Author: Amitendu Palit, Institute of South Asian Studies

Indian Prime Minister Narendra Modi’s signature ‘Make in India’ initiative — which aims to transform India into a global manufacturing hub — specially mentions the importance of special economic zones (SEZs) in attracting foreign investors. But despite the strong pitch, these export-oriented enclaves have struggled to draw investments.

Since the introduction of the SEZ Act in June 2005, almost 200 SEZs are now functioning in India. But just a third of these SEZs are formally approved. And many of the SEZs currently in operation are functioning below their capacities. During 2013–14, the latest year for which data on the performance of SEZs are available, total exports from these zones were US$82.4 billion, roughly a quarter of India’s merchandise exports of US$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. Global developments, including economic downturns in India’s major export markets, particularly in Europe and the United States, have stifled growth. Poor export prospects have led to low capacity utilisation in many zones, while others have failed to take off, with exporters refraining from using the facilities in the zones due to low demand.

But global conditions are only one part of the ills plaguing SEZs. The more serious problems affecting these zones emanate from faulty policies. These problems will continue to hamper SEZs even if global prospects improve for Indian exporters.

SEZs were expected to incentivise 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 developers visualised SEZs as commercially remunerative real estate opportunities. The zones were envisaged as fully-fledged integrated townships and manufacturing centres with quality residential and industrial facilities. This prospect made SEZs creditworthy projects for banks, enabling developers to easily gain loans.

The biggest problem faced by developers in building SEZs was the difficulty in obtaining land. Some state governments encountered strong political resistance to acquiring land for SEZ development by the private sector. With state governments accused of being ‘brokers’ for industry by forcibly acquiring agricultural land, SEZ projects were mired in controversy. As states began backing off from acquisitions, developers without sufficiently deep pockets were saddled with large debts. For banks, SEZs increasingly became synonymous with non-performing loans and risky ventures.

In hindsight, the previous Congress-led federal government should not have introduced the SEZ scheme without an effective policy on land acquisition. The government didn’t anticipate the problems that arose as land acquisition requirements for SEZs took on unprecedented significance.

The SEZs were also the first occasion on which the government put the onus of developing high-quality export infrastructure entirely on private investors. The assumption was that state governments would facilitate the process by acquiring land on ‘public purpose’. This was a mistaken assumption. The land acquisition process became contentious, leading to the revision of the colonial-era land acquisition law. The new law subsequently enacted by the Congress government in its final year complicated prospects for upcoming SEZs. It significantly increased the rates of compensation for forcibly acquired land and made obtaining consent of a large majority of dispossessed landowners mandatory.

Incentivising SEZs by subsidising exports through fiscal incentives was another short-sighted policy. It led to major standoffs between the Ministries of Finance and Commerce, with the former raising strong objections to revenue foregone through tax exemptions. SEZs continue to be viewed as hurdles to increased revenues and healthier government finances.

Subsidising exports in SEZs also discriminated against non-SEZ exporters. Some exporters, such as software exporters, therefore relocated to SEZs to continue enjoying the benefits of tax exemptions. And, over time, some exemptions had to be withdrawn to comply with WTO rules, reducing the attractiveness of SEZs. The possibility of the Modi government’s withdrawing various tax exemptions for the sake of a more predictable tax policy further reduces the appeal of SEZs for developers.

Rather than subsidising exports, SEZs would have fared better had they been incentivised as enclaves guaranteeing better business conditions through effective infrastructure. But that would have called for a much bigger role for the state in developing SEZs. Many zones may still take off if they are developed as public–private partnership ventures with state governments taking the lead in acquiring land and building the initial infrastructure. Without proactive roles from governments, SEZs might hardly contribute to ‘Make in India’.

Amitendu Palit is Senior Research Fellow and Research Lead in Trade and Economic Policy at the Institute of South Asian Studies (ISAS), National University of Singapore.