SPECIAL ECONOMIC ZONES: Lessons for South Africa from international evidence and local experience

Edited proceedings of a Round Table convened by the Centre for Development and Enterprise CDE Number 19 June 2012

EXECUTIVE SUMMARY

IN NOVEMBER 2011, CDE hosted a Round Table on the role that special economic zones (SEZs) could play in accelerating economic and employment growth in South Africa. The Round Table was supported by Blue IQ (the investment arm of the Gauteng Provincial Government) and Business Leadership South Africa, and was instigated in response to government's plans to revise the law governing the country's industrial development zones (IDZs).

Official recognition that the IDZs have failed to achieve their goals of employment creation and accelerated industrial development creates an important opportunity to learn from South Africa's experience as well as that of countries around the world.

Three pieces of research were commissioned for presentation at the Round Table. These were:

• A review of international experience with SEZs, commissioned from Professor Ted Moran, a leading authority on the relationship between trade, foreign investment and industrial development based at Georgetown University and the Petersen Institute of International Economics;
• A review of South Africa's IDZs commissioned from Crispen Chinguno of Wits University; and
• An analysis of changes being proposed to South Africa's legislation in the light of best international practice in the establishment and operation of SEZs, commissioned from Jean-Paul Gauthier, deputy secretary-general of the World Economic Processing Zones Association and a leading international expert in the field.

Since the Round Table, the Department of Trade and Industry (DTI) has released for public comment a draft of the law it hopes to take to parliament after consultations in Nedlac later in 2012. This, together with an allocation of some R2,3 billion over three years for SEZs in the 2012 budget, suggests that government is serious about trying to find a formula for more successful zones. But South Africa needs to learn the right lessons from its own experience and that of other countries.

Local experience

Special economic zones are defined as specially-demarcated geographic areas in which some aspect of the business environment, whether the quality of the infrastructure or the regulatory regime, differs from the norms prevailing in the rest of the country. SEZs have been used as instruments for attracting foreign direct investment, alleviating large-scale unemployment, developing and diversifying exports, and experimenting with new policies. There are now about 3 000 SEZs in 135 countries, accounting in 2008 for more than 68 million direct jobs and $500 billion of trade-related value-add.

Impressive as the aggregate performance of SEZs has been, the international experience with them has varied. There have been some spectacularly successful zones that transformed the economies of their host countries, and there have been many zones which have failed to set themselves apart from the rest of the economy, create a sufficiently attractive business environment, or compete internationally. This has been the experience in South Africa, where the establishment of IDZs has not contributed significantly to economic growth or the transformation of the country's economic prospects.

South Africa's IDZs are defined as ‘purpose-built industrial estates, linked to an international port or airport, specifically designated for new investment in export-oriented industries and related services'. To date, four of these zones have been designated and licensed - at Coega, East London, Richards Bay, and OR Tambo International Airport outside Johannesburg.

Government has recently joined the consensus that the IDZs have not delivered. Investment levels have been relatively low, the number of permanent jobs created has been small, and many of the businesses that located in the zones simply moved there from elsewhere.

There are a number of reasons for this lack of success. Unlike many SEZs around the world, investors in South Africa's IDZs receive no special incentives. And, despite initial promises that businesses in the zones would be treated expeditiously in the management of VAT and tax obligations relating to imports and exports, in practice there has been little variation on the usual treatment afforded to all businesses. Regulations in the zones also do not deviate from the social, labour and environmental rules in force elsewhere.

The main justification for failing to introduce additional measures was an unwillingness to introduce distortions into the economy, but this has meant that IDZs have not been able to offer investors a compelling reason to be there.

From their conception, the IDZs have lacked a comprehensive policy framework. This has led to weaknesses in governance, planning, implementation, management and operations. A lack of inter-agency coordination has resulted in serious deficiencies.

For example, ten years after the policy's inception, none of the IDZs offers a customs secured area or a one-stop shop for customs duties and VAT regulatory requirements or business registration. In contrast, international best practice has shown that consistent high-level political commitment is vital if SEZs are to succeed because these interventions require considerable inter-departmental coordination and cooperation.

South Africa's IDZs are all exclusively government-owned, promoted and financed. The management and delivery of services to firms is the responsibility of a zone operator, all of which are owned by provincial and local governments. This contrasts with the global trend which is shifting towards greater private sector involvement in SEZ ownership and management.

It is impossible to argue that South Africa's IDZs are special economic zones because there is little that distinguishes them from other industrial parks. It is, therefore, not surprising that the return on the investment of public funds - whether measured in jobs, exports or industrial development - has been low.

Lessons from international evidence

If South Africa is to use SEZs to transform the country's economic prospects, we will have to approach their development quite differently from the ineffective IDZ strategy. Successful SEZs must do more than offer an investment proposition that is marginally better than what is available outside the zone - success requires that SEZs be globally competitive. If South Africa is to deliver on the promise of SEZs, the country's new approach will need to embrace some key lessons from international experience:

1. Special economic zones must be special

Successful SEZs offer investors something significantly different from what is available in the rest of the economy. Precisely what an SEZ offers, and how this differs from conditions elsewhere, depends on the goals of the country's SEZ programme. International evidence indicates that SEZs are most successful when they are targeted toward particular industries and offer concrete solutions to the challenges faced by those industries.

2. Global competitiveness is what counts - it's not enough just to be better than the host economy

Our SEZs need to be globally competitive. Investors, particularly foreign investors, choose SEZs for different reasons. Most consider their location, market access and logistics; others consider wage levels and labour market practices; yet others place a premium on access to skilled labour or a favourable regulatory environment.

Many SEZs offer investors particular fiscal incentives - tax breaks, subsidies, etc. International evidence shows that few investment decisions are made on the basis of these incentives alone, and that ensuring the zone's overall competitiveness is critical.

Nevertheless, government should retain the capacity to provide fiscal incentives. This can help ensure that the tax burden in an SEZ is not out of line with the tax rates paid in the investor's home country or other potential investment locations. Tax incentives may also help to attract first movers who may be uncertain of the area's competitiveness.

3. The rest of the host economy also has to work

Although typical SEZs are demarcated spatial enclaves, the extent to which they can function effectively and benefit the host economy as a whole depends on wider economic conditions. The more business-friendly the surrounding environment, the more potential an SEZ has to stimulate economic activity both within and outside of the zone.

An important factor in this regard is the exchange rate. If the local currency is overvalued, competitiveness will be reduced. This is less true when the products being manufactured are themselves import-intensive. However, when local inputs and labour costs make up a significant proportion of total costs, an overvalued currency will undermine competitiveness.

Another factor that affects the competitiveness of SEZs is the availability of skilled workers. Successful SEZ programmes must ensure that businesses have access to the skills they need. In some countries, this has been achieved by locating SEZs in regions where the population is better educated or by aligning interventions in secondary and tertiary education with the skills needs of SEZs.

There is some evidence that SEZs can help to create skills, and firms in SEZs around the world have seen rapid productivity gains through on-the-job training.

4. SEZs should offer tailored solutions to problems faced by local businesses

Although it is widely believed that multinationals invest in SEZs in order to take advantage of cheap local labour, most FDI (including investments in SEZs) is in medium-skill industries. SEZs can tailor their offerings to specific sectors and subsectors across the industrial spectrum. The key is to ensure that the zones help address whatever constraints limit the growth of those sectors elsewhere in the economy. Where mass unemployment is a problem, SEZs should focus on addressing the needs of labour-intensive industries.

5. The costs and flexibility of employment matter

Businesses in SEZs are most likely to create large numbers of jobs if the package of benefits derived from locating in the SEZ meets the needs of labour-intensive industries. Flexible labour markets are essential if SEZs are to be globally competitive in labour-intensive manufacture. Wage levels are important. So too are rigid overtime rules, legal conditions governing temporary employment and/ or piece-work, shift systems, rules of dismissal, etc. Flexibility of this kind is most important for labour-intensive industries, many of which operate in conditions in which order-flows from customers are erratic. Employers' ability to adjust the size of their workforce and their shift systems in response to these variations is an important determinant of their competitiveness.

6. SEZs are badly suited to uplifting poor regions

Some of the least successful SEZs have been set up as vehicles for developing poorer regions of a country. The weakness of this model is that there are often good reasons why some areas are less developed than others: a lack of infrastructure, limited access to skilled labour, distances from markets, etc. To overcome all these disadvantages, SEZs would have to offer extensive subsidies or require levels of investment in public infrastructure that are not economically viable, if costs are to be recovered.

7. SEZs require political commitment from the highest levels of government

Effective SEZ policies and operations require the coordination of a number of government departments. Generally, the highest levels of government must be committed to making SEZs work, if only because the zones will require government entities to do some things differently from how they do them everywhere else. Achieving this requires strong leadership and high levels of political oversight, often for a sustained period.

International best practice suggests that SEZ regimes should be administered by an autonomous but powerful government authority which: oversees the administration of dedicated laws, regulations and practices inside the SEZs; provides regulatory oversight for the SEZs' developers, operators and occupants; ensures the efficient delivery of various services (including regulatory services); and regulates economic activity, controls land use, and acts as the principal interface with private developers and operators.

8. The most successful SEZs are public-private partnerships

The approach where zones are regulated, developed and operated exclusively by government has been discredited by international experience. Today, the preferred institutional model for successful SEZs involves a division of labour and cooperation between the public and private sectors.

Government should formulate policy and strategy, make laws and regulations and enforce them, and provide key public goods.

The private sector should develop and operate SEZs, including undertaking the master planning, investing in core real estate and services, undertaking construction, managing the zones, and promoting investment. The private sector is better placed to perform these functions because it has a profit incentive, business networks and contacts with potential tenants, and experience in development and construction.

9. Effective investment promotion agencies are a vital part of the SEZ strategy

SEZs work best when their host countries have effective investment promotion agencies which actively seek to attract FDI. But many countries' investment promotion agencies are not good at this. Some actually screen investment, acting like investment prevention agencies by imposing informal performance requirements on foreign corporations as a condition of entry. Moreover, the term ‘onestop shop' seems to imply that such bodies can provide authoritative commitments across a wide range of regulatory and licensing requirements. However, these bodies are often involved in turf battles with various government departments. In the process, they cease to be one-stop shops and become one-more-stop shops.

SEZs and the challenge of unemployment in South Africa

Many SEZs have been spectacularly successful and have transformed the economies of their host countries. But many others have failed to set themselves apart from the rest of the economy, to create sufficiently attractive business environments, or to compete internationally. These diverse experiences should not obscure the fact that SEZs are a key platform for export-oriented industries, contributing significantly to global trade, attracting vast flows of FDI, and employing millions of people.

If South Africa is to exploit this potential, it will have to change the approach used with the IDZs. Government has to be clear about precisely what role SEZs should play, what industries should be targeted, and how the specific challenges faced by those industries should be addressed.

The top priority for South Africa's SEZ programme should be to establish zones in which it is considerably easier to establish and run globally competitive businesses - particularly labour-intensive businesses - than it is elsewhere in the economy. These ‘zones of exception' may always be distinct from the rest of the economy, and the economic rules may always differ from those outside the zone. This approach should be coupled with using SEZs as a testing ground for new policy options. Locating such experiments in separate enclaves would allow government to reduce or avoid confrontations with entrenched interest groups opposed to wider reforms. Should these experiments succeed, these approaches could be rolled out to the rest of the economy.

International experience shows that the ‘demonstration effect' of successful SEZs facilitates wider economic reform. This has certainly been the case in China, where Deng Xiaoping's initiatives in the 1980s and 1990s to attract FDI and expand exports through SEZs led to accelerated nationwide economic reform. The same is true of Mauritius, Costa Rica, the Philippines and elsewhere. This potential for positive policy spill-overs into the rest of the economy is the greatest promise held by SEZs.

What should South Africa aim to achieve with its SEZs?

Given the scale of the country's crisis of unemployment, South Africa should view SEZs as a platform for experimenting with reforms that might induce the emergence and growth of industries that employ large numbers of low-skilled workers. South Africa's industrial structure is characterised by the relative absence of these kind of industries - one of the key reasons why our employment rates are so low. Appropriately conceptualized, SEZs could play a key role in creating conditions needed for the emergence and growth of low-skill, labour-intensive industries. To achieve this, South Africa would have to address a range of inter-related priorities.

Labour costs would have to be low. Although labour costs are rising in China's manufacturing sector, they are still lower than those in South Africa. This is true of other developing countries, too. South African businesses that pay higher wages can only be competitive if productivity is also higher. Achieving this usually implies mechanisation, a strategy that reduces labourintensity.

If South Africa is to create large labour-intensive industries, an environment has to be created in which labour costs can compete globally.

Conditions of employment would have to be more flexible. Labour-intensive companies, especially in light manufacturing, often have to deal with fluctuating demand. Employers who are unable to hire and lay off temporary staff and structure shift systems in line with demand struggle to compete internationally.

Other input costs would also have to be competitive. Even the most labour-intensive businesses require more than just unskilled workers. Firms also need cheap and reliable infrastructure and services as well as physical inputs. Production costs are also driven up by the shortage of skilled workers, who therefore have to be paid more. Labour-intensive firms ought to be less affected by this than other firms, but the scarcity of skills could still hamper their emergence and growth. South Africa needs to manage two processes simultaneously: improve education and training, which will begin to address the problem in the medium to long term; and recruit foreign skills much more aggressively in the short term.

Firms would need access to global markets. This is essential to reach effective economies of scale. Light manufacturing firms could only employ large numbers of unskilled workers if they were substantial exporters. This requires cheap and reliable transport systems and appropriate trade policies.

A more competitive exchange rate would help. The level of the exchange rate and its volatility has hurt exporters. Managing this is complicated, and it is not clear what can be done to depreciate the currency without inducing inflation. If the exchange rate is not easily depreciated, other aspects of South Africa's competitiveness equation would have to be improved even more.

Governance and regulatory frameworks must be clear and inviolable. Investors are reluctant to invest in areas where they believe their property may be taken from them, unless returns are exceptionally high. This applies to government expropriation as well as to risks associated with crime and with a judicial system perceived to be unable to act against defaulting creditors.

Some issues surrounding black economic empowerment codes also deter some investors. Fundamentally, investors need to know that policy commitments made in one period will be complied with in the next.

Concluding remarks and recommendations

Taking the steps outlined above would benefit the entire South African economy. Achieving them everywhere at once may be difficult. Problems include technical and logistical challenges as well as administrative deficits. Some of these measures would probably be opposed by organised labour, companies whose profits might be threatened, and skilled workers earning wage premiums. Progress is likely to be slow, difficult and politically disruptive. This is one reason to experiment with reform in SEZs.

If South Africa is to create jobs for millions of unskilled and inexperienced workers, the country need to create the right conditions for these kind of investors. SEZs could play a useful role, particularly if they are used strategically to address the constraints faced by potential employers of unskilled labour.

For this reason, South Africa should establish at least two large SEZs designed to meet the needs of low-skill, labour-intensive businesses. This means paying attention to ten policy areas that:

1. Ensure that production costs (including the costs of labour) are as low as possible;

2. Create more flexible employment relationships;

3. Provide efficient access to international markets;

4. Ensure easy access to skills (including foreign skills); and 5. Offer credible guarantees that policies in the zones will be sustained in the medium and long term.

The international evidence suggests other factors will also be important:

6. The SEZ programme needs to be a presidential priority, thus ensuring that the DTI is supported by all other relevant departments;

7. SEZs should be run largely by the private sector;

8. The zones must be effectively promoted;

9. The red tape hampering start-ups has to be dramatically reduced by government through the establishment of genuine one-stop shops (rather than the ineffective one-more-stop shops that so many investment promotion agencies have become); and

10. Local education and training institutions need to be geared towards providing the skills these firms will need.

The proposed labour intensive zones need to be large. They will need road, rail, and shipping linkages; electricity, water, other major services; and professional and technical services. Effectively, this means they need to be in or near urban centres. These are the essential ingredients of a globally competitive SEZ programme aimed at the rapid expansion of labour-intensive industry.

If the country has the capacity beyond establishing these priority large experimental labour intensive zones, South Africa could also establish zones for more sophisticated businesses. However, these sorts of companies may not need, or be attracted by, SEZs.

It is not clear, for example, why businesses serving offshore oil and gas operations require an SEZ (as is being contemplated in Saldanha). There may be good answers to this question, but the establishment of medium- or high-skill SEZs should be decided on a case-by-case basis.

Any new SEZs in South Africa will need to be globally competitive if they are to succeed. They must offer a business proposition that encourages investment and expansion. Exactly how this should be done will depend on the targeted industry or sector.

Current economic policy is skewed towards high-skill and high-wage methods of production, which do not address the core of South Africa's unemployment crisis. A paradigm shift is required, and this may best be facilitated through a new policy instrument and experimentation.

The Special Economic Zones Bill has not been finalised, and much of the detail has been left open to interpretation in later regulations or through the decisions of the proposed SEZ Board.

The international experience is clear, and our past experience with IDZs is a lesson in what not to do. SEZs represent a major opportunity to do things differently.

South Africa needs to address the factors hindering its competitiveness. Potential investors - in Asia, South Africa and elsewhere - need to be consulted and their views taken into account by government. This is the only way to make sure that the special nature of the proposed zones actually addresses the obstacles faced by labour-intensive industries.

Well-designed SEZs have proven to be a remarkable tool for growth and job creation around the world. Costs in Asia, especially China, are rising and there is much talk of millions of labour-intensive firms looking for new regional locations. South Africa should seize this new opportunity. This will require bold leadership and engagement with difficult choices that must be made. The alternative is to waste resources and energy yet again on a policy that fails.

This is an executive summary of CDE Round Table no 19, SPECIAL ECONOMIC ZONES: Lessons for South Africa from international evidence and local experience (June 2012). The full-length publication is available from CDE, and can also be downloaded here.

Issued by the CDE, May 31 2012

Click here to sign up to receive our free daily headline email newsletter