Is the controversial SEZ policy a path-breaking initiative or is it the mother of all land-grab scams in disguise? By Rex Mathew.

The SEZ policy is probably one of the most controversial of all government policies in the post-liberalisation era. Political parties, senior government ministers, economists, analysts and activists are hotly debating the policy and opinions are sharply divided. The SEZ policy offers a host of incentives to developers of such zones and units within such zones with very minimum regulatory controls. The SEZ Act says the area inside an SEZ would be treated as foreign territory as far as application of commercial laws is concerned.

Apart from wide-ranging tax benefits, 100-per cent FDI is permitted in SEZ units, except in select strategic sectors. Such units can keep full export proceeds in foreign currency and repatriate such earnings as they wish. They can borrow up to $500 million from overseas markets every year and can outsource production and other activities to overseas units.

There was not much opposition to the SEZ policy when the previous government first mooted it and when the SEZ Act was finally passed last year. Instead, it was widely seen as an attempt, though belated, to catch up with China and emerge as a major manufacturing location.

The controversies started when a large number of proposals for new SEZ's were made to the government and some of these promoters, including politically well-connected business houses, were granted land to set up SEZs at amazing speed. The commerce ministry's successful attempt to remove the cap on number of such zones added to the controversy.

The finance ministry resisted the attempt to remove the cap on the number of SEZs by arguing that the policy would lead to large revenue losses because of tax exemptions. The ministry has estimated a revenue loss on account of exemptions on taxes, customs and excise on raw materials and finished products at around Rs140,000 crore at a time when there was an urgent need to widen the tax base.

The commerce ministry countered these with its own estimate of a positive revenue flow of Rs45,000 crore for the government. It still remains a mystery how this figure has been estimated authoritatively when not even a single new SEZ is functional.

The Reserve Bank broadened the scope of attack by arguing that these zones would lead to large-scale resource diversion from other areas widening the industrial inequity since the majority of SEZ applications appear to be in the industrially advanced states. The RBI has also voiced its concern over the potential revenue losses. The IMF chief economist Raghuram Rajan sounded similar caution from Washington.

As can be expected, the Left parties have already called for a review of the policy while the BJP is yet to come out with a coherent opinion on the issue. The ruling alliance is widely split over the issue, but so far the pro-SEZ lobby has had the upper hand.

So, will this policy lead to India catching up with China's industrial growth or is this the mother of all scams involving sums running into lakhs of crores?

The Chinese example The Chinese government first considered large free trade zones to attract foreign capital in the late '70s and in 1979 four such zones were created in Shenzhen, Zhuhai, Xiamen and Shantou. All these areas were in the South-East coast of the country, in close proximity to the main trading and financial centres of South-East Asia like Hong Kong, which was not then under Chinese control.

Subsequently, the entire island of Hainan was declared as a special economic zone. More such zones in the Yangtze and Pearl River deltas, Shandong peninsula and Pudong near Shanghai followed.

After a slow start, these zones started attracting foreign capital in a big way and were mostly responsible for the emergence of China as a manufacturing super power. Liberal regulatory controls, cheap labour and location advantages helped these zones to become major growth drivers for the entire Chinese economy.

More importantly these zones covered large areas, hundreds of square kilometres in some cases, which ensured that the infrastructure was developed in an integrated manner, with sufficient room to expand, once these zones started attracting investments in large scale.

SEZ's - old and new The concept of designated industrial zones to promote exports is not new to this country. The Kandla Export Processing Zone was set up in 1965, even before the Chinese thought about such zones. The Santa Cruz Electronic Export Processing Zone (SEEPZ) in Mumbai followed in 1972. Subsequently, the government set up more such export processing zones (EPZ) in select locations across the country.

These zones were not really "free trade" zones in the real sense and were nowhere as successful as the Chinese ones for a host of reasons. With an average area of just 200 acres each, these early zones lacked sufficient space to grow. They failed to attract large-scale foreign investment as those days overseas investors were not enamoured of India as an attractive manufacturing location.

The total exports from the existing export promotion zones (EPZs), notified as special economic zones (SEZs) after the SEZ Act, for the financial year 2004-05 totalled Rs18,300 crore. Nearly 45 per cent of the total exports came from just one such zone, SEEPZ, the most successful among these early zones.

What would make an SEZ successful? From the Chinese experience and performance of the early zones in India, it is very clear that such zones should meet some basic requirements to be successful. First, they should be strategically located and well connected with large ports and airports. Even zones designated for service sector units like IT and ITeS should be well connected.

Second, they should cover a large area to ensure that integrated infrastructure facilities are developed. Third, they should ideally be multi-product zones. Even SEEPZ, originally established for electronic hardware units, became a relative success only after gem and jewellery units and IT service export units came up later.

Single product zones would only work close to areas that have established strengths in some sectors - like diamond processing in Surat and garment manufacturing in Tirupur. Such clusters can be and should be developed outside the SEZ framework, by providing sufficient infrastructure.

Finally, the need for fiscal incentives. Such incentives provide an added attraction to investors, but are generally not the primary drivers of investment decisions. Ideally, such incentives should be offered very selectively and that too only for a very limited period.

In this era of globalisation, industrial investments would materialise if a country is competitive enough as a manufacturing location in terms of regulatory freedom, availability of skilled and cost-effective labour and sufficient infrastructure. If these conditions are not met, any attempt to prop up export units through fiscal incentives would fail in the long term.

Fiscal bonanza for SEZ developers and units The SEZ Act provides for very liberal fiscal benefits to SEZ developers and SEZ units. These benefits far exceed those available under earlier export promotion schemes and hence have attracted criticism.

Units in an SEZ are exempt from customs duty on imports of capital goods and inputs and excise duty on purchases from the domestic market. These units would be exempt from income tax for the first five years and would get 50 per cent exemption for another two years. Investment allowance of 50 per cent of reinvested profits is also available.

Domestic units supplying goods to SEZ units will be exempt from central sales tax and service tax and can claim income tax exemption under Sec 80 HHC as their supplies would be considered as deemed exports.

Tax benefits to SEZ developers are even more liberal. Apart from customs and excise duty exemptions on purchase of capital goods and other material, they get complete income tax exemption for 10 years. Individuals investing in SEZ developments are also eligible for tax exemptions.

The nature of the incentives being provided would ensure that several of these zones, mostly the smaller ones, would be utilised more as tax havens rather than attract any genuine investments.

Disproportionate fiscal incentives also feed development disparity in the country. If industrial units are being encouraged through such incentives in areas with location disadvantages, the longer-term viability of these units after the exemption period expires would be in question. The government should analyse if the rush to set up manufacturing units in states like Uttaranchal and Himachal Pradesh, which provide large tax incentives to new units, is sustainable in the longer term.

There are also serious concerns as to whether these incentives would be treated by the WTO as unfair practices since these incentives are tantamount to a form of export subsidisation. Incentives like the 80 HHC income tax exemption for export profits and the DEPB scheme have already been questioned by the WTO.

Are SEZs a euphemism for grabbing farmlands? Apart from some political parties, NGO's and activists, even distinguished industrialist Rahul Bajaj has described the current SEZ policy as a "sophisticated land grab" and has asked the government to ensure that farmers are not forced out of their ancestral land without proper compensation. Nasser Munjee, former CEO of Infrastructure Development Finance Corp, and his successor Rajiv Lall have also voiced similar views.

Unlike China, where the government developed the SEZs, these zones in India will be developed mostly by the private sector and in some cases by state-owned infrastructure companies and agencies. State governments are more than willing to 'assist' developers to 'acquire' land for these zones at 'reasonable' costs.

Land acquisitions for some of the larger SEZs like the Reliance Industries ventures in Navi Mumbai and Haryana have already generated considerable opposition. More opposition and legal disputes are certain in the future.

There would always be some opposition to land acquisition and displacement of the local population even for real industrial development. But the provisions of the SEZ Act have do arouse suspicions.

For instance, developers of large, multi-product zones with a minimum area of 1,000 hectares are required to utilise only 25 per cent of the SEZ for industrial purpose. The rest can be utilised for residential and shopping purposes, hotels, malls, and the other trappings of "development". Moreover, the developers have a completely free hand to allocate space and other facilities within the zone on a commercial basis. Though there are conditions that only the units within that zone and their employees can use such non-core facilities inside an SEZ, there is no way that these ventures can be prevented from being mis-utilised as upscale, residential townships for sale or "resale" to those who may have nothing to do without the core activities of the SEZ.

There is no mechanism to prevent the manipulation of land provided by state governments at low rates for SEZs in to commercial townships should the industrial units in the area prove insufficient to sustain the viability of the SEZ project. The policy on de-notification of a failed SEZ and the exit options for developers has either been left deliberately opaque or is non existent.

Why allow these tiny SEZs? Under the current SEZ policy, anybody can build a few buildings on a small plot of land and call it an SEZ as long as prior government approval has been obtained. Out of the SEZ proposals cleared by the government in the first phase, a large number of proposals are for setting up small zones with areas between 10 and 20 hectares.

What kind of infrastructure can be built on such limited spaces and what benefits would units in such zones get, other than the tax benefits? Most of these tiny 'free trade zones' would be within the limits of metros. Instead of releasing the pressure on existing infrastructure, these zones could become a further addition to the list of infrastructure horror stories.

Predictably, a majority of these proposals are for setting up IT and ITeS SEZs with IT services majors like TCS, Infosys, Wipro and Satyam drawing up plans to set up such zones.

It is very clear that these small SEZs would purely be for availing the tax benefits. The current tax exemptions to IT service companies are due to end in the next couple of years. Shifting operations from current campuses to tiny new SEZs within city limits would help them to get these tax benefits extended.

If the government desires to continue with tax benefits for the IT and ITeS sector, it can do so as long as long as the WTO agrees. But why use the SEZ route to do so? More importantly, do these companies - which are among the most competitive in their businesses globally - require special treatment any longer?

Two other sectors for which a number of proposals have been developed are single-product SEZ's for pharmaceuticals and auto ancillary. Indian manufacturers are globally competitive in these sectors as well and SEZs in these sectors are also aimed only at availing tax benefits.

Can the government prevent a company from 'selling' its existing manufacturing assets to an overseas buyer and then repurchasing and importing the same assets to set up a 'new' unit within an SEZ to get tax benefits? Large-scale abuse of the SEZ provisions to avail of tax benefits will soon emerge the new tax scam, if the government does not provide for adequate pre-emptive measures well in advance.

Building real free trade areas Some of the larger multi-product SEZs being planned in states like Gujarat, Maharastra and Andhra Pradesh may be successful, even if they do not become replicas of Shenzhen, Pudong and Shandong overnight. For that to happen, the government needs to think on a much larger scale like an entire city being granted SEZ status.

For free trade zones to become drivers of industrial growth in the country, then the current SEZ policy needs to be revamped. The focus should decisively shift to large integrated zones, which are strategically located with very selective fiscal incentives. Such zones would attract capital and the best technologies from across the globe and would take India to the next stage of growth.

There are reports that the government of Gujarat is planning a special economic region spread over 250-square kilometres at Dholera, near Ahmedabad. The project would develop the entire infrastructure necessary for industrial units, but would not provide any fiscal benefits. That is the Chinese model, which has proved successful and the model we should seek to replicate rather than plan to shrink the tax base.