Success involves more than just a well-designed policy package
For developing countries, the attraction of export processing zones (EPZs) seems to continue unabated. The first ones were created in the early 1970s. Since then, some 100 have been established and a large number are in various stages of being set up. The idea behind these zones is to stimulate exports of nontraditional manufactured goods, thereby contributing to the growth and development of the host country. But the record so far has been mixed, with most of the notable success stories in Asia. One prominent example outside Asia is the EPZ in Mauritius, credited with helping to diversify the primarily sugar-based economy into an export-oriented producer of manufactures. This article takes a look at how the Mauritian EPZ has performed over the past 20 years and the ingredients for success.
Elements of an EPZ
EPZs date back to the free ports of city states in medieval Europe. The basic concept has been adjusted to meet the needs of developing countries that wish to diversify, create employment, and open up their economies, but face actual or perceived constraints in pursuing a comprehensive liberalization policy (e.g., a low level of foreign exchange reserves, limits on borrowing, and social and political considerations). The individual elements vary from country to country, however, typically, the liberal trade regime created for the EPZ is supplemented by some sort of preferential treatment of investors with regard to national tax laws of the host country, liberal ownership policies that allow foreign investments to reach the 100 percent level, unlimited and free transfers of profits, a physical infrastructure package, and simplified regulations.
For a detailed analysis, see “Export Processing Zones for Growth and Development: The Mauritian Example,” by Rolf Alter, IMF Working Paper, WP/90/122, available from the Indian Ocean Division of the IMF.
In the case of Mauritius, the Government first decided to embark on a program of diversification in the early 1960s, with the initial emphasis on tax exemptions, long-term loans at favorable rates, and protective import duties and quotas. But given the small size of the domestic market and the negative experiences of others with import substitution as a long-term strategy, the thrust soon switched to an outward-looking development policy. The establishment of an EPZ served as the centerpiece, and in 1970, the necessary legislative framework was created.
EPZ policy package
Overall, Mauritius has provided a package of incentives that has attracted foreign investors from all over the world, with Hong Kong accounting for about two thirds of investment in the mid-1980s, followed by France, with 10 percent. But, particularly in the early stages, nearly all of the funds came from local sources—an unusual element of the Mauritian story—thanks to the profitable sugar industry. The chief export market has been the European Community (EC)—mainly France, Germany, and the United Kingdom—with the United States taking up the largest chunk of the remaining one third. (Until recently, EPZ companies had to export all of their products.) From the very beginning, some 80–90 percent of EPZ activity (as measured by the number of companies and employment) has been in textiles (mostly articles of apparel, such as sweaters and shirts, and accessories, such as gloves); the other 10 percent has involved numerous products, such as leather, footwear, optical goods, watches, jewelry, and recently, electronics.
Labor market. This is perhaps the most attractive aspect of the EPZ package. The availability of surplus labor was originally a key enticement; indeed, unemployment in Mauritius remained rather high until 1985, with an unemployment rate of more than 14 percent, after which it declined rapidly to less than 3 percent in 1989. At the same time, the level of wages stayed relatively low—even in 1988, Mauritian labor costs were about 25 percent of those in Hong Kong and Singapore. Foreign investors have also benefited greatly from the literate, trilingual (French, English, and Chinese), and highly adaptable workforce, along with favorable labor laws for the termination of employment and overtime. With the Mauritian economy approaching full employment, the private sector and Government have recently set up the Industrial and Vocational Training Board to maintain the attraction of the labor market.
Fiscal and financial incentives. These include income tax relief and exemptions from customs duties on EPZ-related imports and exports. Profits and dividends may be freely repatriated, capital brought into Mauritius (excluding capital appreciation, which is subject to exchange control and the regular rate of stamp duty) may be freely taken out, and preferential financing schemes are available. After 1985, the corporate tax incentives were standardized and broadly applied to all exporting companies.
Infrastructure. The EPZ is not restricted to designated industrial estates or enclaves—as is typically the case—but is instead dispersed throughout the island. This arrangement was made possible by the already existing infrastructure, and has benefited investors, workers, and the environment. The majority of firms rented ready-made industrial estates at subsidized rates until the mid-1980s; companies also enjoyed subsidized electricity tariffs.
On the administrative level, the Government reacted to complaints about difficult procedures for foreign investors by creating the Mauritius Export and Investment Authority in 1984. Problems in the 1970s with chronic port congestion were solved by building deep-water quays and a separate bulk sugar terminal. The use of air freight has become increasingly common among EPZ industries, given that many of the products (particularly fashion garments) must reach their markets quickly.
How the EPZ fared
To get a sense of how the EPZ has performed over the past 20 years, it is useful to divide the ups and downs into four stages, during which time a number of distinct movements can be traced (see chart):
Stage I: The “take-off,” 1970–77. Following passage of the EPZ legislation, investment, employment, and exports expanded vigorously, benefiting greatly from high local investment. Nonetheless, net exports for the zone—which can be used as a proxy for net foreign exchange earnings actually accruing to the host country—were quite low, because of the high level of imports of plant and machinery. As a result, the net export coefficient (the share of net EPZ foreign exchange earnings in total EPZ earnings) remained far below 10 percent during the first part of the period.
Stage II: External and internal problems, 1978–82. In this second phase, the expansion continued, but at a much slower pace. The number of companies fell, but then picked up again, while employment slowly rose; for most of these years, foreign investment did not play a major role. As could be expected during a slowdown, net exports rose, and thus the coefficient remained close to 40 percent.
Mauritius: key EPZ Indicators, 1975–90
Source: International Monetary Fund.
Stage III: Revival of the boom, 1983–88. Especially in the mid- and late-1980s, the EPZ once again expanded rapidly. The number of companies surged from 115 in 1982 to nearly 600 in 1988, employment grew, and foreign investment became a major factor, accounting on average for 25 percent of total EPZ investment. Exports quadrupled in US dollar terms, but as investment rose, the net export coefficient dropped to an average 26 percent.
Stage IV: Consolidation and reorientation, 1988-present. In this phase, first export growth declined slightly, the number of firms fell off a bit from the 1988 peak, employment stagnated, and the net export coefficient eased to slightly below 20 percent. However, preliminary results for 1990–91 indicate a recovery in the EPZ’s performance—including a strengthening of the textile sector and progress in diversification.
Why the EPZ worked
After 20 years, it is clear that the Mauritian EPZ has assisted growth and development. The special zone now accounts for more than 60 percent of total exports, more than 30 percent of total employment, and more than 85 percent of total foreign direct investment. To what can this extraordinary expansion be attributed? To answer this question, we tried to identify individual factors that had a bearing on the zone’s performance, as measured by export growth (see box on longer study). Our analysis showed that beyond the well-conceived EPZ package, two other groupings were critical: the macroeconomic conditions and the external environment. They were decisive against a background of political stability, a continuity of social and economic policies, and the Government’s unflagging support.
Domestic conditions. Throughout the EPZ’s history, its development closely paralleled movements in the Mauritian economy. In the early 1970s, the domestic economy grew rapidly, largely thanks to good sugar crops and a surge in world sugar prices; a depreciation in the real effective exchange rate also helped to encourage exports. But in Stage II, when Mauritius failed to adjust to external changes, creating fiscal and balance of payments imbalances, the EPZ’s performance deteriorated and both domestic and foreign EPZ investment declined.
After 1979, however, the Government—with the support of five IMF stand-by arrangements and two World Bank structural adjustment loans—implemented a strong stabilization program (notably, a flexible exchange rate policy) and a number of structural reforms, with an emphasis on restoring competitiveness and encouraging the private sector. As a result, in Stage HI, the EPZ responded vigorously and again became a driving force behind growth. In fact, the surge in EPZ employment translated not only into a reduction of unemployment but also into stiff competition for workers, and consequently, rising wages and high inflation by 1988. Thus, in Stage IV, the relative position of Mauritius vis-a-vis some of its competitors—Indonesia, Malaysia, and Sri Lanka—deteriorated, and the external current account swung back into deficit.
External environment. Mauritius has been far from immune from the volatile global changes, especially in export demand. In the early 1970s, Mauritius experienced a surge in demand from its trading partners, but after 1979 (in Stage II), the world recession contributed to a substantial slowdown. Then in Stage HI, recovery in the industrialized countries triggered a remarkable increase in exports of Mauritian products, averaging 8 percent between 1983–88. In Stage IV, overall demand growth has eased slightly, largely the result of stiffer external competition and a weakening of demand from Europe and North America for textiles.
Another critical influence has been international agreements covering investments and exports, as well as a general protection against nationalization. Perhaps the most important one has been the Lome Convention, which Mauritius signed in 1972, giving its products duty-free access to the EC. Mauritius has also benefited from the US import regulation scheme for clothing. For example, when Hong Kong producers were looking for new sites in countries that had not yet become subject to the US import quotas, Mauritius became an attractive alternative.
As for the future, much will depend on how the Government deals with two key challenges. On the domestic front, inflation needs to be further slowed and wage-setting policies liberalized (e.g., the regular tripartite wage negotiations de-emphasized, and wage adjustments linked to productivity growth, including measures to promote the movement of labor from lower to higher productivity sectors).
The authorities will also have to continuously refine the package of EPZ initiatives—as they have recently done with tax harmonization, vocational training, and the opening of the domestic market for EPZ products—with the aim of increasing specialization in the textile industry, encouraging diversification into new industries, integrating the EPZ with the economy, and creating a more service-oriented export industry (e.g., data entry functions and translations). An Export Services Zone would fit well with the envisaged expansion of offshore banking. Progress in these areas will help to transform the EPZ’s labor-intensive, low-technology production base to a more capital-intensive, high-technology, skill-intensive one and to maintain the status of Mauritius as a globally competitive location for new investors—especially as new competitors, such as neighboring Madagascar, emerge.
Lessons for others
In light of Mauritius’ success, it might be tempting to conclude that the EPZ concept offers a straightforward policy instrument for diversification, export growth, and development; indeed, numerous examples in Asia support this view. However, the case study of the Mauritian EPZ—as well as experiences elsewhere (see “Export Processing Zones and Trade Policy,” by Peter G. Warr, Finance & Development, June 1989)—makes it clear that a number of caveats exist, ones that no doubt will serve to substantially limit a wider use of the EPZ:
There is no substitute for general liberalization. The EPZ concept mainly offers temporary advantages. The enclave status does not mean that EPZs can be regarded as sealed off from the host economy; in particular, it does not reduce the need for effective and sound monetary and fiscal policies, an outward-looking external policy stance, and the promotion of an entrepreneurial climate. The contributions of EPZs are very likely to be maximized if they are established in the first phase of an economic policy reorientation. Countries may wish to set up EPZs to concentrate resources, facilitate the internal adjustment process, and create greater internal and external “visibility” for their policy reorientation.
Targets are achieved to different degrees. In terms of direct effects, the creation of employment, and at a later stage, the reduction of unemployment, are likely to be the most unequivocally positive ones. As for growth and foreign exchange earnings, however, caution is in order. In the case of Mauritius, the EPZ’s share of value added in total GDP consistently remained in the 10 percent range. On the external side, host countries could reasonably anticipate net export earnings of about 30 percent of gross exports, a proxy of the actual additional EPZ-generated foreign exchange earnings.
Expectations for forward and backward linkages with the host economy should also be guarded. The former are unlikely to be created as long as EPZ companies are obliged to export their production completely, and the latter will be highly dependent on the nature of EPZ production and the ability of local supply to meet the requirements of quality, timeliness, and quantities of input. In addition, host countries should not become overly optimistic about diversification. There is a tendency for EPZs to become concentrated in a few industries—notably textiles and electronics—that seem to be particularly compatible with the EPZ concept from the investor’s point of view, meaning that they can be relocated easily and do not require highly skilled workers.
There is a need for preferential market access to trading partners’ countries. The Mauritian example seems to indicate that while this is a valuable element, it can also become a limiting factor once the advantage is exhausted (e.g., in cases of a fully used import quota). Bilateral arrangements can also be subject to unpredictable political considerations.
The costs of EPZs can be substantial. Positive net foreign exchange earnings of the Mauritian EPZ indicate that the economic benefits have been higher than the costs involved. But two caveats should be made: (1) since this measure is not very exact, losses in economic welfare cannot be completely ruled out either, which might come as a surprise given that individual Mauritian targets have been realized to considerable degrees; and (2) we cannot draw any conclusions as to the superiority of the EPZ concept over alternative development strategies.
As for the budgetary implications, typically, the expenditure for EPZ-related infrastructure will be a substantial long-term burden on the budget without guarantees for a positive return, especially where the overall availability of infrastructure in the host country prior to the EPZ’s creation is limited or nonexistent (this was clearly not the case in Mauritius). Accordingly, the feasibility of establishing and operating a zone on a commercial basis should be considered, although private EPZs could create sovereign entity conflicts and result in less attractive terms for investors. Systematic evidence on other budgetary EPZ costs (e.g., subsidies and revenue foregone for tax breaks) in Mauritius are not available, but neither are the data on benefits (e.g., a broader income tax base and lower social expenditure). Since both the negative and positive effects can only occur to the extent that an EPZ actually creates economic activity, their net effects represent less of a risk for the budget than outlays on infrastructure.
EPZs now face stronger international competition. This will increase—especially given the new investment opportunities in Eastern Europe—putting even more pressure on existing and new host countries to ensure favorable macroeconomic conditions and offer ever-more generous incentives to investors in financial and fiscal terms, along with improving the quality and quantity of infrastructure facilities. Particular attention will also have to be paid to facilitating administrative procedures for investors, such as the establishment of “one-stop” agencies.