Subir Gokarn: The SEZ bounty

The state governments' stand on labour market flexibility will determine the success of the special economic zones.

On March 17, the government approved 148 proposals for setting up special economic zones (SEZs), covering about 40,000 hectares of land and involving a total investment of Rs 100,000 crore. All these will enjoy the several benefits that have been offered under the recent SEZ policy framework and are expected to be operational within three years in order to be entitled to them. Among the developers of the approved zones are such prominent corporate names as Reliance, Bajaj Auto, Mahindra & Mahindra, TCS, Wipro and Ranbaxy, as well as others known for their strategic orientation and long-term commitments. Their participation provides a great deal of credibility of the process and reinforces the expectations of proponents of the whole programme.

Before going into the merits of those expectations, one would have to concede that both history and the current policy regime run somewhat counter to them. Over the years that we have had various generations of the concept in place""free trade zones or export-processing zones or any other""their collective share of the country's total exports has not risen above 5 per cent. This sluggishness was evident even while the growth rate of aggregate exports was quite buoyant, leading to the inescapable conclusion that these mechanisms simply did not offer a large enough advantage for exporters to locate their facilities in them. Whatever impeded the competitiveness of domestic producers outside the zones apparently had an influence inside them as well. The direct fiscal incentives were obviously not strong enough to offset those disadvantages.

On the policy front, the issue that was most debated was the possibility of exempting producers locating in the zones from the labour market regulations, particularly those applying to job security. Many people saw this as an indispensable part of the SEZ strategy and were disappointed by the ultimate decision not to provide these exemptions.

Obviously, the huge enthusiasm shown by developers, specially the names mentioned above, suggests that this concern is not as significant as it first appeared. One way or another, the zones will be able to create conditions necessary for globally competitive production. This perception is reinforced by the fact that many of the zones are focused on multi-product manufacturing activity, where the failure to deal with labour market issues has the maximum potential to cause damage. Well, apparently not, in the minds of the developers.

What, then, gives the developers the confidence that their huge investments will bear fruit? There is one clear difference between the old and new regimes. The developer""private or in partnership with a public agency""will have enough control over the infrastructure and services within the zone to provide his clients with a high degree of assurance with respect to their quality and reliability. The zones that we have had so far have been managed by public agencies, who, as we well know, cannot usually offer that kind of comfort.

What the developers are essentially banking on is a huge pent-up demand for high-quality facilities, the absence of which is deterring a range of investment activity. There is a perception that a lot of investment that would otherwise take place isn't, because the infrastructure situation is a huge deterrent. If this problem is solved within the framework of the SEZ, a substantial part of this potential would be realised.

While the labour issue may continue to be an irritant, there are bypasses available. For example, state governments, whose permission has to be sought to lay off workers, may be willing to co-operate in order to attract investment. In short, potentially high occupancy levels combined with extensive fiscal benefits provided to developers make this an attractive business proposition.

That explains the commercial interest in SEZ development. Is this interest aligned with the country's economic objectives? From the macroeconomic standpoint, it would be a tragedy if the performance of the economy did not stimulate a high level of investment, which would then complete the virtuous circle by itself, reinforcing the growth momentum. To the extent that the zones bring about an improvement in the investment climate and thereby contribute to increasing levels of investment in the economy, their impact will be unambiguously positive.

Given the average size of the bigger zones, the developers should be able to offer extremely attractive prices for high-quality services, sweetened by the fiscal benefits they will receive. Although the policy objective is oriented towards exports, it does not prohibit producers from selling in the domestic market, provided they pay all the duties that exports are exempt from, including customs duties on imports into the country.

I suspect that for many products, producers will find it economical to locate in the zones and sell in the domestic market. This tendency will be reinforced by falling import duties, which will reduce the price gap between exports and domestic sales for producers within the zones. For zones in the interior parts of the country, weak transport linkages to ports may offset the efficiency gains from locating in them and make domestic sales even more attractive.

The critical question is: are the zones "investment-creating"""attracting investment that wouldn't otherwise take place""or "investment-diverting"""inducing relocation from existing facilities? Either way, the business proposition remains intact, but, quite obviously, the macroeconomic interest is best served by the former. Which way will the pendulum swing?

Two factors will determine the direction. The first is the signal that state governments send on allowing de facto labour market flexibility. If they fight shy, producers who already have workers on their rolls will shift in order to take advantage of the infrastructure, while losing nothing on the labour front. However, new businesses will continue to have a problem with the prospect of a permanent labour force. The second is the degree of dependence on infrastructure outside the zone, which will, almost by definition, not match up to its counterpart within. Again, the logic of relocation is clear, while the logic of start-ups is not.

In short, in the current policy framework the zones undoubtedly offer a great business proposition to the developers. Their overall economic impact, however, depends not only on the zone policy itself but also on the situation with respect to several other issues. For those looking to emulate the Chinese experience, there is still some way to go.

The author is chief economist, Crisil. The views here are personal