India's pockets of prosperity?

Special Economic Zones are attractive on paper. But they pose thorny political problems.

Opinion

Imagine that the US government designated Long Island a Special Economic Zone (SEZ). Firms could operate there with tax exemptions, minimal red tape, no tariffs on imported inputs, and superior infrastructure.

Many firms would want to locate there, boosting industrial activity, exports, and jobs. But would Long Islanders benefit? Would they be willing to sell their land to firms? What if the government acquired the land on behalf of the firms?

In India, these questions aren't hypothetical – they have become thorny political problems.

India enacted an SEZ Act in 2005, hoping to boost infrastructure, promote investments, attract foreign firms, create industrial clusters, and increase exports while creating jobs.

SEZs are not novel: Previous incarnations, such as free-trade zones, have had a mixed record worldwide. But perhaps due to China's rapid growth, developing nations have taken a second look.

In 2007, China attracted $84 billion in foreign direct investment (FDI), mostly through its SEZs. India had only $23 billion in FDI and a large trade deficit, so SEZs became a key part of its development strategy.

That policy has become a magnet for criticism. The preferential treatment given to SEZ firms is being challenged by a case filed in Indian courts, alleging the SEZ policy to be "discriminatory" and "arbitrary."

Favors to SEZ firms also raise other concerns. For instance, would these advantaged firms withstand global competition once tax breaks were removed? How much employment would these zones generate? Should a government with a growing budget deficit grant five-year tax exemptions? All nations that have tried SEZs have had to deal with these trade-offs. In India, however, these concerns have been trumped by a bigger issue: land.

Doing business in these zones has proved quite risky for firms. As of June 2009, 568 formal approvals had been granted for SEZ projects, but only half of these had acquired the required land. The government's role in land acquisition, either via joint ventures or eminent domain, has many perceiving SEZs as "land scams." Projects initiated by India's leading industrialists, including the Ambanis and the Tatas, have stalled in the face of farmer opposition to land acquisition. The issue has become so contentious that the recently reelected Congress Party made stronger landowner protections part of its manifesto.

More than half of India's workforce is tied to agriculture, so the transfer of farmland from small owners to large firms has stirred up strong passions. Peasants don't see the payoff. China was able to suppress similar unrest, but India has not. A lethal government response to a 2007 protest ended up scrapping the Nandigram SEZ. And a bill that would have made it easier for government to seize land for private companies didn't pass.

What measures are left for the Indian government to ease these land acquisition problems? Rules that require original landowners to benefit economically from the success of SEZs sound appealing, but may slow the pace of their creation.

If the market is allowed to work on its own, the "invisible hand" would probably force firms to pay higher prices directly to landowners, thus slowing down projects and reducing rates of investment return. There is certainly no silver bullet, but measures aimed at addressing landowner rights and equity may reduce some of the opposition to SEZs and thereby ensure their long-term sustainability for India.

Considering how thorny the issue has become, the question must be asked: Does India really need them?

India's growth process has been largely bottom-up: Entrepreneurs have succeeded despite government bureaucracy – not because of it. The best policy for the government may be to provide the benefits of SEZs – low tariffs, reasonable taxes, good infrastructure, little red tape – to all firms in all parts of the country.

Laura Alfaro and Lakshmi Iyer are professors of business administration at Harvard Business School. Semil Shah is the founder and principal at India Strategy Consulting.