Special Economic Zones (SEZs) have come to stay, and India has joined the band-wagon. The SEZ Act, 2005, came into force in February 2006. Government expects these manufacturing and services SEZs to attract investments worth Rs.10,000 crore by 2009 and create 500,000 jobs.

 

The basic problem with the policy is its lack of awareness of the need for scale. While a minimum of 1,000 hectares is required for multi-product SEZs, this floor has been significant lowered for services and certain sector-specific SEZs, where the minimum is 100 hectares; and for gems and jewellery, biotech, software, electronics hardware and non-conventional energy, it is 10 hectares. That’s not all. For developing these zones in  ‘backward’ states, the minimum land requirement is 200 hectares and 50 hectares respectively for multi-product and sector specific SEZs.

 

Fiscal incentives abound. For instance, developers can deduct all profits from an SEZ for any 10 consecutive years out of the first 15. Those who invest in SEZ companies are exempt from taxes on interest and capital gains. There is neither Minimum Alternate Tax (MAT) nor dividend distribution tax for the developers. For those setting up units in SEZs, all export profits are deductible for the first five years; and 50% for the next five. In addition, capital gains from transfer of assets due to shifting of a unit to an SEZ is exempt from tax; as is MAT from April 2005.

 

How does our SEZ policy stack up with China’s? Chinese SEZ’s are universally large, covering areas well over 1,000 hectares. India has chosen to promote significantly smaller sector-specific and state-specific SEZs. Many of these lack the scale to build the requisite infrastructure in a cost efficient manner. Besides, Indian SEZs don’t have the advantage of flexible labour laws — a critical element of building competitiveness. Moreover, China promises and delivers streamlined administrative control. While the SEZ administration  will be under zone commissioners, experience suggests that these worthies create more hindrances than help.

 

What’s driving this craze? Real business opportunities sought by long term infrastructure players with deep pockets? Or the lure of quicker fiscal incentives? If it is the latter, we may be in deep trouble. Remember those who used all the fiscal and interest rate sops to build unviable ‘mini plants’ in ‘backward areas’ — only to declare bankruptcy after handsomely recouping their meagre equity? It is important to be forewarned of this danger.

 

There is also the issue of taxes. SEZs will generate zero direct tax revenue for the government for at least the first 10-12 years. Besides, if most of the units set up in SEZs do so only to transfer their existing export business from domestic tariff areas, there can be a negative impact on direct tax collections. There are indirect tax effects as well. As SEZs get linked to the Indian economy, goods and services produced domestically for SEZs consumption will not attract sales tax or excise duty.

 

This doesn’t mean that SEZs won’t work. Five conditions need to be met for success:

 

1. Scale: SEZs must span at least 5,000 hectares.

2. Location: These must be near major ports or airports, and have to be connected by world class infrastructure. You can’t have SEZs in Bastar or Chhindwara and expect them to succeed.

3. Deep pockets and executing ability: Promoters must not only have the financial muscle to absorb large cash outflows for the first five to seven years, but also be known to have world class execution abilities.

4. Political skills: SEZs need considerable government support, and promoters must have the stature to garner such support.

5. Attracting units to the SEZs: The promoter must have the imprimatur to call upon Indian companies to set up their units.

 

Certainly one promoter, perhaps two, maybe two and half meet these criteria. That’s my worry. So, I expect a major shake-out before things stabilise. And pray that we don’t have an SEZ scam before that.