Foreign Direct Investment (FDI) focuses on international social and economic integration along with positive effects on the Balance of Payments. It creates stable, long-lasting, and direct economies of scale. It promotes globalization and liberalization wherein helps to transfer technological knowledge and modern production know-how. The spillover effect of FDI on special economic zones (SEZ) is immense. FDI can affect the working of the labor market, capital market, trade pattern, and so on.
Some economists like Brecher-Alejandro said that foreign capital inflow in small economies can be trade immiserating. While there are plenty of other economists who spoke of the glorious effects of FDI on social welfare. A developing economy suffers from the vicious circle of poverty which in turn results in low productivity of the economy. A foreign capital injection helps to break this poverty circle. Here, we are trying to review the impact of FDI on Indian SEZs.
In 1965 Kandla in India was the first export-processing zone to be set up in Asia. Indian Special Economic Zones functions under the supervision of Foreign Trade Policy and is provided fiscal incentives. A special economic zone is an area in which trade and production laws are more lenient than the rest of the country. The main purpose of SEZs is to attract foreign currency, increase trade balance, create employment opportunities, and push the development of the country ahead.
According to the OECD Benchmark Definition of Foreign Direct Investment (1996), FDI implies the existence of a long-term relationship between the direct investor who is a resident entity in one economy and the direct investment enterprise, an entity resident in another economy, with a significant degree of influence of the investor on the management of the enterprise.
SEZs all over the world have started adopting development strategies intending to attract foreign capitals. The foreign capital acts as a catalyst in enhancing or deteriorating the conditions of the SEZs. SEZs are established with the view that FDI will enhance the export scenario even though they have competitive market prices. However, foreign investment does not always lead to welfare-improving scenarios. The bursting of the telecom “bubble” in 2001, and the huge cutback in information technology (IT) investment that followed, had severe knock-on effects for East Asian economies such as Singapore and Taiwan. (Economic security for a better world-ILO 2004)
The political economy approach contends that SEZs benefit a few capitalists through tax incentives and land acquisition at the cost of the rest of the population, leading to overall welfare reduction. According to the heterodox approach, SEZs attract FDI inflows and facilitate spillover of improved technologies and managerial skills. The agglomeration of firms in SEZs provides a stimulus to productivity and innovation through specialization, linkages, and demonstration effects and facilitates the development of global cities where resources can be utilized at local, national. (Foreign direct investment in developing countries)
There is a large economic literature that focuses on this area. This includes works of Hamada (1974), Hamilton and Svennson (1982, 1983), Miyagiwa (1986, 1993), Young and Miyagiwa (1987), Beladi and Marjit (1992a, b), Yabuuchi (2000), etc., which have found a formation of export zones to be welfare worsening in the presence of tariff-protected and capital-intensive import-competing sectors. However, Devereux and Chen (1995) have shown that the welfare effects of export zones can be of two types: volume of trade effect and a factor terms-of-trade effect. The second effect raises welfare, while the first effect is ambiguous and depends crucially on factor intensities of the protected sectors in the economy.
FDI and SEZ MODEL:
I am presenting a model to explain the working mechanism of FDI in SEZ. Consider a small open HT type economy with three sectors. Sector 1 is an agricultural sector and produces good X1 by means of labour (L) and land (N). Sector 2 is an SEZ industry that manufactures an industrial good, X2 by using labour (L), land (N), and capital (KD and KF). Sector 3 is the urban sector that produces a commodity X3, with the help of labour (L) and capital (KD+F). We are following the general equilibrium model hence, I am assuming all markets are in perfect competition. The notations and the equations of the general equilibrium model are as follows:
- W = flexible rural sector wage;
- R = return to land in efficiency unit;
- W* = unionized urban wage of labour;
- s = rate of price subsidy given to encourage formation of SEZ;
- N = given endowment of land in physical unit;
- t= ad valorem tax rate on foreign capital income;
- KF = supply of foreign capital
- KD = Domestic capital
- r = Return on capital
Price–unit cost equality in perfectly competitive markets imply
WaL1 + RaN1 = P1 ………. (1)
WaL2 + RaN2 + raK2 = P2 (1 + s) ………. (2)
W*aL3 + raK3 = P3 ………. (3)
where aji is the amount of the jth factor used in the ith industry to produce one unit of the output and Pi is the price of the ith good. It is assumed that the income on foreign capital is subject to taxation and the supply of foreign capital is a positive function of the net rate of return to foreign capital. Also, we assume that the entire government revenue earned from foreign capital is remitted to SEZ as a price subsidy.
Hence, the supply function of FDI is KF = KF [r, t]; and s = s[KF(t)]. Using Rybczynski and Stolper Samuelson theorem to further analyze the mechanism; we come to the conclusion that if SEZ or sector 2 is comparatively more capital intensive then the sector will benefit.
X2>KF> L (or N) > X3 (X1) ……….. (Rybczynski theorem)
r> P2(1+s)> P3 (or P1) > W (or R) …………. (Stolper Samuelson theorem)
(W* is institutionally fixed)
Thus, it would apt to state that if SEZ is capital intensive, the sector and its investors will benefit. However, stating this solely doesn’t help. There are live examples where the sector is labour intensive and as well as the growth due to FDI is immense. So, the results may vary to a great extent with respect to the trade policies adopted by the zone.
Although SEZs had a significant role in giving a boost to the Indian economy, their contribution to the national figures is below the expected level. In comparison to other countries, research shows that the potential of SEZs wasn’t fully exploited, even after attracting FDI.
The controversial reasons due to which the impact of FDI in Indian SEZs were low were: firstly, the profit-motivated industries simply reallocate to seek the benefits of tax exemptions; secondly, the government already suffering from financial crisis incurs massive revenue loss due to tax cuts; thirdly, large-scale acquisition of agricultural lands lead to reallocation and rehabilitation of farmers with meager compensation. The list goes on covering all aspects of corruption, inequality, region disparity, social insecurity, labor market disruption so on, and so forth.
India has always been a good persuader in attracting FDI; SEZs in India failed to deliver the benefits to its full extent. So, simply saying that FDI enhanced the trade scenario of SEZs is not true. Proper analysis is required to understand the mechanism of how FDI creates an impact on SEZs, just a single chapter is not enough!
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4 thoughts on “Does FDI boost SEZ performance?”
Truly the article shows the broad horizon but a detailed analysis is required to understand every shade of every sector of the sez. FDI and FPI will have different working mechanism and might give varying results in different zones
It’s a great but I hardly understand whole because it’s much more high level. But I got some very important facts from this article which are very important for me.
Its such a nice and very informative article…
It also helps us in our study also…