Special Economic Zones (SEZs), first implemented in 1959 in Ireland, were designed to stimulate the inflows of Foreign Direct Investments (FDIs), boost exports and employment, and generate growth spillovers in local regions. The term “SEZ” encompasses various zones like export-processing zones, industrial parks, and others. It can be generally defined as a designated area within a country that operates under a separate administration with more liberal economic regulations, enhanced infrastructure support, and fiscal incentives aimed at attracting foreign investors and facilitating economic activity (Wang, 2012., Frick et.al., 2018). SEZs have been credited as a significant driver behind China’s unprecedented economic growth, leading to the widespread adoption of this instrument as other countries sought to replicate the Chinese success story. In fact, the number of SEZs has increased from 176 in 47 countries in 1986 to 5,383 across 147 economies in 2019 (UNCTAD 2019). Nonetheless, such attempts have often fallen short of expectations, raising questions about the effectiveness of SEZs. This article will examine the case of China to identify the critical success factors, aiming to illustrate when the application of SEZs is appropriate and how they can be leveraged for maximum benefit.
SEZs: a miracle policy tool for emerging markets?
Before 1978, China had practically zero FDI and low levels of foreign trade (Wang, 2012). When the country opened its doors to the world economy in 1980, SEZs were used as the testbeds for capitalism necessary for a gradual economic liberalisation. Original SEZs in China shared several key crucial features which have created suitable environments for foreign businesses to operate in. First, the protection of private property rights was a fundamental step made by the Chinese government to encourage foreign investors to set up businesses in the SEZs, especially since such rights lacked constitutional guarantee outside these zones until 2004 (Leong,2012). Second, the SEZs allowed the investors to develop and use land for their business purposes, even though, under Chinese law, all land belongs to the state (Wang, 2012). Third, tax incentives also attracted foreign enterprises, as they benefited from a lower corporate tax rate of 15 to 24% based on their products’ tech level, in contrast to the 33% levied on domestic firms (MS Advisory, 2022). On top of that, these companies enjoyed minimal customs duties, and many employees were granted income tax exemptions (Zeng, 2015). Fourth, SEZs had a degree of institutional autonomy, which allowed them to freely pursue innovative policies.
Besides the foundational elements highlighted above, the continuous success of SEZs is supported by several country-specific factors. Specifically, access to cheap labour, good infrastructure, and skilled personnel coupled with a technologically driven environment fostered by government incentives (Zeng, 2015). Additionally, SEZs maintain strong connections with domestic companies via supply chains and are better integrated into international markets, given their strategic placement in regions with a history of foreign trade and access to major transportation hubs (Zeng, 2016).
Against this backdrop, SEZs have had profound and multifaceted positive impacts on China’s economic landscape. According to the World Bank Report (Zeng, 2010), in 2007, SEZs in China accounted for approximately 22% of national GDP, 46% of FDI, and 60% of exports, contributing to the creation of over 30 million jobs. Later research conducted by Jin Wang in 2012 revealed that the SEZ programme increased the FDI growth rate by 6.9 percentage points within municipalities without crowding out domestic investments. Moreover, she found that SEZs saw a rise in total productivity growth of 1.6 percentage points, which is in line with the common view that clustering allows firms to become more productive (Greenstone et al., 2010). This could also be attributed to dynamic spillover effects, where new foreign entrants share their expertise and technological advancements, thereby enhancing local skills and boosting local innovation (Farole, 2011). Lastly, the research highlighted that SEZs made local workers financially better off, as they experienced an 8% increase in the average wage coupled with a 5% increase in the CPI. The positive impacts of SEZs in China received additional validation from Song et. al. (2020), who, drawing on traditional institutional theory, discovered that SEZs improve “partial institutional quality” thanks to their greater legislative independence, thus facilitating foreign entry.
China is not the only country that benefited from SEZs; Jordan’s Aqaba SEZ brought in $18 billion and 10,000 jobs (Zeng, 2016); Bangladesh’s eight zones drew 412 firms, $2.6 billion in investments, and employed 350,000 (IFC, 2017); the Dominican Republic’s free zones grew from 500 jobs in 1970 to 200,000 by 2007 (World Bank, 2006); and Costa Rica’s Export Processing Zones surged from under 10% to 55% of manufactured exports between 1990 and 2003 (Ferreira, 2009). Now, do these notable numbers mean that SEZs are an ultimate path to attracting FDI and stimulating economic growth for other developing markets? Many scholars would beg to differ.
The other side: challenges and limitations
Indeed, even in China, the effects of SEZs have their own limitations. For instance, motivated by the early successes, many local Chinese governments attempted to replicate this approach, initiating a series of additional industrial zones without any thorough assessment. As a result, later SEZs saw reduced impact from intensifying competition and “race-to-the-bottom” fiscal policies, leading to distortion in the locations of FDIs (Zeng, 2015). Moving on from China, Frick et. al. (2019) analysed the effects of 346 SEZs across 22 emerging countries and provided empirical evidence suggesting that SEZs have a strong distance decay effect. Namely, the effects are strongest only within a 10 kilometre radius of the zone and decline dramatically with distance. This implies that the influence of SEZs is very localised, failing to foster broader national development. Cirera and Lackshman (2014) raised further scepticism about the job creation impact of SEZs. After synthesising 59 studies across different developing markets, they concluded that there is insufficient evidence to prove that employment in these zones represents a net increase. Some scholars even went as far as to call the SEZs a suboptimal policy due to the varied results across countries, uneven distribution of benefits, and distorted resource allocation (Engman et. al. 2007). Complementing this sceptical perspective, perspective, a 2011 World Bank study conducted by Thomas Farole in 2011, demonstrated that SEZ programmes in Ghana, Kenya, Lesotho, Nigeria, Senegal, and Tanzania had a noticeably limited impact when compared to other non-African SEZs.
Given the mixed outcomes across countries, it is evident that SEZs are not a guaranteed solution for economic growth in emerging markets. Thus, it poses the question: under what conditions should SEZ programs be adopted, and what factors contribute to their successful execution?
Next steps: what else is needed for SEZs?
Research suggests that further elements are necessary for SEZs’ effective implementation, and has identified a set of prerequisites for when they are an appropriate policy choice. Such key considerations include the importance of country- and regional-specific contexts, indicating that zones located not too far from major cities and those in countries with easier access to developed markets or a history of industrialisation tend to perform better (Frick et.al., 2019). The effectiveness of incentive packages and corporate tax breaks has been limited, while the viability of a low-cost labour base and market access continue to be key considerations for foreign firms (Frick et.al., 2023). Additionally, the broader economic strategy of liberalisation is crucial, as the presence of SEZs should support and not replace the need for greater economic openness to ensure sustainable growth beyond the immediate regions of the SEZs (Leong, 2012). This strategic alignment involves adopting a realistic development model that leverages local advantages and foreign know-how within SEZs, fosters inclusive economic growth, and caters to local needs. In conclusion, while SEZs have emerged as significant tools in the strategic toolkit for economic development, their potential to incite widespread economic transformation should be approached with measured expectations.
As evidenced by the Chinese example and other international experiences, SEZs are most effective when strategically implemented to target the economies of specific localities and smaller regions, rather than being viewed as catalysts for nationwide economic rejuvenation. Policymakers must adjust their ambitions associated with SEZs, grounding their goals in the realistic potential of these zones and the prevailing level of local development. They must ensure that SEZs are not isolated interventions but are integrated into broader economic strategies. By doing so, decision-makers can harness SEZs as instruments of localised change, stimulating innovation, employment, and economic diversification.
References
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About the author
Vitaly Zakalskiy (LBS MiM 2024) is an Outreach and Communications Intern at the Wheeler Institute for Business and Development. Vitaly holds a BSc in Economics & Politics from the London School of Economics. He has experience in strategy consulting and research in the field of business strategy in emerging markets.