Creating Special Economic Zones: Lessons from the Real World

Guillermo Peña
Guillermo Peña is a political economist focused on economic development through the private sector. He is President of Fundación Eléutera, a nonprofit free-market thinktank, founded in 2013. In the private sector, he is President of Orchid Properties, a special economic zone development company, and Managing Partner of Blackbeard Media Group, a brand and strategy firm. He also serves as a non-profit board member of the Free Zone Association of the Americas, Asociación Nacional de Industriales (Honduras), and as the Vice Chair of the Honduran Electricity Market Operator (ODS).

Special Economic Zones (SEZs) have been an international subject of debate for several decades now, especially as a model of economic development. In our case, Honduras has been a part of this conversation in academic, business, and policy circles since 2011 when SEZ legislation reached Congress, pushed by a now famous TED Talk by Paul Romer, the Nobel Prize economist, and a group of Honduran reformers and politicians. These politicians were determined to risk political capital in order to enact a world-leading policy reform, and they liked the international attention that came with it—very similar to how President Bukele is receiving international attention with his Bitcoin push in El Salvador.

Throughout history, from Ancient Carthage to the Hanseatic League, from the British Empire to the modern World Trade Organization, there have been special jurisdictions with differentiated or zero tax/tariff systems. SEZs related to the US economy and its supply chain picked up speed after World War II when there was no need for as many military bases in the Pacific, and some of these were changed into trading and logistics posts. In general, the SEZ industry has been used to streamline supply and production lines for global trade for developed countries and as tools for economic development and investment attraction to developing countries. Today, there are over four thousand SEZs competing around the world to be part of the many regional and global supply chains available, with varying regulations from country to country. This development strategy has been demonstrated to be a useful and practical way to connect mature economies to developing economies to maximize efficiencies.

Many developing countries or regions have a hard time competing with mature markets and their network of supply chains to attract investment (foreign and domestic alike). SEZs with regulatory flexibility, driven by private investment, create opportunities to test and advance economic openness and reduce regulatory hurdles to attract and create business opportunities. New SEZs need to focus on attraction via competitive regulation instead of simply enabling tax-free operations or giving direct subsidies and tax holidays to new operations. Today, businesses in the knowledge economy look for locations with legal and political stability and market access before they look for tax-free locations. Having a regulatory framework that gives long-term stability to an SEZ, promoting the SEZ’s relation to the surrounding economy, maintaining a “good neighbor policy” with the rest of the economy, and complying with international transparency and best practices standards, can create leapfrog economic processes that permeate the rest of the national economy and regulations.

Much has been written on the model for the Zonas de Empleo y Desarrollo Económico (ZEDEs) and how they allow for the creation of free cities or unregulated industries to flourish—mixing libertarian, modern urbanist, and technologists’ dreams all at once. But this same attention has also been one of the main problems in getting these ZEDEs off the ground and connecting them with mainstream public support. The opportunity for an ideological blitz brought the attention of policy reformers on the fringes of the ideological bell curve (for and against), as well as investors with drives to solve problems that were not even in the Honduran imagination, pushing the boundaries between reality and the unknown for the local population. Academics and policy “experts” fought against each other to try to place their names in the history books as the real father of this idea or as the lead opposers. All this was happening in the ego-feeding background, but what really mattered was to demonstrate the benefits that the ZEDE legislation (SEZs) could deliver, with tangible development, investment, and decent working conditions in the Honduran and Central American reality. This SEZ plan was born inside a democratic system (albeit a weak one), and it could also be destroyed by the same democratic system, as the recent electoral cycle has shown, with newly elected President Xiomara Castro promising to eliminate ZEDEs on her first day in office.

Some of the initial SEZ projects were formulated in ways that disregarded the fact that they still existed within the framework and social limitations of a poor developing country in Latin America, among people with little hope for real upward social mobility and where massive migration cycles meant large numbers of people were leaving the country. Let this be an article illustrating some of the mistakes, and lessons learned, from starting semi-autonomous SEZs within a democratic system in the hope that other countries and development entities can learn from them and avoid falling into some of these same pitfalls.

Before reviewing the lessons learned, let’s revisit how the ZEDE law was able to go through the Honduran Congress with a favorable vote of over 90 percent. In 2009, the Honduran military removed President Manuel Zelaya for challenging all institutions and branches of government in an attempt to stay in power, going against electoral rules and the Constitution itself. Since the vice president had resigned earlier in an attempt to run for the presidential seat, the President of Congress, from Zelaya’s same party, took over the top office for the remainder of the presidential period until the elections and handed over power to incoming President Lobo from the opposition, the National Party (PN), which stayed in power for three consecutive terms, until the recent election in November 2021.

The electoral result in 2009 caused the collapse of the historic two-party system as the Liberal Party (PL) split in two, and the PN won absolute control of Congress, with enough power to almost single-handedly enact constitutional reforms. The PN and the general public felt the political system had reached bottom, and the democratic system needed major reforms, which opened the door to the ZEDE project (initially known as the REDs legislation, reformed after a constitutional challenge), first with a constitutional reform, and then with the ZEDE Law.

The first problem for these SEZs came on the public relations front, when the head of Press in Congress dubbed the REDs as “model cities,” and Congress tried selling the idea to the Honduran public as if they were building the new Busan and Songdo (South Korea), Singapore, or Hong Kong. It was such a stretch of the imagination for a country known for poverty, corruption, economic migration, and security issues, that it became a joke for many academic, political pundits, and in business circles, which leads to the first lesson: Sell the dream, but keep it within the realm of possibility in the public mind, otherwise the project might cause a feeling of alienation and lose public support.

The second problem came from mistakes made by Mr. Romer, as some of his proposals included in the original RED legislation were unconstitutional or simply politically impossible under Honduran limitations, specifically: 1) handing over a piece of land to a guarantor government, (no foreign government took the bait); 2) he requested a 1,000-sq km concession from the Honduran government to the guarantor country, no less, but that amount of contiguous land was only available in national park reserves; 3) an open migration policy to attract refugees from other countries such as Haiti, but doing so in a Honduras where unemployment and underemployment prevailed. Mr. Romer’s insistence on handing over the jurisdiction to a guarantor country (and the government allowing it) led to another PR disaster. The foreign governments perceived this as neocolonialism and the Honduran public perceived it as a violation of Honduran sovereignty. This provision was removed in the second tour through Congress to avoid an unconstitutionality claim, but the characterization stuck for years to come. Today, a rumor continues in the public’s opinion as “they are giving the country away in pieces,” and this created anger and more lack of trust. So the next lesson is, Neocolonial practices should not be promoted in modern times to start an SEZ; it should be a private endeavor where meeting market demands and modeling good behavior are rewarded with economic returns.

Between the Supreme Court striking down the RED legislation and the new legislative process, Mr. Romer had a falling out with the administration. He stated in a public letter in a major US newspaper that he was leaving the project because of corruption issues, but there was never any public evidence to support his claim, nor did the government clarify the situation, in an apparent attempt to avoid a public fight with the influential economist. That gave way to another rumor: ZEDEs are plagued with corruption by those who are promoting them.

Additionally, the national media reported an incident where he visited the coastal Trujillo area and told the local Garifuna community (Afro Caribbean) that they should accept an SEZ in their land and they should consider joining or selling. This started a third rumor: The ZEDEs were going to expropriate Garifuna property along the Honduran coast, and this is when the human rights nongovernmental organizations (NGOs) made their entrance into the scene, as defenders of human and ethnic rights. This expropriation issue has been one of the costliest and probably the hardest to correct and clarify since it began.

Both the RED and the ZEDE legislation had an expropriation article, as recommended by the Supreme Court. The problem with the provision was that since the ZEDE law allowed for more autonomy than any other legislation in the Honduran system, it appeared as a threat to those around one of the approved SEZs. When consulted for the ZEDE legislative process, the Supreme Court said that the expropriation clause had to be included in the legislation because expropriation was a right that the Republic of Honduras could not give up as it was established in the Constitution. In hindsight, even if included, this article needed to be much clearer and should have said that only the State of Honduras, under rules set by the Constitution, could use the power to expropriate. This problem is very similar to the eminent domain discussion in the United States, and the legal battles it has caused, except these are taking place in a poor country with weak institutions and a judicial system that lacks judiciary independence and is therefore easier to misuse. If it was up to many of us who have been involved in the project, the expropriation clause would have never existed in the ZEDE Law. Hence, the third lesson: SEZs developed privately should not use any expropriation tool to acquire their land or to expand their footprint.

The next major problem was the lack of proper communication, transparency, and publication of the governance rules for the Comité para la Aplicación de Mejores Prácticas (CAMP), the ZEDE supervising body. The CAMP was created by the ZEDE law and it had a maximum of twenty-one members and a minimum of twelve. It was composed of a mix of Hondurans and foreigners with policy and business experience. CAMP never received a proper budget to operate and its members were spread across the world, from Honduras and Georgia, to Denmark, Oman, Peru, and Washington DC. After a couple of years, the group was reduced from twenty-one members to twelve (its legal minimum) for reasons unknown to the public, but it became operational. The private development entities that were trying to develop SEZs still had a hard time understanding how to get a ZEDE project approved, the investment and timeframe requirements, the internal CAMP governing rules, who was supposed to set up the court of appeals, and many other aspects of the rules. The developers had to work with CAMP to set up these processes, and together we had to find and solve all the gray areas where the ZEDE law and the regular Honduran system interact and find a way to make it all functional, which highlights the next lesson: Transparent and trusted SEZ supervising bodies are needed to establish the connection with the general public and should make efforts to ensure that unsubstantiated rumors do not run free.

However, resolving these gray areas was still necessary, and there were gray areas aplenty. How should a ZEDE set up an import and export process that complies with international treaties but doesn’t curtail the regulatory autonomy that the ZEDE law allows? In this case, since ZEDEs need to comply with all international treaties signed by Honduras, the solution had to comply with the standards set by the World Customs Organization (WCO) and the World Trade Organization (WTO), which are the organizations that set the global rules for international trade and logistics. In order to have an internationally recognized customs point, it needs to be recognized by the customs agency in the country where the operations are located. In the case of ZEDE Orquidea, we had to sign an agreement with Honduran customs, just like any other Free Trade Zone would do (ZOLIs in Honduras), and have Honduran customs personnel interacting with our import/export process within ZEDE Orquidea’s agro-industrial park.

Another problem came with connecting the Honduran sales tax system in reference to buying and selling goods inside the rest of the economy when ZEDE businesses have a different company registry and a different tax ID, creating an invoicing/tax agency problem. Sellers from the national market need to be able to use the sales tax from their sales, against the sales tax from the purchases, to net and declare every month. If the Tax Authority does not recognize invoices to a ZEDE registered business to net the sales tax, then the seller cannot net the 15 percent sales from his purchases with that sale, therefore the seller would be forced to tack on the sales tax for the ZEDE business, making their goods more expensive. Sellers from the national market had two choices: declare these sales as exports (and have to be a registered exporter and deal with the bureaucratic compliance that exporting entails) or sell with a sales tax, creating a disincentive for ZEDE registered businesses to buy in the local market and instead purchase from Nicaragua, El Salvador, or anywhere else where the products would come free of a sales tax.

To fix the situation, legislation was pushed through Congress in 2021 that allows the Tax Authority to create a tax-exempt sales system for national markets to interact with  ZEDE registered businesses. This is now operational, but that issue took two years to fix. There are many other examples like this where SEZs need to find the areas where both systems tie in together to become operational and allow for commercial activity to happen within regulatory limits. The sales tax issue might seem insignificant to many, but the goal of SEZs is to pull up the surrounding economy, not just that of the zone. In order to do that, businesses inside need to be able to interact with businesses outside. If they don’t, growth is much slower and the SEZ is an isolated economic island that cannot bring in the surrounding business community, municipalities, and national governments as stakeholders in the SEZ’s growth process. SEZs, and in this case ZEDEs, need to be tied to the local and global economies, not only in taxes and customs as explained above, but also in financial systems, labor compliance treaties, municipal governments, local civil society, and national security and defense structures. The fourth key lesson is this: The SEZs need to comply with international treaties in order to operate within the global economy; they should not be isolated economic islands.

Ultimately, SEZs are part of the country they are in, and should behave as such. When this is not respected, projects will face public rejection and social scrutiny resulting from apparent foreign arrogance, disinterest in the wellbeing of their surroundings, or disrespect to local social norms. SEZs in democratic systems need to continuously respect the political process, democratic opposition, and the public debate. This should start with humility and with a constant effort to demonstrate their willingness to invest in and earn the public’s support. An economic development regime cannot be forced onto its constituents; they have to want it to be successful. SEZs and their supervising bodies, working within democratic systems, need to permanently build public trust and deliver on the promises to those directly in their surroundings, otherwise, they can and will be used as a political tool by those opposed to SEZs to gain votes in an upcoming election. Egos and personal goals can easily work against important reform processes such as these, and all of those participating in such reforms need to be aware of the public’s expectations and demands, and must work to build trust in the process, or they will likely fail..

 

 

Guillermo Peña
Guillermo Peña is a political economist focused on economic development through the private sector. He is President of Fundación Eléutera, a nonprofit free-market thinktank, founded in 2013. In the private sector, he is President of Orchid Properties, a special economic zone development company, and Managing Partner of Blackbeard Media Group, a brand and strategy firm. He also serves as a non-profit board member of the Free Zone Association of the Americas, Asociación Nacional de Industriales (Honduras), and as the Vice Chair of the Honduran Electricity Market Operator (ODS).