6. FEPZs - Structure and Operation

Establishing free trade zones to exploit the advantages of international trade is a recognized approach worldwide with roots in the past. Its post World War II incarnation takes the form of "Export Processing Zones" (EPZs). These are generally industrial parks, which provide for free intrazone economic activities with a fence around them and customs officers at the gate. EPZs have proliferated rapidly among developing countries over the last decade. There are similar "Foreign Trade Zones" in the U.S., "Free Ports and Zones" in Europe, a "Trade Development Zone" in Australia and "Special Economic Zones" in China. Twenty-five developing countries operated 80 free trade zones in 1975; by 1986 there were 47 such countries with 175 zones in operation and some 100 in the construction and planning stage. In the mid-1970s, a total of 550,000 persons were employed in these zones, with the figure more than doubling to 1,300,000 by the mid-1980s (an increase of 135 percent). 17 These figures do not include such Eastern European countries as Bulgaria, Hungary and Poland, which alone have 15 zones. The former U.S.S.R. is currently considering the establishment of 60 zones. 18

Koichi Hamada broached a comprehensive definition of these zones in the early 1970s, when the famous Kaohsiung and Masan Export Processing Zones of Taiwan and South Korea, respectively, had been functioning only a few years. He writes:

...a country provides a portion of its well-located land for foreign investments in certain industries, and in return...it can enjoy benefits of various forms, such as an increase in the employment of labor, an increase in exports leading to improvement in the balance of payments and the absorption of advanced technology....Without sacrificing the interests of protected industries...a country...provides various conveniences and facilities to foreign firms:...duties on imported equipment, materials and intermediate goods are exempted; commodity taxes on production in the zone are exempted; goods from other parts of the country...are considered as exports...;administrative procedures for the registration of firms...are simplified; less restrictions are imposed on foreign exchange transactions...." 19

The success of an FEPZ requires a suitable location, an export-oriented industrial base, and the attraction of DFI to finance industrialization and bring in technology and access to foreign markets. The FEPZ is an efficient industrial park which provides all essential facilities to serve investors and enhance their competitiveness in international markets by creating a "controlled investors' paradise." FEPZs minimize social and economic fallout during transition from a protected economy to a competitive externally-oriented economy due to their being separate from the regular economy.

The evidence is overwhelming that export-led industrialization outperforms import-substitution. FEPZs are an efficient tool for embarking on a strategy of emphasizing exports during the preliminary stages of industrialization and economic liberaliza- tion. An outline of the structure and benefits of the proposed FEPZ system follows.

Free Export Processing Zones are industrial parks based on free trade, where legal restrictions and long procedures do not apply. FEPZs are established and administered through appropriate legislation. They are "outside" the customs zone of the country, but under its control. Production is 100 percent for export but can be "exported" to the domestic market under the usual import conditions. FEPZs create advantages of economy-of-scale in industrial inputs and services, thus enhancing entrepreneurial efficiency. They are managed as profit-making institutions by public and/or private enterprise under the framework of the "FEPZ Act", to be administered by an "FEPZ Authority". 20

The government will define the following categories by means of "FEPZ Act" legislation: FEPZ Authority, Concessionaire and User. 21

FEPZ Authority - The Authority is the supervisory body whose Board of Directors is appointed in accordance with the provisions of the legislation. In addition to pro forma membership of the Prime Minister or another key minister, its members will consist largely of the businessmen who will operate the zone and who will invest in the zone. (The Peretz bill, set forth in the Appendix, is top heavy with government ministers and other public officials. It will be important to reduce the government's representation on the Authority to insure that existing interests do not subvert the zones for their own political advantage.) The Authority is the legal structure that will select a Concessionaire to establish and operate each zone and insure that the objectives of the legislation are attained, viz., massive foreign investment for export. The Authority will be required by law to process applications and grant approvals for the selection of a Concessionaire within 30 working days.

Concessionaire - The Concessionaire is a firm composed of investors, foreign and/or local. It is the body that manages, operates, markets, and promotes the zone. It is required to process applications from potential investors within six working days. It will supply "one-stop service" for all technical, legal, managerial, and transportation needs of investors. It will operate on a for-profit basis. It obtains its income from rentals to investors and the provision of services.

Users - These are foreign investors who will establish businesses in the zone (a local firm must obtain permission from the Bank of Israel, as investment in an FEPZ is treated as foreign investment). A User candidate will apply to the Concessionaire, indicating the nature of the product to be produced, the structure of labor required and the level of technology and automation to be employed. Within six days (as mentioned above), an answer will be given. The financial relations of the User with the Concessionaire and local labor, as well as the purchase of services and raw materials, will be conducted by means of foreign exchange via official local and foreign financial institutions. The Concessionaire will provide the industrial and communications infrastructure required for optimal institutional and environmental efficiency, so that the User can devote his efforts and resources to developing a competitive edge in foreign markets.

Government revenues will be supplemented by the following income sources:

• Land leases and a share of the Concessionaire's profits.
• Income taxes on the wages of foreign and local labor collected by the User.
• Increased income and corporate taxes of enterprises supplying materials and services to the zone.

7. FEPZs - Benefits to Israel and to DFI in Israel

Israel's economy is characterized by visible and invisible unemployment, economic stagnation, a dearth of capital and foreign exchange, a non-convertible currency, inflation, inefficient industry, a convoluted bureaucracy, massive government intervention, lack of expertise in international marketing, commerce and technology, and a large international debt. A Free Export Processing Zone can improve these conditions. FEPZs would stimulate Israel's economy. Earnings, duties, taxes and other services are transferred in convertible currency, which augments revenues and enhances the balance of payments. To the extent that higher incomes and the flow of DFI generate undesirable demand pressures on prices, the acquired foreign exchange can finance additional imports to relieve pressures.

Three features of Free Export Processing Zones are largely responsible for their contribution to the national welfare: the enclave effect, the direct foreign investment effect and the export-oriented industrialization effect.

This combination creates a favorable microeconomic "playground" on which the requirements of both the host country and international business can be met.

The Enclave Effect

FEPZs should be located in an area attractive to export industries, which provides access to transport infrastructure and labor services.

Given the concentration of industry in this defined area, economies-of-scale in the following industrial inputs and services can be achieved: (1) infrastructure services such as power, water, sewage and communication; (2) technical services such as repair, maintenance, spare parts and engineering; (3) security services such as fire and guarding; (4) support services such as accounting, computers, labor welfare, insurance, banking, and access to governmental regulatory agencies; (5) exchange controls, and; (6) easier supervision of external and internal trade and rapid customs clearances of goods.

The low-cost industrial infrastructure and services will heighten competitive ability in terms of punctuality, quality and costs. Agreements establishing peaceful industrial relationships between business and labor will also be easier to achieve on an enclave scale than nationwide.

Foreign investors will be attracted by the free movement of capital and earnings within the enclaves. The enclave system also prevents possible damage stemming from zone Users' outcompeting local firms in the short run or damaging politically influential vested interests. "Approved Enterprise" status could be automatically granted within the zones, thus avoiding unnecessary bureaucratic hassles.

An investor decides to establish an enterprise in a foreign country only after an in-depth investigation of its political and economic stability, laws, regulations and pertinent privileges. Feasibility, finance and business plans are prepared and studied carefully. FEPZs would be an efficient way to meet these requirements of foreign investors. 22

The Foreign Investment Effect

The optimal relationship between the host country and direct foreign investment has been described by Grubel:

...the inflow of capital which raises the productivity of labor, may generate dynamic linkage effects and gives rise to income tax revenue from the profits of foreign firms, all of which translates into gains in welfare for the host country. At the same time, the owners of capital in the rest of the world gain since their private yields are increased. 23

From this account it emerges that both sides must realize that a situation which benefits only one of them is unacceptable. This axiom of free trade zones is confirmed by the former Director- General of the Export Processing Zone Administration in Kaohsiung, Taiwan, Mr. K.Y. Yu:

...for my country 20 years ago obtaining capital was a problem ....[T]he best way was to attract it...in the form of investment by foreign companies....If you want to get a benefit, you have to share it with your partner; your partner is the investor who comes from another country. 24

Direct foreign investment is a complex combination of managerial expertise, production know-how, established factor and product markets and financial resources. Local firms which serve as sub-contractors and input suppliers to DFI gain experience in punctual delivery, quality, marketing and competitiveness, and become exporters themselves. These by-products of foreign investment are "gifts" to the host economy while the financial risks are borne by DFI.

DFI in export-oriented industries based on local economic advantages is a proven contributor to economic growth and welfare. 25 Examples of DFI in the beginning stages of development can be found in many labor intensive, developing countries. For instance:

...the price of labor in Mexico, Puerto Rico, Hong Kong, Korea, Malaysia, and Taiwan is low for its productivity. This feature has attracted direct foreign investment in labor-intensive industries. If laborers in these countries earn the local currency equivalent of $2 per hour and are as productive as their U.S. counterparts, who earn $4 per hour, a firm can cut its per-unit labor cost in half. Of course, other factors of production, such as shipping, tariffs, equipment, plant, and land, may cost much more in these countries, thereby offsetting the labor differential. Furthermore, over time labor costs may increase more rapidly in these countries than in the United States because of foreign demand for their services. In the meantime, however, a temporary market imperfection for labor exists and attracts direct foreign investment. 26

Export-Oriented Industrialization

The contributions of export-oriented industrialization to productivity and economic growth have been assessed in empirical inter-country cross-sections and individual country time-series. 27 To summarize the empirical findings, the export sector is not only more productive but also influences the non-export sector. The dynamic aspect of exports is revealed by the following development:

...the factor productivity difference between export and non-export sectors became larger in low-income LDC's over the 1970s and that enlargement, which can be characterized as an accentuation of the "enclave" nature of the export sector in these countries, seems to account for much of the increase in the importance of exports for economic growth in low-income countries. 28

This note is important in the context of the present paper. A recent study of the export industry development in Taiwan argues that the main engine of growth has been production economies-of- scale resulting from the size of the international export market, rather than from qualities generated by the export sector itself. 29 This could lead large countries of potential market size to tilt towards the populist path of import-substitution development, instead of insisting on export-led development.

In expanding our discussion of the contribution of exports to growth we will find the following three categories enumerated by Blumental: a) direct effects, b) effects of export industries on other industries and c) how export earnings effect growth via imports. 30

Direct Effects - There are direct effects since the value added generated by exports is a part of GNP. This may stem from a variety of features which are built in to the export sector, such as higher marginal productivity, economies-of-scale resulting from the larger size of export markets, a more efficient division of labor, superior technology, efficient management and production processes arising from competitive pressures that induce innovation and adaptability, a more highly skilled labor force and an uninterrupted flow of inputs, credit and foreign exchange. 31 Increasing exports can also encourage overall liberalization of the economy, remove restrictions on foreign trade and reveal comparative advantages in favor of exports.

Indirect Effects - Export industries foster growth through their effect on other industries in the local economy. Blumental shows that in Japan the export industry has been integrated into local industry to a high degree: "...the dependence of exports on other industries per unit of exports, is larger than that of domestic uses..." 32 A similar trend of integration of foreign firms into local industry can be seen in South Korea. The share of domestic raw materials purchased increased from 18 percent in 1974 to 30 percent in 1978. It is worth noting that during the same period firms in the Massan Export Processing Zone (EPZ) bought even higher percentages of materials domestically, indicating significant local integration. 33

Integration has the advantage of accelerating technical progress through contact with foreign institutions and ideas. Benefits generated by the export sector are externalized, enhancing other industries as well, and leading to increased productivity throughout the economy. There is a "learning effect" on locally- owned firms, particularly those with whom backward and forward linkages were created. Training and know-how acquired by individuals in management, marketing, organization, engineering, frequent product quality improvement, control of production quality and cost and other modern manufacturing skills may circulate from the export sector to the non-export sector. This free spillover of benefits to the host economy from the export sector is established by empirical findings that "suggest that even when entrepreneurs optimize resource allocation given the price they face, there are substantial gains to be made due to the externality effects." 34

Export Earnings Effects - Since exports are a source of foreign exchange, they effect growth in imports. Increased export earnings permit import expansion. This may directly promote the national welfare by financing imports of higher quality at lower prices, thereby reducing the propensity to autarchy. More important is the likelihood that export earnings will finance the importation of machinery, raw materials and intermediate products which incorporate technological innovations and production improvement elements.

8. Post War Experience and the Origin of the FEPZ

The main goal of the Free Export Processing Zones is to increase economic activity by removing bureaucratic and economic constraints, thus enhancing a country's comparative advantages in the international trade arena. The logic of introducing FEPZs originated in fear of the likely political, social and economic fallout attendant upon nationwide economic liberalization. The introduction of free trade elements can promote outward-looking policies, attract direct foreign investment and smooth a gradual transition into an open market economy.

TAIWAN - The Export Processing Zones

The 1950s found Taiwan in a process of agricultural development and import-substitution industrialization. The slogan was "fostering industry with the aid of agriculture and developing agriculture with the aid of industry." 35 During this period Taiwan received substantial economic and military aid from the United States. For political reasons this aid was terminated in 1965. The new slogan became: "developing agriculture with the aid of industry and expanding industry with the aid of foreign trade." 36 The U.S. contribution to the Taiwanese economy continued in the form of trade relations, direct investment and technology transfers which helped to maintain a stable political and economic environment. During 1953 to 1961 Taiwan achieved real annual GDP growth of 6.9 percent and per capita growth of 3.1 percent. Between 1962 and 1977 these figures increased to 9 percent and 6.3 percent, respectively. 37

In Taiwan export promotion was advanced by means of a devaluation, removal of the multi-exchange rate system, liberalization of foreign exchange and freeing financial markets and interest rates. The philosophy of development has been to press market forces into the service of economic policies. Exports were encouraged by creating an esentially free trade, free market regime. 38

Confidence in Taiwan's economic policies and ability was expressed in a report by the Director of U.S. AID in Taiwan, dated November 29, 1963:

Acceptance of phase-out [of U.S. aid] over a relatively short time...is based in part on increased confidence by the Chinese in their own capacities and talents....[E]vidence...is found in the over-subscription by U.S. banks of the recent IBRD fisheries loan, the declared interest of the ExIm Bank...and the active exploration of investment opportunities in Taiwan by the foreign business community. 39

Following the export sector liberalization of 1958-1960, the way was clear to attract direct foreign investment, which was channeled into export development. Among the possibilities considered was the establishment of a Free Zone Industrial Park or an Export Processing Zone. This concept had been bandied about for some time since the idea was first suggested by the Economic Stabilization Board in 1956, to the accompaniment of spirited debate. 40 The actual establishment of the EPZ was effected by a central personality in the Taiwanese "economic miracle," K.T. Li, former Minister of Economic Affairs and former Minister of Finance, and presently Senior Advisor to the President of Taiwan. Mr. Li describes his first-hand experience regarding the conception and implementation of the Export Processing Zone:

Over the last four decades, I have been associated with our industrial development program in Taiwan. For the first decade of the 50's, we concentrated on stabilizing the economy, balancing the budget, and improving country productivity through the then reform programs. As a result our earning power was greatly increased. At the same time, we developed import substitution industries for people's basic necessities, such as food, fertilizer, clothing, housing and transportation.

By 1958, Mr. K.Y. Yin, who chaired the foreign exchange and trade commission, found that our complicated multiple rate system for exports would jeopardize exports and encourage imports. In other words, we would have to depend on U.S. aid forever. The best thing would be to overhaul the foreign exchange system to get into a unitary rate, which finally settled down at $40 NT dollars to $1.

So this second decade of the 60's is when we tried to switch from import substitution to export promotion industries, so the entire investment economy had to be changed to encourage exports, and to get people in the factories all becoming export-oriented....U.S. Aid dried up, so we decided to promote exports and to work on foreign capital to substitute for the U.S. Aid.

I studied this problem while I was a member of the Industrial Development Commission in the 50's: how could we create an economy comparable with Hong Kong to attract overseas Chinese, many of them having moved from Mainland China to Hong Kong, and some of them to Taiwan, and so how to create a similar economy?

...[I]ndirect taxes are very important for any developing country. Heavy reliance on the indirect tax, such as customs duty, excise tax, and local sales tax, is very important. How could we do away with all these complex indirect tax procedures, make them simpler? The answer was the export processing zone which would allow these people to access world markets utilizing the local semiskilled and trainable low-cost labor to process for export. Thus, the export processing zone idea was created and finalized as it was drawn up in 1963-64.

The first function of the Kaohsiung EPZ was as a show window to attract investment in export-oriented industries. After the establishment of KEPZ, foreign and overseas Chinese investors poured into Taiwan, some investing directly in the zone, some settling at suitable locations outside the zone. Many established bonded factories outside the zone - a number of consumer electronics companies like RCA came in because they need a large quantity of labor and had to be in a location where labor was available.

Finally I want to say a few words about the contribution of the EPZ in the Republic of China. From 1966-1988 the cumulative exports from the three zones reached $27.8 billion, and our reserve now is $72 billion, so actually the export processing zone has made a substantial contribution to our reserve. In 1988 alone we exported $3.76 billion and provided jobs for 84,000 people. There were 257 companies operating with a net total investment of $417 million in 1984. By the end of 1988 the total number of companies was reduced to 244, but their net total investment increased to US $625 million. The companies are shifting more towards capital-intensive and technology intensive production, more automation. 41

For countries in the early stages of development zones can be an efficient and productive means of absorbing surplus labor....[They] also expose domestic businesses to examples of internationally competitive enterprises, this demonstration effect is undoubtedly valuable.... 42

These data show the importance of the zones at different stages of development. 43 In 1971 zone exports constituted 10 percent of total industrial exports, but 60 percent of the total electrical machinery and apparatus sectors.

Mexico - The Maquila

This paper seeks to concretize the advantages of the FEPZ system and its adaptability to different economies. The Mexican Maquiladora is perhaps the best example of an FEPZ which made a contribution to the economy in its preliminary stages, culminating in a triumphant nationwide impact.

In Mexico's hottest and driest states in the far north, the unemployment level ranged from 50-90 percent of the labor force. In 1964 Richard Bolin "designed a plan [for the government of Mexico] for relieving unemployment in the northern border region by attracting industry through the creation of specialized industrial parks....the twin-plant concept." 44 The concept refers to plants belonging to a single U.S. firm, each of which is located on a different side of the Mexico-U.S. border. The plants share the production and the assembly of a given product, which becomes more competitive in the U.S. market due to the low wages prevailing in Mexico. The plan was to attract labor intensive manufacturers in order to solve the pressing unemployment problem.

Such a relationship had already been established with East Asian countries. Despite the fact that these countries are even more distant from the United States and exact higher transportation costs and complicated coordination and logistical support, the low labor cost proved sufficiently attractive. The first instance of such "production sharing," which consists of transferring the labor intensive part of the production process to low labor cost areas, occurred in 1961 when Fairchild semiconductor manufacturers set up an affiliate in Hong Kong for the re-export of the complete product to the United States market. 45 Hong Kong, a laissez-faire British Crown Colony, permitted unrestricted international trade, and boasted a low-cost supply of labor relative to the U.S.

In Mexico, however, conditions were different. Government policies and the political climate did not provide free access to the Mexican labor market or the free entry of foreign investment. In the 1960s Mexico ran an economic policy which was protectionist, based on import-substitution industrialization. Despite some growth, it had two major failings: first, it did not allocate the benefits of growth equitably among the population, and second, the growth did not lead Mexico to economic independence. 46

DFI entrepreneurs were eventually attracted to the maquila industry by the special conditions Mexico provided in order to promote business activity in the northern border area.

...[O]n the basis of Article 321 of the Mexican Custom Code, the duty-free import of materials and equipment required for production was provided for, but the location of plants was to be limited within a twenty kilometer strip along the border and enterprises were obliged to export their entire production. On the other hand, in these cases 100 percent foreign ownership of the firms was permitted...so that in Mexico the maquiladora program is understood to be essentially a northern border program. 47

The Maquiladora can be defined as a pure Free Export Processing Zone. Political divisibility existing in the economy enabled the creation of an enclave system where international economic activity could be freely conducted. Only in that context was profit-seeking DFI attracted and export-oriented industry developed by exploiting local economic advantages (the low cost of labor). The Maquiladora "is a manufacturing service...thus included in the service category in Mexican balance-of-payments statistics" so that the maquila industry was utterly separated from the economy and was hardly affected by the economic situation in the host country. 48 The years 1970-1982 are called the "dozena tragica"- "the tragic decade," characterized by high inflation, an oil boom, nationalization of the banking system and the government's official announcement in August 1982 that it was no longer able to service its foreign debt. 49 Yet the maquila posted substantial economic growth during the decade 1970-1980. The number of enterprises increased from 120 (in 1966 there only 12) to 620, and the number of employees increased from 20,000 (in 1966 there were 3,000 employees) to 120,000, while foreign exchange earnings increased from $80 million to nearly $800 million. 50

Since the early 1980s, more outward-looking policies have been introduced. As for the maquila industry, more flexibility in location was permitted so that maquila could be established in other parts of Mexico. 51 From 1980 to 1989 maquila plants increased from 620 to about 1,700; by 1989, the number of jobs increased to about 450,000. In 1987, some 100 maquila enterprises were located in interior Mexico (outside the 20 kilometer border area constraint). Local input purchases are estimated at around 10 percent in the maquila established in the interior area compared to the figure of 0.7-1.0 percent in the border area enterprises.

The maquila industry is recognized as an important contributor to the economy. The Bermudez Group, which had been the pioneer in the establishment of privately-owned industrial estates for the maquila system since the mid-1960s, issued $10 million in bonds on the Mexican Stock Exchange in 1989, which were easily oversold. 52 General Electric established thirteen enterprises in six cities. U.S. companies are moving away from the border to inside Mexico: "Guadelajara 950 miles south of El Paso...is becoming Mexico's Silicon Valley....IBM, Hewlett-Packard, Wang and others are making computers there for domestic and export markets." 53

It must be stressed that the success of maquila cannot be attributed to its location in the border zone. It could have sprung up in any part of Mexico. The link of the maquila industry to U.S. firms was a function of Mexican policies which limited its expansion beyond the 20 kilometer border strip.

...[U]ntil a few years ago [the maquila industry]...was regarded as an element in a regional development program based on industrialization and employment generation, which only slowly transformed itself into an effective means of earning foreign exchange. 54

The proportion of foreign exchange earnings (of non-oil merchandise and services) generated by maquila operations rose from 2.5 percent in 1970 to 7.2 percent in 1987, "a not insignificant proportion in a year of particularly intense crisis in Mexico's export trade as a result of the collapse of oil prices." 55

It would not be an overstatement to suggest that the maquila system has become a cornerstone of Mexico's economic policy, blazing the way for nationwide economic liberalization and the possible establishment of a free market with the U.S. and Canada.

...Carlos Salinas de Gortari, Mexico's...President...is betting that a free-trading Mexico, bordering the world's largest and richest market, will divert the river of money and technology that now is flowing into the low-cost havens in Asia and Eastern Europe....[A] free trade accord will in many ways simply codify what is already taking place...from San Diego to Brownsville, Texas. 56

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PART 3