Special Economic Zones Are Not Cheat Codes
A booming zone next to a poor village looks like a triumph. Usually it's an accounting trick
Two years ago, I wrote a primer on SEZs. This is the follow up. See the original piece here:
Special Economic Zones: A Primer
A Special Economic Zone (SEZ) is designed to transform the business environment in a specific area. The government typically offers tax breaks, tariff reductions, and other incentives to encourage investment. Each SEZ operates differently—some focus on tax exemptions, while others offer relaxed labor…
If you need a reminder, a special economic zone is a designated region by the government that has a more friendly business environment to encourage more development. These zones have different legal and commercial regimes than the rest of the country. You can say that Britain’s colonial outpost in Hong Kong in the 1800s was an SEZ.
The British colonized Hong Kong in the 1800s after flooding China with opium during the “Opium Wars”. Under British rule, Hong Kong developed much higher living standards and operated under different laws than the mainland. Hence it was a “special economic zone”. When China opened up its economy more in the late 1970s/early 1980s under Deng Xiaoping, Hong Kong was one of the biggest “foreign” investor initially to mainland China! So special economic zones must always be successful right?
The Success Rate of Special Economic Zones
Special Economic Zones (SEZ) are generally described as successful if they attract additional firms and generate new jobs. The go-to example that everyone thinks of is Shenzhen. Shenzhen used to be a poor fishing village. But when Deng Xiaoping turned it into a special economic zone, modeled after the Irish Shannon Free Zone, it became a mega-dynamic city.
Increasingly, you have many organizations and people thinking that the road to development is just to make more special economic zones, attract foreign direct investment (FDI), and then the nation will be rich. Some of those SEZ advocates think the only reason why many local countries don’t have SEZs is because those nations are ruled by idiots, corrupt pro-status quo fools, or ideological socialists who refuse to pick the low-hanging fruit which could make their nation richer. While bad leadership exists, the harder truth is that SEZs can fail even when governments sincerely try to copy the Shenzhen model. The hard reality is that the failure rate of a special economic zone in generating incremental economic activity is 60%. Today we’ll find out why.
Case 1: Enclaves vs. Engines
The fundamental issue is that SEZ benefits are highly visible and concentrated, while its costs are dispersed and hidden.
If you walk into a booming zone and see 1000s of people making jeans or assembling electronics, the policy looks like a success (especially when you compare the zone to a neighboring poor village). Look below at the SEZ in Haiti. It is the Caracol Industrial Park.
BUT, it’s misleading to compare the zone with neighboring areas. SEZ have fiscal and regulatory incentives along with already higher than average government spending in electricity, roads, and water that will give that zone an upper hand compared to the rest of the country. So, looking at the success of an SEZ by job creation is not a rigorous analysis of whether a SEZ is good. A rigorous analysis tells us if the zone is bringing incremental gains, with the comparison being the imagined counterfactual of not having the zone in the first place.
It’s also misguided to judge a zone based on hitting export or investment goals since performance could come at the expense of other areas. Lastly, a good analysis asks what the zone costs the rest of the economy.
The Haitian SEZ, which was made in 2012 under president Michel Martelly, was supposed to create 65K direct jobs. It never came close to that number. At its absolute peak, it created 15K jobs. In addition, these jobs were overwhelmingly minimum-wage garment assembly jobs. There were also almost no spillover effects to the rest of the economy. The foreign firms did not source parts from Haitian suppliers, but rather imported all their goods.
Caracol was funded by foreign grants (the US government and the Inter-American Development Bank), Haiti didn’t pay anything. The donors spent $300M to make the park and power plant. Also, there was land displacement. Roughly $1M was spent compensating the evicted 366 families from the 600 acres of agriculture land. The foreign firms that operated on the zone had a 15 year tax holiday.
Sadly, there was zero spillover/linkage effect to the rest of the economy.
Before I continue, let me explain what I mean by “linkages”. You can’t transform an economy without it. There are two types:
Backward linkages: foreign firms buy materials and services from local suppliers (Locals providing inputs for foreign firms)
Forward linkages: foreign firms sell goods and services to local firms (Foreign firms providing inputs for local firms).
It’s hard to get both. Sometimes backward linkages don’t happen because local inputs are not up to the standards expected by foreign firms. Also skills transfer that may occur through labor mobility are limited, especially if the workers are low skilled.
The foreign firms that operated in Haiti (like South Korean SAE-A) imported goods almost entirely from China, so there was almost zero domestic supplier contracts.
Now let’s see another case.
Case 2: The Cannibalizing SEZ
If you throw enough spending, any government can make a specific plot of land look successful. But equating the number of workers in an SEZ factory with “newly created jobs” is often a statistical mirage. Sometimes, SEZs don’t generate incremental economic activity but rather, they can cannibalize activity from the rest of the country. There are times when domestic firms relocate to an SEZ to get lower taxes, but they aren’t really expanding the output. When that happens you are starving the government of tax revenue without adding incremental value.
A great example is comparing India and China. In 2005, Manmohan Singh was the Prime Minister and he pushed the SEZ act through parliament.
Singh and his commerce minister, Kamal Nath thought they were replicating China’s success in Shenzhen and thought they were on the road to creating the factory of the world with their SEZ law. Supporters of the bill would frequently say “just look at the results in China!” to advocate for it.
The success didn’t happen the same way. Let’s see why.
Land
In China, land is state owned. When Deng Xiaoping turned Shenzhen from a fishing village into an SEZ, the state simply commanded it. The government acquired massive tracts of land (Shenzhen is roughly ~33K hectares) and built entire cities with integrated ports, highways, and power grids.
In India, land was a highly contested fight club. The Indian government and private developers tried to acquire large tracts of farmland for multi-product manufacturing SEZs. But what happened was that it triggered violent protests from farmers, like the Nandigram protests in West Bengal in 2007.
West Bengal farmers violently clashed with police. The farm land was supposed to be acquired to make a chemical hub SEZ, having firms like the Salim Group in Indonesia.
The protests were so bad that Singh’s government compromised hard. Singh’s government froze the creation special economic zones for three months, capped the size of zones, and stripped land acquisition powers away from state governments. As a result, it was now politically impossible to make a Chinese-style mega zone in India.
Size
The result was that the amended SEZ law now created very small SEZ zones. If you want a multi-product SEZ with complete supply chains, you need at least 4K hectares. India didn’t really get that. Instead the minimum hectares kept reducing from 1K to 500 to 50 hectares. In addition, the government had an exemption for the information technology and IT Enabled Services sector, allowing IT-specific SEZs to be made on just 10 hectares. Instead of getting 4K+ hectare multi product SEZs, India got small zones that basically attracted already- Indian IT firms.
Democracy, specifically, the right of anyone’s voice to be heard and listened to in a protest, damaged Singh’s vision. Instead of attracting new foreign manufacturing firms to build massive, job-creating industrial cities like Shenzhen, the law was curbed sharply by local peasant farmers. And then, India’s domestic tech giants used the watered-down law to pay lower taxes. As a result, already-Indian firms like Infosys, TCS, WNS, and Wipro bought 4 to 10-hectare plots right down the road from their existing offices in Pune, Chennai, and Bangalore, walled them off, and declared them “Special Economic Zones”, and moved their staff inside to claim a 10 to 15-year tax holiday.
The SEZs did not cause incremental growth of skill development, it just created a real estate and tax arbitrage vehicle for domestic software firms.
Case 3: Misallocation: Bribing firms into Bad Geography
Businesses naturally gravitate to efficient locations, places with deep talent pools, proximity to good ports, and good existing infrastructure. Think of how tech firms and VCs flock to Silicon Valley.
When a government creates a special economic zone in a suboptimal location to force regional development, it has to offer massive tax breaks to compensate for the awful geography. These incentives act as a bribe, subsidizing the inefficient allocation of resources. If the location was actually optimal, then the companies would already be there. I’ll give an example with China (yes China has failures too). In this example, I’m comparing Chinese-Singapore SEZ in Suzhou (Sue-Joe) vs. Chinese-Kazakhstan SEZ in Khorgos/Horgos. Both SEZs had many issues, but Suzhou turned out more successful than Khorgos.
The Suzhou industrial park in eastern China was a success because it leverages its natural geographic advantage. It sits 80 km from Shanghai in the Yangtze River Delta, with deep talent pools and access to global shipping lanes.
It attracted genuine high-tech manufacturing such as Samsung, Philips, and Bosch. It is now a global hub for semiconductors, biomedicine, and nanotechnology. People who live in Suzhou make a median salary of ~¥110K or $16K, which rivals European countries like Portugal, Czechia, Latvia, Lithuania, Poland and Greece.
When you do an autopsy on this economic zone, you realize what made this successful. Many policy makers think an SEZ just needs “hardware” (roads, ports, power). But in Suzhou, the policy makers realized that foreign investors care just as much about software (legal frameworks, customs-efficacy, anti-corruption, and intellectual property protection).
In 1994, Vice Premier Li Lanqing (lawn-ching) teamed up with Lee Kuan Yew to make a joint venture in Suzhou.
Lee Kuan Yew invested money and exported his governance model.
Singapore trained 1000s of Chinese officials in Singaporean bureaucracy. If a foreign multinational wanted to make a microchip plant in Suzhou they didn’t deal with China’s slow and corrupt 1990s bureaucracy, they dealt with SIPAC (Suzhou Industrial Park Administrative Committee), a Chinese administrative body built around Singapore-style “software”.
Suzhou actively recruited foreign firms and made backward linkages so it wouldn’t be importing 100% of all goods like in Haiti.
The zone management aggressively helped the local Chinese small-medium enterprises (SMEs) upgrade their quality standards so they could supply these foreign giants. Suzhou deliberately attracted big corporations like Samsung, and then tried to build a cluster of Chinese & Singaporean suppliers to help them.
So think of it like this, instead of Samsung importing plastic castings or metal screws from a Japanese firm, they were motivated to buy them from a Chinese SME right outside the zone. This is the magic technology and spillover effect. Local Chinese firms learned world-class manufacturing standards which permanently upgraded the domestic economy.
Unlike Haiti’s SEZ, Suzhou moved up the value chain. After they mastered basic electronics assembly in the 1990s and 2000s, they focused more on biopharmaceuticals, AI, and nanotech. They partnered with global universities to build research institutes in the zone.
If you think Suzhou was smooth sailing, you are mistaken. In fact this zone almost died. Between 1994-1999, Suzhou was bleeding money: Singapore invested over $140M and the park faced average annual losses of ~$24M. The Suzhou local officials even lied and said the project was profitable when the Singaporean officials said it wasn’t. In 1999, Lee Kuan Yew was upset with the project and realized that the central government and local officials are not always totally aligned.
The joint venture was split 65% Singapore and 35% China. Because the local Suzhou municipal government only owned a minority stake, they didn’t care if they succeeded. In fact, the local Chinese mayor secretly built a competing zone right next door called the Suzhou New District (SND), which was 100% Chinese.
When foreign investors arrived at the airport to look at the Singaporean park, local Suzhou officials would intercept them, drive them to the 100% Chinese owned SND, and offered them cheaper land and lower taxes. The local government was cannibalizing the Chinese-Singaporean project.
But in 1999, the Chinese Communist Party saw this and hated what the Suzhou mayor was doing. In 2001, the CCP flipped the ownership structure to being 65% Chinese and 35% Singaporean, giving the local Suzhou officials the majority of the profits. After this, the local Suzhou government stopped sabotaging the Chinese-Singaporean Suzhou park, and redirected all their best resources to it. The Chinese-Singapore park turned a profit that same year and exploded in profits since. After 20 years, the Suzhou park had a positive cumulative net present value.
However, Khorgos/Horgos had deep issues. Horgos sits in Xinjiang (West China) on the Kazakh border. This was supposed to be the crown jewel of the Belt and Road Initiative called “New Dubai”, but it has had a rocky start at the moment.
The Communist Party of China (CPC) offered 5 years of no taxes. Because the Communist Party of China did not force firms to actually build factories or hire local Chinese workers (like Suzhou did), the program was immediately hijacked. Over 20K firms registered there, and over 2K film, entertainment and media studios flocked to Khorgos to register as a shell company purely for tax arbitrage. Barely anyone built actual factories there.
A rich actor or director would rent a fake desk in Horgos, register their production studio there, funnel their domestic movie profits through that address that paid 0% corporate tax. The Chinese media nicknamed the city “Horlywood” because every major movie’s end credits listed Horgos based shell firms. In 2018, the jig was over. The CPC realized Horgos was bleeding government revenues without creating a single job. The CPC changed the rules demanding that firms have one address for their company. As expected, there was a mass exodus of firms from Khorgos, hollowing out the tax haven.
Khorgos could still function as a dry-port for the Belt & Road Initiative, but the tax-haven aspect of the SEZ was a massive failure of poor incentives.
Case 4: The Hidden Infrastructure Bill and Crowding Out
A “successful” SEZ does not come free. It’s heavily subsidized. The above-average roads, the uninterrupted power grids, and modern water systems built inside the zone come at a steep opportunity cost: the capital spent pouring the asphalt, steel, and engineering in the SEZ is capital denied to the rest of the country’s infrastructure.
Furthermore, governments usually borrow heavily to build these multi-billion dollar zones, which means absorbing the country’s finite pool of credit. When a government does this, it triggers the crowding-out effect. It starves domestic firms of cash they need because the government is sucking up the money for the SEZ. This happens through two main mechanisms, depending on how free market the country’s financial system is.
Free Market Mechanism: Driving up Interest rates:
In a more market-oriented developing country (think Ghana, Sri-Lanka, Kenya, or Egypt), the government pays for mega-project SEZs by issuing bonds and then investors buy them. Usually, these countries don’t have enough domestic investors to fund a multi-billion dollar SEZ. As a result, these governments use a mix of domestic borrowing (borrowing in local currency from domestic investors) and external borrowing (borrowing in US dollars from foreign investors). Both of these choke lending to the local small-medium sized business. But in different ways.
Domestic bond squeeze: To fund the local costs of the SEZ (land acquisition, connecting roads), the government issues domestic bonds. Domestic commercial banks buy these bonds instead of issuing commercial loans to SMEs. Because the banks have tied up their capital to government bonds, the supply available of loanable funds shrinks, and local commercial interest rates go up.
External debt squeeze: To pay for foreign contracts and import heavy machines, the government takes on massive external US dollar loans. If the new SEZ fails to generate enough exports (which would give the central bank US dollars) to pay back the loan, then investors panic. The country’s sovereign credit rating will tank and the local currency will crash. To prevent capital flight and defend the currency, the central bank will hike up the short term baseline interest rate to attract investors. Commercial banks immediately pass this massive rate hike onto SMEs.
State-Directed Mechanism (Credit & Currency Rationing)
In developing countries where the government controls the financial system (think Ethiopia, Vietnam, Bangladesh, and China), the government doesn’t have to tempt banks with high-yielding bonds or rely strictly on foreign borrowing (they will still borrow in foreign currency if they need to though). The government just directs where the country’s cash goes through two mechanisms: credit rationing & currency rationing:
Credit rationing: The government legally forces domestic banks or if the banks are government-owned, tells the banks to use their cash deposits to fund state mega-project SEZs. Local SMEs are left to fight over whatever loans remain.
Currency rationing: Because the central bank has a limited amount of foreign exchange reserves, it hoards those foreign exchange reserves (usually US dollars) for the construction imports for the SEZ. A local manufacturer who needs dollars to import a machine from Germany outside the zone is deprioritized compared to a foreign Chinese/Italian firm who needs to be paid so he can make the SEZ’s power stations, wastewater plants, and highways.
Here’s an example of failures vs. successes. Dukem in the Eastern Industrial Zone was Ethiopia’s first special economic zone. The whole zone was entirely developed and financed by a private Chinese consortium called the Jiangsu Qiyuan group and the Export-Import Bank of China .
This whole plan was relatively successful. Qiyuan Group asked the Ethiopian government permission to secure a long-term lease on the land and build the zone themselves. Because the Chinese provided the roads, power lines, and factory sheds, the Ethiopian state didn’t have to issue bonds, trigger a debt crisis, or hoard US dollars to build it. It attracted foreign investment without crowding out domestic SMEs. The Chinese brought the bulldozers, asphalt, and power.
So Ethiopia got the roads, the textile factories, and the FDI off the government’s balance sheet.
However, the Hawassa Industrial Park was a different story. In the 2010s, Ethiopia decided to finance their own SEZ. Hawassa was a state-owned mega project. The Ethiopian government via its government-owned, Industrial Parks Development Corporation decided to build it.
The Ethiopian government hired the Chinese state contractor, the China Civil Engineering Construction Corporation to lay the roads, build the eco-friendly water treatment plant, and make the factory sheds. The Ethiopian government paid the Chinese contractor in US dollars. To get those dollars, the Ethiopian government spoke to the Central Bank governor to pull central bank reserves to pay the Chinese. As a result of taking foreign reserves, the local Ethiopian manufacturer who isn’t in an SEZ was suffocated from getting foreign currency to import basic machinery. Besides siphoning dollars away from the locals, Ethiopia needed more dollars, so Ethiopia raised a $1B eurobond (foreign borrowing) in 2014. Sadly, the parks weren’t generating the export growth to generate enough dollars to continue to make interest payments on the eurobond. Frankly, the Hawassa park was just one problem, of a broader external debt and foreign exchange issues that Ethiopia had, compounded by the Tigray War. By December 2023, Ethiopia defaulted on a $33M eurobond payment.
Conclusion
Special Economic Zones helped transform China, but as we’ve seen, they are not an economic cheat code. When executed terribly, they are a fast track to developing enclaves with no forward or backward linkages (Haiti), cannibalizing your own tax revenue (Chennai, India), subsidizing fake shell companies (Horgos, China), or killing your local firms so you can funnel your reserves to pay foreign contractors (Ethiopia).
The success of an SEZ is measured by what spills over outside the zone. If an SEZ doesn’t encourage technology transfers, upgrade local supply chains, and integrate with the broader domestic economy, then it’s not really an engine for national development.
The TLDR is basic: a successful SEZ accelerates “learning-by-doing”. A good zone makes local workers learn new skills, helps local suppliers match global standards, and drives local firms learn to compete globally. If none of that spills outside the zone, then the zone is more of a fenced-off enclave or a tax shelter scheme for local firms rather than a development engine.
Here you point to an important point about next generation special economic zones, which feature distinctive legal regimes,
"But in Suzhou, the policy makers realized that foreign investors care just as much about software (legal frameworks, customs-efficacy, anti-corruption, and intellectual property protection)."
See the Dubai International Financial Centre (DIFC) for the best example of such a zone.
See also Lotta Moberg's book on the Political Economy of Special Economic Zones, one of the best resources out there,
https://www.amazon.com/Political-Economy-Special-Economic-Zones/dp/1138237817
She makes the point that generally privately financed zones do better than government subsidized zones because of the incentives involved.
Also listen to all available interviews with Bob Haywood, the most experienced SEZ architect in the world. Here is one,
https://underthrow.substack.com/p/the-invisible-hand-behind-a-hundred
SEZs as accounting tricks. The 2012 Addis panel with Monhla Hlahla and Gao Xiqing had the same optimism. Still waiting for the spillover.