Special Economic zones represent the areas, which are subject to economic regulations that are not the same as those, applied to the other regions in the country. These regulations pursue the aim to attract foreign direct investment, to create employment and to reform country’s economy on a larger scale, in order to diversify exports and to create long-term structural changes in the economic orientation of the country (Hinkelman and Putzi ).
Free Zones
Free Zones, Free Trade Zones, Commercial Free Zones are the oldest type of the Special Economic Zones, which are usually located in or near the major transportation nodes, mostly in seaports and some airports. They are directly or indirectly controlled by the administration of the port/airport and are physically separated from the port’s or airport’s main premises, since they do not belong to the custom territory of the country. All the activities, which are allowed in a Free Zone are limited to minor processing operations, such as packaging and quality controls, as well as to the trade-related procedures, such as warehousing and exhibition (Farole). Freeports are also a type of special economic zones, which occupy the largest territory, compared to the other kinds of economic zones, usually encompass some of the rural or urban area, and include transportation facilities, such as airports or ports. Their territories may even contain administrative or political units of the country. Moreover, freeports include all the economic activities and population, which is located on the territories of the freeports (Farole).
An important prerequisite for success of a Free Zone is a strong governmental support and a clear vision of the future role of the area in the economy of the region. Thus, in East Asia Free Zones were a strategic tool to restructure economy and to shift away from the inward-looking policies by promoting export industries and attracting FDI. Therefore, they have become a part of the country’s long-term growth strategy both for the region around the free zone and for the economy in general. Although there is still some ambiguity about the definition of Free Zones, its impact on the economy is quite substantial. The employment multiplier, associated with Free Zones, varies between 0.25 and 2, according to the current estimates, thus creating approximately 1 percent of the world employment, with the majority of them located in China (Farole).
The benefits of the Free Zones are usually divided into two categories: dynamic and static. Dynamic benefits refer to the structural changes, derived from the existence of the Free Zones, such as technology transfer, economic openness and entrepreneurship. It is important to note that in the majority of cases Free Zones target major international corporations, rather than small and medium local businesses, due to the high cost and volumes required for using infrastructure facilities. The effect on the small businesses in the country can only be manifested through strengthening of the bonds between local companies and major international corporations, which can contribute to the growth of local businesses. Static benefits are short-term positive results, which mostly refer to trade and investment improvements. They are derived from specialization and more efficient resource allocation through trade creation, and include employment creation, FDI and improvement of the economic efficiency. The impact of Free Zones on trade will be further discussed in more details .
Impact of Free Zones on Trade
Establishment of Free Zones was often seen as a tool to correct for distortive policies, such as tariffs and import quotas, which create bias towards imports. This argument is based on the assumption that in a completely free economy, Free Zones will become irrelevant, therefore trade liberalization is considered a more efficient way to achieve the same objectives, which serve as the rationale for creating Free Zones. The cost-benefit analysis of the Free Zones is often conducted using the “enclave model”. According to this model a free zone acts as an enclave, since it is separated from the domestic economy by trade barriers, however it is well-integrated into global economy through trade and investment. Therefore, industries in the Free Zones are dominated by international sourcing of raw materials, while the attractiveness of local products is jeopardized by country customs regime. In addition to disadvantaging local producers of raw materials, Free Zones represent a threat for the local export industries, which are competing with the ones located in the Free Zones. Since the companies in Free Zones are exempt from paying taxes and from complying with the country’s customs regime, they have a competitive advantage over local producers, thus threatening local exporting sector. Therefore, some countries try to attract local producers to open facilities on the territory of the Free Zones, in order to reap the benefits of the relaxed customs regime.
The potential gains from Free Zones have been extensively explored by the developing countries, which account for the majority of free zones in the world. Unfortunately, in some instances major global companies have very low switching cost, therefore they remain in the Free Zone only while the government continues to provide concessions. Once some of the benefits are removed, big companies tend to search for another location. This practice leads to a “race to the bottom”, where developing countries try to offer as many concessions as possible, often at the expense of employment security and environmental standards (Farole).
Free Trade Areas
While a Free Zone is a form of trade liberalization on the national level, Free Trade Areas represent trade promotion through regional integration. Therefore, they no longer reflect national policy, but an agreement between several countries on the international level. Thus, Free Trade Area represents a deal between two or more countries, which establishes a free flow of goods between the participating countries without regard to the national borders (Hinkelman and Putzi ). In some instances this freedom only refers to certain goods, such as agricultural products. Members of the Free Trade Area define own tariffs and customs regulations with the countries outside of the Free Trade Area. The freedom of movement only refers to the products and does not suggest any other common policies or labour mobility (Czinkota, Ronkainen, and Moffett). In order to protect countries with more hostile tax regimes from the penetration of the foreign goods through the borders of other members of the Free Trade Area, where customs regimes are more lenient, all goods have to be certified according to the rules of origin. This certification proves that a certain minimum level of local material input and final processing has been performed in a country, which is a member of the Free Trade Area. In this case the product is subject to the preferential treatment of liberalized trade (Jones, Grossman, and Rogoff ).
The idea behind Free Trade Area creation is aligned with the theory of comparative advantage, which prescribes every country to specialize in products, which it can produce at a comparatively lower cost, both in terms of financial contribution and in terms of the opportunities forgone. Therefore, in a free market place a country should substitute products, where it does not have a comparative advantage, by the exports from another country within the Free Trade Area, while focusing on the industries, where it has comparative advantage. Figure 1 provides a simplified illustration of the processes, associated with an introduction of a Free Trade Area on the example of the European Union.
As a result of specialization, Free Trade Area gives an opportunity to obtain lower prices for the products. However, the presence of the external tax limits specialization to the countries within the area, thus shifting the price of the internal Free Trade Area suppliers below the price of suppliers from outside the area. The result of this fact is two-fold: on the one hand the quantity supplied by the local producers decreases by QS1 – Qs2, while local quantity demanded increases by Qd2 – Qd1 due the decrease in prices. The amount of Qd1 – Qs1 is currently imported from the other member countries, thus creating trade. The consequence of trade creation is usually an enhancement in the social welfare, therefore an increase in consumption of both foreign and local products. Thus, trade creation creates spill-overs for the non-member countries as well, by increasing imports, fostered by an improvement in welfare (Jain and Ohri).
However, along with trade creation, Free Trade Areas are also prone to trade diversion. It occurs when a lower-cost international supplier is replaced by a Free Trade Area partner through a reduction of common tariffs within the area. The result of the introduction of the external tariff on non-member of the Free Trade Area can be illustrated in Figure 2. Thus, if the price of international suppliers is artificially increased from Pw to Pw+t by an introduction of a tariff, imports from outside the Free Trade Area are going to decrease from QsQd to Qs2Qd2. Local production, on the other hand, will expand from Qs to Qs2, while demand for international products will fall to Qd2. The graph illustrates that only a small portion of these changes, square M, represents the gains of the government from tariffs, and therefore may be directed to improve the welfare of the people. The area of the two adjacent triangles represents a deadweight loss to the society, which is a consequence of trade diversion through an introduction of an external trade barrier for non-members. The result of the switch from a more efficient non-member to less efficient members of a Free Trade Area usually reduces societal welfare, diverges from the principles of comparative advantage and promotes inefficient allocation of scarce resources (Jain and Ohri).
The most influential Free Trade Agreements were signed in 1960 between seven European nations to form European Free Trade Association (EFTA) , in 1993 between Canada, the USA and Mexico to form NAFTA and in 1992 between the members of the Association of Southeast Asian Nations to create the ASEAN Free Trade Area (AFTA). However, along with them there are numerous bilateral and multilateral agreements between countries, which aim to liberalize trade on all or some products (Jain and Ohri).
While Free Trade Area represents the second stage of economic integration, following a preferential trade area, where tariffs are reduces but not abolished completely, there are still a number of possibilities for further trade liberalization and integration between countries. The next stage includes introducing a common external tariff, thus creating a customs union, or developing a set of common regulations regarding trade of goods and establishing a free flow of the four factors of production: resources, capital, labour, and entrepreneurial abilities. Finally, harmonization of all the economic policies between the countries leads to the creation of an economic union. The final stage of economic integration is full integration, which implies harmonization of all aspects of the country policies, including monetary and fiscal policies.
References
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Hinkelman, Edward G., and Sibylla Putzi. Dictionary Of International Trade, Handbook Of
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Jain, T. R., and V. K. Ohri. Principles Of Economics. New Delhi, India: VK Publications,
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Jones, Ronald Winthrop, Gene M. Grossman, and Kenneth Rogoff. Handbook Of
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