Print this article | Return to Article | Return to

India's Turn?

As China phases out foreign investment incentives, companies may find havens in India's special economic zones — if they get built.
Uday Sekhar and Oliver Jones, CFO Asia
February 29, 2008

In less than six months, property developer QuarkCity is expected to complete its special economic zone (SEZ) in Mohali, a district in the Indian state of Punjab. "Frankly, we paid more than the market rate," says Fred Ebrahimi, QuarkCity's chairman, talking about land acquisitions. "In my opinion, if one is reasonable and gives a premium to farmers, then there won't be any problem." He expects the SEZ to start operations this June.

Tell that to Rajendra Hinduja, managing director of Gokaldas Exports, India's largest apparel exporter. In 2006, the company bought land near Bangalore for its apparel and textiles SEZ, but last year some holdout farmers began asking for what the company considers "exorbitant" prices. Gokaldas feared that those who already sold would demand the same rates, rendering the project uneconomical.

Eight years after India first announced its SEZ policy, there are still more frustrated Hindujas than satisfied Ebrahimis across the country. True, more than 400 projects have won formal approval, and scores more have been given the go-ahead in principle (see charts, page 40). But most are behind schedule largely because of land acquisition problems. QuarkCity is the exception rather than the rule — it can afford to be generous because its SEZ is just 36 acres. Gokaldas's special economic zone sprawls across 400 acres.

It's getting frustrating for export-oriented and other companies in Asia and elsewhere, including India's own IT enterprises. Income tax holidays on exports under the Software Technology Parks scheme are set to expire in March 2009, putting pressure on India's globally focused IT firms — from Infosys to Wipro — to find space in SEZs where they will continue to benefit from such incentives. China, which built its economic prowess on a system of SEZs and development zones, is phasing out incentives for many industries. Vietnam, Cambodia and other developing economies in Southeast Asia can take up some of the slack, but many see India and its mostly young population of one billion as the ideal alternative.

Balancing Act
If only India can get its act together. As its economy develops, more and more land is getting converted from agricultural to industrial and infrastructure uses. For many decades, state government agencies have been empowered to make compulsory land acquisitions, using standard government norms of valuation (read below market prices) for all large projects, not just SEZs. The practice has long stirred strong feelings and confrontations. Those tensions have intensified since SEZ developers seem poised to reap large profits from government incentives, while displaced farmers receive far less.

Last December, opposition from local citizens and political parties forced the state government of Goa to scrap all SEZ projects in its territory. Seven projects had previously received the green light there. Between January and March 2007, almost two dozen people died in clashes between farmers and the police in Nandigram in West Bengal, where land was being acquired for a chemicals SEZ project being set up by Indonesia's Salim Group. The Tata Group's high-profile small car project in Singur in the same state, while not an SEZ, also met concerted resistance.

In response to this upheaval, the government issued a circular stating that consent letters were needed wherever land is acquired for an SEZ. A new National Policy on Resettlement and Rehabilitation for Project Affected Families was also announced, including measures to protect landowners, tenants, and agricultural workers. Further, plans to amend the existing land acquisition act are in the works. The central government hopes such changes will help avert future fights.

But SEZ developers worry that the protests and New Delhi's populist response will result in inflated price expectations. Worse, closed deals may be reopened as disgruntled sellers demand better terms. Gokaldas, which is being acquired by the U.S. private- equity firm Blackstone, had paid the Karnataka Industrial Areas Development Board 200 million rupees (US$4.5 million) for that state government agency to acquire 400 acres of land and hand it over to the company. Two years on, the agency has yet to do so because of New Delhi's changes to its SEZ policy in response to protests from landowners, politicians, and activists.

Gokaldas and other SEZ developers facing similar problems have had some success in lobbying New Delhi. The cabinet has now agreed on an amendment that will allow state governments to make compulsory acquisitions of land. The government can determine the price, provided that at least 70 percent of the acreage has already been purchased for the SEZ. The policy change, says Gokaldas chairman Hinduja, will ensure that "nobody acts funny." The decision is yet to become a formal order or law, however. In India, there are typically long gaps between policy announcements and their implementation.

More Changes?
Divisions within the cabinet may lead to more adjustments. Finance Minister P. Chidambaram has made it clear that he views the tax incentives on offer as excessive. The Ministry of Commerce and Industry, which crafted the SEZ policy, argues that the perks are needed because the private sector is being asked to carry most of the burden of funding, constructing, and operating the SEZs. The incentives are also meant to make the Indian zones competitive with those in other countries, although China's decision to abolish some of its SEZ incentives may have weakened this argument.

The hands-off approach is a change in India. Most of the country's 19 existing zones near major cities, established prior to the SEZ Act enacted in 2005, were funded and built by the government. But the demands on state resources and expertise led the government to encourage private capital to take on the lead role instead. The SEZ developers, like the companies that locate within them, received attractive fiscal incentives, including a ten-year income tax holiday.

In addition, SEZ tenants that generate positive net foreign exchange earnings (that is, export earnings net of imports) within five years of starting operations can avoid income tax on export earnings during the first five years. Over the next five, half of export earnings will be exempted from income tax. During the third five-year period, half of reinvested export profits will be tax-free, while imports will be duty-free. The SEZ policy also promises to cut red tape through "single-window" clearances for the various approvals needed by a number of government agencies.

The government is encouraging the SEZs to be industry- and, in some cases, product-focused to avoid overcapacity. India hopes to avoid two unintended consequences of China's model — duplication and overcapacity — where each local government sought to develop the same industries.

So far, 36 textiles and apparel SEZs have been approved formally or in principle in India. One of them, Brandix India Apparel City in the port city of Visakhapatnam in Andhra Pradesh, is being developed by Brandix, Sri Lanka's largest apparel exporter. The SEZ's CEO, Reshan Wickramasinha, says that some of the company's supply chain partners, such as Ocean India, have already started building in the zone. The presence of industryspecific suppliers offers the prospect of conglomeration benefits.

Over half of the formally approved SEZs in India are focused on the IT industry. In addition to next year's phasing out of the software technology parks scheme, a further reason for this focus is that the minimum size of IT zones dictated by the SEZ policy is roughly 25 acres — much smaller than for other sectors. Consequently, it is easier for developers of IT SEZs to acquire land, since they only need to negotiate with a few parties. IT firms also have an incentive to establish bases outside traditional hubs such as Bangalore, where salaries and employee turnover are rising.

In part to discourage a proliferation of small SEZs, the minimum size for non-IT zones is 250 acres, while that for multiproduct zones is 2,500 acres. But following the problems at Nandigram and Singur, New Delhi has introduced a 50- square-kilometer (12,355-acre) upper limit for multi-product SEZs. This is much smaller than many of China's development zones, which are often over 100 square kilometers. Setting a limit could make it hard for companies to expand later.

Long Wait
Despite the problems, policymakers and many businesses remain convinced that special economic zones are good for India. Indeed, the prospect of SEZs helping boost exports was a factor behind the recent increase in the bilateral trade target between India and China. Even some traditional opponents of the idea are coming around. In Uttar Pradesh, which has a population three times that of Germany, the populist chief minister Mayawati recently told CFO Asia that she is "not averse" to trying out China's government-led SEZ model, as opposed to New Delhi's preference for the private sector. The state government has identified three large areas that can be turned into SEZs.

India's SEZs will eventually be up and running, but prepare for a long wait.

Uday Sekhar is an economist and contributor to EIU's Business India Intelligence. Oliver Jones is a regular contributor to CFO Asia.

Special No More in China

Shenzhen's transformation from backwater to megacity is legendary. The mainland Chinese special economic zone bordering Hong Kong is seen as the gold standard for other SEZs, including India's. In the first 11 months of 2007, Shenzhen exported US$71 billion worth of goods, nearly half of what all of India shipped in the same period.

But Shenzhen and China's other SEZs face new challenges. The foreign-invested, exportoriented companies that operate in these zones long enjoyed tax breaks such as a corporate rate of 15 percent or lower. This year, these SEZ tenants will now be assessed at 18 percent. The rate will rise progressively until it reaches 25 percent, the same rate as everyone else in China.

The new tax rates have taken some companies by surprise, says Bolivia Cheung, a tax partner at KPMG Huazhen in Guangzhou. The expectation was that the transition period would last for five years, instead of four, and that the 2008 rate would be 16 or 17 percent, not 18.

Still, says Martin Lin, a tax partner at Deloitte in Shanghai, local governments can grant subsidies such as rebates on local income taxes to cushion the tax blow. But while affluent Shenzhen can afford it, less successful SEZs in smaller cities may not. Already, some SEZ makers of low-value goods like toys and shoes have said they will close or move to places like Vietnam. Others may also consider India. — Cesar Bacani and Chen Wu

Favored Sectors
Industry distribution of India's Special Economic Zones*
Information technology
(including BPO & hardware)
255 18
Multi-product SEZs 19 57
Biotechnology 19 4
Textiles and apparel 17 19
Pharmaceuticals, chemicals 15 6
Engineering, aviation 14 12
Multi-services 11 12
Footwear, leather 7 3
Gems & jewelry 7 4
Others 40 30
TOTAL 404 165
* Approvals as of November 2007, by the Board of Approvals, a committee consisting of bureaucrats from concerned ministries. In-principle approval means that the zone has yet to acquire land; it can apply for formal approval once it has made the acquisition. Source: Department of Commerce, India

Popular Places
Geographical distribution of India's Special Economic Zones*
Maharashtra 84 40
Andhra Pradesh 66 5
Tamil Nadu 55 14
Karnataka 39 15
Gujarat 36 10
Haryana 32 18
West Bengal 16 16
Uttar Pradesh 13 9
Kerala 11 2
Madhya Pradesh 10 7
Orissa 9 6
Goa 7 0
Punjab 6 7
Rajasthan 5 10
Others 15 6
TOTAL 404 165
* Approvals as of November 2007, by the Board of Approvals, a committee consisting of bureaucrats from concerned ministries. In-principle approval means that the zone has yet to acquire land; it can apply for formal approval once it has made the acquisition. Source: Department of Commerce, India