Strategy

India’s Turn?

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

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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*
Formal
Approval
In-Principle
Approval
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*
Formal
Approval
In-Principle
Approval
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