The Indian Prime Minister Narendra Modi’s signature initiative ‘Make in India’ – aiming to transform India into a global manufacturing hub – specially mentions Special Economic Zones (SEZs) for attracting foreign investors. But despite the strong pitch, these export-oriented enclaves have hardly been able to draw significant foreign investments.

Almost 200 SEZs are functioning in India since the introduction of the SEZ Act in June 2005. But these are just a third of the SEZs formally approved for commencement of operations. While many zones are yet to become functional, many of the operational SEZs are functioning below their capacities. During 2013-14, the latest year for which data on performances of SEZs are available, total exports from these zones were USD 82.4 billion, which was roughly a quarter of India’s merchandise exports of USD 314.4 billion. SEZs clearly are not the main sources of India’s exports, as they were intended to be. Various factors have impeded the growth of India’s SEZs.
These include both external and domestic issues.

External developments like deceleration in demand in India’s major export markets, particularly in Europe and the US, since the outbreak of the global financial crisis, are among these. Poor export prospects have led to low capacity utilizations in many zones. Several other upcoming SEZs have failed to take off with manufacturers refraining from using the facilities in the zones due to low global demand for their products. Depressed demand in overseas markets is only a part of the problems affecting India’s SEZs. The more serious problems holding back the development of these zones are domestic and emanate from faulty policies. These problems will continue to hamper SEZs even if global prospects improve for Indian exporters.

India was one of the earliest countries to develop dedicated export-processing zones (EPZs). The Kandla EPZ in the state of Gujarat on India’s west coast was developed in 1965 and was the third such zone in the world, while being the first to come up in Asia. More zones (e.g. Chennai, Mumbai, Noida, Cochin, and Visakhapatnam) came up in India during the later decades of the last century. But the economic impact of these zones was limited given their poor infrastructure linkages with the rest of the domestic economy and India’s persistence with an overall inward-oriented foreign trade and investment policy.

This was in sharp contrast to China, which had some hugely successful SEZs (e.g. Shenzhen, Xiamen, Guangzhou, and Tianjin). These Chinese SEZs were the inspiration behind India’s efforts to build a new generation of SEZs leading to the announcement of the SEZ Act in June 2005 and SEZ rules in February 2006.

The new SEZs were expected to incentivize large-scale export-oriented production in India by offering a gamut of fiscal incentives to manufacturers. These included duty-free import of raw materials and inputs, income-tax holidays and exemption from domestic sales and excise taxes. As a result, many developers found the SEZs attractive propositions. Most of them visualized SEZs as commercially remunerative real estate opportunities capable of yield ing high returns on initial investment. The zones were envisaged as fully-fledged integrated townships and manufacturing centres with quality residential and industrial facilities. These prospects made the SEZs creditworthy projects for banks and enabled many developers to easily avail loans.

The biggest problem faced by developers in building SEZs was the difficulty in obtaining land. Some state governments in India (e.g. West Bengal, Odisha) en -
countered strong political resistance to acquiring land for SEZ development by the private sector. The resistance led to violent conflicts and loss of material property and human lives. With state governments accused of being ‘brokers’ for industry by forcibly acquiring agricultural land, SEZ projects were mired in controversy.

As states realized the political cost of promoting SEZs and began backing off from land acquisitions, developers without sufficiently deep pockets were saddled with large debts. For banks on the other hand, SEZs increasingly became synonymous with non-performing loans and risky ventures. In hindsight, the previous Congressled United Progressive Alliance (UPA) government should not have introduced the SEZ scheme without an effective policy of land acquisition. The government obviously didn’t anticipate the problems that arose as land acquisition requirements for SEZs assumed unprecedented significance.

The problems also drove home the importance of land as a constraint for India’s industrial development. Indeed, in the past few years, difficulties in acquiring land have been recognized as among the most critical obstacles delaying commencement of major projects. The SEZs were also the first occasion when the government put the onus of developing high quality export infrastructure entirely on private investors. The assumption was state governments would facilitate the process by acquiring land on ‘public purpose’. This was a mistaken assumption.

Over time, the land acquisition process became contentious leading to revision of the century- old colonial land acquisition law (the Land Acquisition Act of 1894). The new law subsequently enacted by the UPA government in its last year further complicated prospects for upcoming SEZs. It significantly increased the rates of compen -
sation for acquiring land and made obtaining consent of a large majority of dispossessed landowners mandatory.

Industry and businesses have heavily criticized the new land Act. The Modi government’s proposed amendments to the Act for making it more businessfriendly are being reviewed by a Committee of the Indian Parliament comprising members from various political parties. The amendments are unlikely to go through unless the ruling Bharatiya Janata Party (BJP) and the main opposition party – the Congress – reach a consensus. Incentivizing SEZs by subsidizing exports through fiscal incentives was another short-sighted policy. It led to major stand-offs between the Ministries of Finance and Commerce with the former raising strong objections to the revenue foregone through tax exemptions.

SEZs continue to be looked at as hurdles to increasing revenues and healthier government finances. Furthermore, subsidizing exports was also a discriminating move against non-SEZ exporters. Some among the latter, such as software exporters, relocated to SEZs for continuing to enjoy benefits of tax exemptions. Over time, some exemptions like those on Minimum Alternate Tax (MAT) on profits earned by the SEZ units and dividend distribution tax (DDT) on dividends paid to shareholders in the SEZ projects, had to be withdrawn for complying with WTO rules. These withdrawals have reduced the attractiveness of SEZs.

The Modi government’s policy of ending ‘tax holidays’ by withdrawing various tax exemptions for moving to a more predictable tax regime would further reduce the appeal of SEZs. Indeed, the latest Union Budget presented on 29 February 2016 by the Finance Minister Arun Jaitley has fixed a ‘sunset’ clause on income-tax benefits for new SEZ units by freezing them at 31 March 2020. Rather than subsidizing exports through fiscal incentives, which a revenue-constrained economy running deficit budgets year after year would have inevitably found difficult to sustain, SEZs might have fared better had they been incentivized as enclaves guaranteeing better business conditions through effective infrastructure. But that would have called for a much bigger role of the state in developing SEZs.

Many of the latter can still take off if they are developed as public-privatepartnership (PPP) ventures with the state governments taking the lead in acquiring land and building the initial infrastructure. Without proactive roles from governments, SEZs would hardly contribute to ‘Make in India’.

An earlier edition of this article - `Getting the basics right on India's SEZs´- was published in EastAsiaForum on 25 February 2016

(http://www.eastasiaforum.org/2016/02/25/getting-the-basics-right-on-indias-sezs/)