the reduction of tariff barriers.

Many studies have evaluated the economic performance of Free Zone programmes in developing countries.  Most of the studies focused on government developed and operated Zones and neglected private zone development.  Critics of Zone development, on the other hand, have focused on the social and environmental impacts of Zones, and have largely been dismissive of economic contributions.  Almost all the studies failed to evaluate zone contributions relative to the counterfactual – if zones did not exist.  How do Free Zones and Zone-based enterprises compare with local firms or those operating under other incentive regimes?

From the above attempt to evaluate some of the socio-economic benefits of Free Zones we can conclude that the economic benefits are both static and dynamic.  The static benefits which are straightforward include:

  • Employment creation and income generation;
  • Export growth and diversification;
  • Foreign Exchange earnings;
  • Foreign direct investment’
  • Increase in government revenue.

The dynamic benefits are more difficult to measure and are far more important to long-term contributions from Zone development.  The most common include:

  • Indirect employment creation/backward linkages;
  • Skills upgrading and female employment’
  • Technological transfer;
  • ‘Demonstration effect’ arising from application of ‘best practices’;
  • Regional development.

Although some critics argue that Zone development has a negative socio-economic impact, particularly in relation to the role of women, labour and working conditions in Zones. The positive impacts outweigh its costs and the benefits are obviously amplified in poorer countries where jobs and foreign exchange earnings and government resources are scarce.

Below is a short note on the overall consensus on the goals and objectives of Free Zone:

  1. Foreign Exchange Earnings Potential– This is one of the main benefits expected from a free zone. It is already a known fact that free zones provide foreign exchange earnings that allow low income economies to slacken the foreign exchange constraints regarding their imports for the rest of the economy and provides the government with development funds. Early works on free zones impacts showed substantial growth in gross exports, leading experts to support the zones enthusiastically. In some countries, increases in gross export and earning of free zones have been phenomenal. For instance, in Mauritius, EPZ exports earnings grew from 3 percent of total export earnings in 1971 to 52.6 percent in 1986 and 68.7 percent in 1994 and has been on the increase.
  2. FDI Effects: Technological Transfer, Knowledge Spill-over and Backward Linkages– The foreign direct investment effects goes beyond that of receiving needed infusion of capital (financial as well as machinery) from developed countries. The positive spill-overs of such FDI extend beyond the demonstration effect discussed above to include technology and further knowledge transfer. Such transfer, together with the “catalyst” factor, would foster industrial development in non-traditional goods and efficient gains in production processes of the traditional ones. Such a transfer also fosters a backward linkage to the host country firms, which would allow them to step in as suppliers to the free zone firms in the medium to long run.

This process integrates the zone into the regional and national economy and promotes regional development beyond the immediate and limited servicing of the enclave structure. Eventually, it was hoped, these domestic supplier firms would mature to compete in the international market.

In developing countries in the early stages of development, a linkage has occurred when the firms in the zones used basic production processes, where domestic raw materials and intermediate inputs could be used. A great success story in this regard is the experience of the Indonesian zones, where the dominant garment industry uses domestic cloth and other raw intermediate inputs for its production.

Linkages also occur in advanced developing countries like South Korea and Taiwan, where a large industrial base already existed and could provide electronics firms in their zones with high quality, internationally components.

  1. Employment Effect on National Economy – Job creation is considered one of the most important contributions of any free zone to the economy. This goal is based on two assumptions. The first one is that the country high unemployment or underemployment. This is a reasonable assumption and the argument would work only until the excess labour is absorbed, then the host nation faces a tight labour market and rising labour costs. Of course, rising labour cost translate into higher labour income, and improving workers’ living standards.

The second assumption equates creating jobs with alleviating unemployment. Free zones have created jobs which wouldn’t have been there without the existence of the scheme. For some of the employed workers in the zone, the alternative to the Free Zone employment would have been unemployment, underemployment or return to village subsistence life. If the workers are unemployed, their opportunity cost is zero and any new activity – including the free zone firms – which expands employment will have a high economic rate of return.

  1. Education / Training Benefits (Human Capital Development)There has no doubt been a great deal of knowledge spill-over effect from the creation of EPZs in developing countries. Several examples abound on how a previously unskilled labour force has become semiskilled and skilled production workers through training and learning by doing on the job. By extension, these improved skills and productivity increased the workers income earning capacity. Given the high labour turnover rate in the free zones, domestic firms get the opportunity to benefit from these training and skills by hiring workers previously employed in the zone firms. Some employees also receive training at the managerial or supervisory level, thus enriching the entrepreneur capital of the country. Also, the presence of free zones allows domestic entrepreneur and workers to benefit from observing and copying the traits that make the zone firms successful exporters. These traits may include managerial and production skills, negotiations and marketing skills in dealing with foreign business contacts.