Are they really such a good idea?
Once upon a time there was a concept arrived at called the Free Economic Zone (FEZ). In order to bring in foreign investors, along with their capital and know-how, a government would set up a special area with legislation and tax breaks that would encourage the growth of new industry. In the aftermath of the economic nationalization policies followed from the 1960s on in most of the MENA area, such zones were seen as politically expedient: too small to worry those concerned about national economic sovereignty, and effective enough to bring in some of the benefits that foreign direct investment (FDI) can offer. However, the raison d'etre of FEZs across the region is beginning to change, and with it could come a series of foreseen consequences that at present worry few. Once again, the UAE case seems the most pertinent.
FEZs can go by a number of names, such as Free Trade Zones (FTZs), Free Zones (FZs), Special Economic Zones (SEZs), Qualified Industrial Zones (QIZs) and Special Industrial Zones (SIZs). FEZs are not, however "tax-free areas" or areas where the rules of a nation are entirely absent. There are quite a few inexperienced investors who haven't cottoned on to that fact yet. Such zones, or enclaves, are established with different conditions to the external environment in which they are placed to encourage economic activity. FEZs also do not mean that the state has in some way surrendered sovereignty. Their creation entails the formation of a special environment under which alternative rules apply that still are under the control of the ruling political authority. Bigger companies understand this fact. As one senior foreign executive told me, "If the business idea can only work inside of a free zone, forget it. It ain't working."
At present, the Middle East has some 63 functioning FEZs according to the World Bank, with Saudi Arabia being the exception. It, however, offers a range of inducements to investors that make its Industrial Zones (IZs), especially in the Royal Commission of Jubail and Yanbu, function in a similar manner. The largest number of FEZs in the Middle East is in the UAE, with the Jebel Ali Free Zone Area (JAFZA) now considered a worldwide benchmark for this form of operation. The most common forms of FEZs are those concerning logistics or industry, or a combination thereof, although a new form that deals with service industries, especially in the financial area, is becoming more and more the case, finance hubs being the flavor of the month nowadays. However, the use of FEZs in the UAE is beginning to exhibit differences from classical economist thinking.
At the vanguard
Technically, FEZs in the UAE are not allowed to export goods and services into the local economy unless such exports are done in conformance with federal law. While this is reasonably well-enforced in terms of goods, the use of services in the broader UAE economy has proven almost impossible to regulate, and the legal restrictions have rarely been enforced. Laws pertaining to foreign labor mean that while workers are employed by a specific company in the FEZ, the free zone authority itself is the official sponsor of the employee.
The UAE has been at the vanguard of the free zone landscape in the MENA region, yet some worry that the lines between the regular economy and the free zone are beginning to become blurred. The country managed to attract 60% of the $26 billion of FDI for the region in 2006, and more importantly has managed to concentrate it into industries such as IT, tourism and construction instead of the hydrocarbon sector.
The heightened readiness of the UAE to receive FDI and utilize it in different ways is very much a tale of how a Gulf state can break out of the restrictions that the economic enclaves oil and gas investment have tended to produce. Linking the concept of economic growth and employment with FDI is never as straightforward as it first appears. Generally, such attempts point out the improvements in technology, efficiency and productivity that come following the arrival of FDI. Another concept is that an economy receiving FDI benefits from the "contagion" effect, as the practices and technology from overseas become adopted by local businesses. Such a contagion effect is also called a "spillover". This generally occurs in situations where the education and technological gap between the two parties is relatively low, facilitating ease of replication.
Another form of spillover can occur when local companies must better use their own resources and technology in a more efficient manner, or bring in such things to be able to maintain a competitive edge with the foreign entrant. In such a case, the local firm either has the ability or the resources to replicate or purchase externally the tools and methodology of a foreign entrant. This also requires a low gap between education standards, and sufficient capitalization to be able to bring in inputs necessary to remain competitive.
Equally, the foreign firm may require services and inputs not available on the market, thus inspiring local businesses to begin supplying them. In other words, the arrival of foreign firms means that it is looking for inputs from local firms in order to supply its operations. Electronics manufacturing is a good example of this process, as a central producer outsources for parts from smaller local firms.
Another kind of spillover effect
A different form of spillover can occur when the local employees hired by the foreign firm leave and join other local companies or start their own, and thus bring with them the techniques learned previously. In most of the above examples of spillover, we are seeing how the UAE has been successful at inspiring its creation. Of course, these are not the only ways that the entrance of foreign firms, and hence FDI, into a market can improve its growth and employment patterns, and economists will likely argue for many more years to come over the effects of the now highly sought FDI.
However, the UAE seems to have become overly enthusiastic in the use of FEZs. The answer for this is simple: lack of consensus. While all of the emirates are pursuing their own free zones, and thus can create the rules pertaining to them for their local environment, attempting to come to federal agreement on changing company law at present appears an impossibility. So, in the absence of agreement, each emirate has gone its separate ways. While they are drawing in foreign investors, the big question is "What happened to the rest of the economy?"
While the creation of FEZs has brought in business, the disadvantage those in the mainstream economy may be operating under might begin to become more apparent in years to come. Either the rules of the regular economy begin to replicate those of the FEZs, or the reverse will happen. Either way, through their multiplication in the UAE context such a result seems to be a long-term consideration. The golden age of the FEZ may be but a temporary affair. And once again we are left with the question: If a business needs an FEZ to work, is it really such a good idea?
© Executive 2007
