Export processing zones as catalysts

Pergamon World Develo/,menr. Vol. 25, No. 12. 2 115-2 128, I997 pp.

0 1997 Elsevier Science Ltd All rights reserved. Printed in Great Britain

0305-750x/97 $17.00 + 0.00 PII: s0305-750x(97)001034

Export Processing Zones as Catalysts

HELENA JOHANSSON and LARS NILSSON* Lund University, Sweden

Summary. - A potentially important indirect effect of export processing zones (EPZs) is the catalyst effect. The foreign affiliates attracted to the EPZs could stimulate local firms to begin to export by showing them how to produce. market, sell and distribute manufactured goods on the world market. Our results indicate a significant catalyst effect in Malaysia. 0 1997 Elsevier Science Ltd. All rights reserved.

Ke? M.O& - The European Union, Malaysia. Export processing zones, catalysts, exports

1. INTRODUCTION

For several reasons, non-traditional exports could play an important role in the development and industrialization process in the Third World. For instance, exports may generate the scarce foreign exchange needed to finance imports of industrial inputs and capita1 goods, help to realize economies of scale and also be a source of employment and GNP growth.’ A common policy instrument aimed at stimulating exports has been the establishment of export processing zones (EPZs). EPZs are geogra- phically or juridically bounded areas in which free trade, including duty-free import of intermediate goods, is permitted provided that all goods produced within the zone are exported. The objective is to lure export-oriented enterprises to the EPZs. In addition to free trade status, various incentives such as tax rebates are commonly offered.

Economists over the years have argued that EPZs have a negative or, at best, a very limited positive effect on the host country.’ Still, EPZs are an increasingly popular trade instrument all over the world, and there are reasons to believe that an important beneficial effect of EPZs has been overlooked in most previous studies. Recently, several authors. in particular Romer (1993a), have discussed in various contexts the presence of idea gaps’ in development and emphasized the role of multinational enterprises and foreign direct investment in diffusing ideas among countries.4 Many indigenous tirms in developing countries lack “export know- how” that is, the knowledge that would enable them to master the production, marketing, distribution and selling of export goods. Since one purpose of EPZs is to attract foreign direct investment and use foreign knowledge and capita1 to create an export base, local firms may be stimulated to enter the export market

by learning from the experience of the foreign affiliates. That is, the foreign affiliates may have a caraZysf effect on potential domestic exporters and EPZs may thus contribute to the host country’s total exports in two different ways: directly, since the exports from the EPZs is part of the country’s total exports but, more importantly. also indirectly by inducing local firms to export. Further, this catalyst effect could be more than internal to EPZs, that is, affect not only local firms which operate. or are induced to operate within the EPZs, but also spill over to domestic firms outside the EPZs.

The catalyst effect has largely been overlooked in

the literature on EPZs and as a consequence, the success of EPZs has mainly been judged in terms of employment creation, linkages to the host country, foreign exchange earnings and suchlike.’ The approach chosen has been to compare benefits, in terms of foreign exchange earnings and tax revenue, with incurred costs such as subsidies, administrative costs, infrastructure, etc. This kind of traditional cost-benefit analysis helps to indicate the direct profitability of the zone but often fails to capture positive externalities, such as the catalyst effect, as well as potential negative externalities.’ A second shortcoming of this type of analysis is the underlying assumption that an EPZ which is profitable auto- matically is beneficial for the host country. The relationship is, however, more complex. A successful EPZ performance could either provide the host

*We are grateful for useful comments and suggestions from Yves Bourdet. Geoffrey Reed and two anonymous referees. Financial support from the Swedish Council for Research in the Humanities and Social Sciences (HSFR) and the Swedish Agency for Research Cooperation with Develop- ing Countries (SAREC) is gratefully acknowledged. Final revision accepted: June 9, 1997.

2115

2116 WORLD DEVELOPMENT

country with an impetus to continue with trade liberalization reforms, thereby promoting additional export expansion, or have an adverse effect on total exports by conserving existing anti-export biases.

We use a version of the gravity model to investigate what impact the establishment of EPZs has on host country total exports. The purpose of this exercise is twofold: first, as the primary objective of EPZs is to promote exports, we are interested in whether the establishment of EPZs affects total host country exports at all. The EPZs’ direct contribution to total exports, the possibility of a catalyst effect and the fact that a prosperous EPZ could induce additional trade reforms speak in favor of an overall positive impact on total exports. If, on the other hand, the establishment of EPZs preserves an initial inward oriented trade policy a negative effect on non-EPZ exports could occur. Second, we investigate whether a positive catalyst effect is present. Because of data limitations the latter exercise is only conducted for the case of Malaysia

The paper is divided into five parts. Section 2 discusses the lack of export know-how in developing countries and the role of EPZs in transmitting ideas between countries. The link between the overall trade strategy and the impact of the EPZs on total exports, the attributes of a potentially successful EPZ, and the possible impact of the EPZs on the host country in an ample context are described in the Section 3. Section 4 consists of a brief outline of the gravity model, the empirical estimations and a discussion of the results. Concluding remarks are found in Section 5.

2. EXPORT-LED INDUSTRIALIZATION IN THE PRESENCE OF IDEA GAPS

Developing countries wishing to promote indigenous, non-traditional exports have often found that the creation of a trade-friendly environment does not suffice to induce a local export supply response. Traditional theory often assumes that once a critical number of trade-related constraints have been removed, a resulting export supply response will instantaneously come from local firms and foreign investors, but this may not be the case. Instead, indigenous firms in developing countries with little or no export experience may have problems in entering into the world market. They often lack “export know-how,” not only in the technological sense, but also in terms of marketing and managerial competence.

In Romer (1993a), an important distinction between object gaps, that is, shortage of machinery, human capital, infrastructure and suchlike, and idea gaps is made. The notion of an idea gap is similar to what several authors have called a technology gap,

but is considered to mean something broader. To quote Romer (1993a, p. 544):

Ideas include the innumerable insights about packing, marketing, distribution, inventory control, payment systems, information systems, transactions processing, quality control, and worker motivation that all are used in the creation of economic value in a modem economy.

Even if both types of gaps coexist in developing countries, and even if overall stable macroeconomic conditions in combination with policy favoring education, secure property rights and legal institu- tions help to eliminate both of them, the closing of idea gaps requires substantially different policy measures than those for object gaps. In developing countries large gains could be made by exploiting the ideas developed elsewhere and attention is thus directed toward the diffusion of ideas among countries. An important channel for this transmission is foreign direct investment made by multinational enterprises. The foreign affiliates may, for instance, provide an important example for potential indigenous exporters by demonstrating how to combine managerial, technical and marketing know-how in order to enter the world market. That is, the host country may benefit from a catalyst effect stimulating local firms to engage in export activities. The Rhee and Belot (1990) study of individual, non- traditional, manufacturing industries in 11 developing countries and the circumstances behind their successful entry into the world market provides some support for this hypothesis.’ Their tentative finding is that in almost every case a particular person, firm or public agency played a critical role in the initial export phase by combining local endowments with managerial experience, marketing knowledge and mastery of relevant technology. In industries where the country in question had little or no previous experience, this role was often played by an affiliate of a foreign multinational enterprise. This was especially true for the least developed countries.

Since EPZs are intended to attract foreign multinational enterprises, it is possible that that they could have a catalyst effect on the host country and lately, some authors have argued along these lines. In the case of Mauritius, for example, Romer (1993b) argues that the Mauritian EPZ played a crucial role in the country’s tremendous development record by bringing ideas and knowledge to the island.’ So far, only one attempt to assess the catalyst effect of EPZs has, however, been made. In a study of the Dominican Republic, Rhee et al. (1990) use a questionnaire to survey foreign and domestic firms as well as joint ventures operating in the Dominican Republic’s EPZs. They found that the foreign firms present in the zones have initiated exports of a wide range of products and that native managers trained in

EXPORT PROCESSING ZONES 1117

foreign firms played an important role in the establishment of locally owned firms in the zone. Important vocational training and learning-by-doing was found not only among the officials but also on the factory floor: for example, labor productivity grew rapidly during the first years of a new firm’s life reflecting a high degree of on-the-job training of unskilled workers. Thus, foreign firms clearly had a positive impact on the local export supply emanating from the Dominican Republic’s EPZs. In this case, however, the effect is narrowly defined to consider only what happens within the EPZs. It seems plausible that a first step in the diffusion of the supply response is to induce the establishment of locally owned firms within the zone. An important point, however, is whether the catalyst effect is also external to the EPZs, that is, spills over to domestic firms outside the EPZs. A major risk with the enclave structure of the EPZs is that this fails to occur because of lack of linkages and communica- tion channels between the EPZ and the rest of the economy. If the export-generating effect fails to spread outside the EPZs, their establishment has had only a minor impact on the conduct of the indigenous firms in the host country and thus on the development process. It is therefore not enough to look at the export performance of the EPZs in isolation when assessing the effect of EPZs on exports, but to consider how the total amount of exports (EPZ+non- EPZ exports) are related to the establishment of zones.

3. PREREQUISITES FOR A SUCCESSFUL EPZ

For an EPZ to have a significant catalyst effect on the host country, some basic features are required. Those include both key micro characteristics of the EPZ and overall macro aspects such as the general trade and development regime pursued by the host country. To begin with, in order to generate any effects at all, the EPZs must function as intended, that is, they must attract investment, export the mainstay of their output and function without heavy subsidies. These criteria are far from satisfied in many EPZs today. Second, even though the EPZ may be successful in attracting investment and generate export earnings, it is not automatic that the export supply response will spread outside the zone. If the trade policy reforms are confined to the EPZ and an anti-export biased policy situation remains in the rest of the country, foreign firms may have a positive influence on domestic firms within the zone but fail to stimulate the emergence of a domestic export sector outside the zone. Finally, the EPZ may also influence the trade policy regime of the host country, either by conserving anti-export

biases present in the rest of the country or by initiating additional trade-oriented reforms.

The possible impact of the EPZs on the host country’s exports, both directly and indirectly, is but one aspect of EPZs. It is important to bear in mind that several other issues are relevant if we are to fully understand the role of EPZs in the development process.” For example, EPZ manufacturing consists in most cases of simple assembly or production with low value-added. Although unskilled labor is almost always abundant in countries establishing EPZs skilled labor and entreprenuership is commonly in short supply. If, as noted by Kaplinsky C 1993). those scarce resources are drawn from more technically advanced or higher value added production elsewhere in the economy to the EPZs, the country may suffer a loss of capabilities.“’ EPZs should perhaps further not only be seen in a narrow host country context, but also in a world wide development perspective. For instance, Kaplinsky (1993) draws attention to the danger of fallacy of composition. He argues that since cheap, unskilled labor is the major attraction for foreign investors in EPZs, competitive devaluation may cause EPZs to be beneficial when established by a few countries but result in a drop in real wages and deteriorating terms of trade when established simultaneously by a large number of developing countries.

(a) Microc,huructeristics cud the perjormance of the EPZ

Since the late 1960s a large number of EPZs have been established in the developing world but far from all function satisfactory today. Especially in the early 1970s several mistakes were made in the design, locational choice and implementation of the zones and it is noteworthy that the failure to appreciate fully the potential merits of EPZs may be due to the large number of mistakes commonly made in connection with the zones. A common mistake was to incorporate regional development objectives into the EPZ investment decision. Be- cause of its convenient enclave structure, an EPZ could in principle be located anywhere in the host country and policy makers quickly saw the possibility for killing two birds with one stone. Thus, the EPZs were in some cases established in rural underdeveloped areas considered to be most in need of economic development, in order to promote a more balanced economic development in the country. Other commonly cited factors explaining the poor performance of several EPZs are poor planning and design. abundance of red-tape procedures, insufficient and inefficient promotion. lack of supporting government policy interventions. and finally, pure mismanagement.” In spite of all


possible pitfalls, many successful EPZs do exist. The common features they share are basically the opposite of the above-mentioned impediments: a favorable location, promotion, adherence to the basic EPZ principles, i.e. duty-free imports of inputs, minimized red-tape procedures, guaranteed profit repatriation and the presence of a supporting infrastructure such as telecommunication, electricity, and water.

(b) EPZs and trade policy

Since EPZs are most often enclaves, two diame- trically opposite scenarios are feasible for initially import-substituting countries. The establishment of an EPZ could either be part of an overall trade- oriented reform program aimed at opening up the country, or regarded as an opportunity to reap the benefits from export promotion while simultaneously continuing with an import-substituting policy in the rest of the country. In the first case, supporting trade- oriented reforms, putting the rest of the country on an equal footing status with the rest of the world, facilitates the spread of the export supply response outside the zone. In Sri Lanka, for example, the introduction of the Katunayake zone was part of a series of trade-oriented reforms. The zone attracted a large number of foreign direct investments. As other types of duty-free regimes were introduced outside the zone, a successful manufacturing export sector evolved, largely located outside the zone. In the latter case, when the import-substituting development policy remains in the rest of the country, the EPZ may well be prosperous per se but the diffusion of the export supply response may be restricted.

An additional important link between the host country’s trade policy and EPZs, which indirectly influence the potential for the catalyst to work, is that EPZs might also influence the overall trade policy. Even if the initial intention was to continue with import substitution, a convincing performance of the EPZs may provide both the arguments and the resources needed to induce a policy shift toward greater openness. In China, for example, the developing prosperity within the free economic zones has raised demand for further trade reforms. ‘* Such reforms should permit a further expansion of exports. Another possibility, emphasized by the World Bank (1992), is that a successful EPZ may just as easily conserve an inward oriented industrial structure in the host country. The underlying reason is that a well-functioning EPZ generates export earnings and creates employment. Since one of the potentially important explanations behind a policy change aimed at reducing anti-export biases is an acute trade deficit due to low export earnings, possibly in combination with high unemployment,

the presence of EPZs may prolong the time period in which a country can pursue a protectionist trade strategy, undertaking no or few trade liberalizing reforms. This may be the scenario if the EPZs are important enough to create considerable employment and large inflows of foreign exchange. EPZs accomplishing this are commonly regarded as a successful investment for the host country but if outward orientation is a primary goal, EPZs could delay reforms’s This line of reasoning indicates the unsuitability of assessing the performance of EPZs in isolation, not taking the total effect of the EPZ on the host country into account.

4. EMPIRICAL ANALYSIS

Below, we analyze the impact of EPZs on the host countries’ total export performance in order to see how the establishment of EPZs are related to the host countries’ total export performance (EPZ + non-EPZ exports) and to investigate if a significant catalyst effect can be detected. The direct contribution of EPZ exports in combination with the catalyst effect suggest that EPZs may increase total host country exports. But, if the establishment of EPZs conserves protectionistic policies, this effect may diminish. Further, if a positive impact on total exports is encountered we can compare this estimate with the volume of exports from the zones. The difference between the EPZs’ estimated impact on total exports, which includes both the zones’ direct contribution to total exports and the catalyst effect, and the EPZs’ exports over a subsequent number of years gives a hint of both the magnitude and the development of a possible catalyst effect over time.

In order to capture the quantitative effect on total exports of the establishment of EPZs we use a version of the gravity model. Gravity models have experienced a renaissance, mostly due to improved theoretical underpinnings but also because of their consistently high statistical explanatory power of trade flows. The basic idea is that bilateral trade flows are determined by three sets of independent variables: variables indicating the total potential demand of the importing country, variables indicating the total potential supply of the exporting country and variables aiding or hamperin trade between importing and exporting countries. 1: The third set of variables could include trade regime, trade preferences and suchlike. Recently, gravity models have been used, for example, to study regional integration schemes and the interaction between trade policy regimes and trade preferences.i5 A gravity model is also a suitable instmment when examining the trade impact of EPZs. Since the principal objective of EPZs is to stimulate exports, EPZs could be included in the model as a variable in facilitating trade. The

EXPORT PROCESSING ZONES ?I I’)

gravity model then enables us to trace out the export effects of the EPZs.

(a) The gravi~ model

The traditional cross-sectional gravity model explains trade between two countries by log linearly regressing values of bilateral trade flows on a constant, on the value of nominal GDPs and on the populations of the trading countries, on the distance between the economic centers, or capitals, of the importing and exporting countries and on any other factors aiding or resisting trade between them. The model may best be interpreted as providing a long-run equilibrium view of trade patterns. Hence, prices are excluded from the model due to its long-run nature, since in a general equilibrium setting prices are endogenous and simply balance to equate supply and demand.lh To account for additional factors aiding or restricting trade, binary variables are generally added to the model. A major advantage of this technique is that a test of the statistical significance of the binary variables are provided for. The specification of the gravity model used in this paper is as follows:

Mij = dollar value (1000$) of country i’s imports from country j, ok = a constant, Yj, Yj = nominal GNP of the importing and exporting countries in dollars, Ni, Nj = populations, in millions of people of the importing and the exporting countries, D, = the geographic distance, in kilometers, between the importing and exporting countries’ capitals, Z, = binary variable for the exports of the jth developing country with EPZs, ejj = a log normally distributed error term and D and 6 are parameters.

The variables Yi and Ni capture the import demand of the importing country. Yi captures economic capacity and demand for varieties while Ni captures the size of the domestic market. A larger Nj indicates a larger domestic market and, hence, less need to trade. A large population however promotes division of labor and implies the presence of economies of

scale in production and therefore also opportunities to trade with a greater variety of goods. Thus, the effects on imports of an increasing population in the importing country is unclear. The variables Yj and N., capture potential export supply of the developing countries in the sample, using the same arguments applied to import demand. The variables Y; and Y, are expected to influence M, positively while N, and N, have an indeterminate impact on M;j. The variable for geographic distance D, is a measure of transport and transaction costs. Transport costs are related to distance while transaction costs reflect the fact that people are better informed and have smaller cultural differences when belonging to adjacent countries. The variable Di, is expected to influence trade flows negatively. The binary variable Zjj are included to account for the export effects the EPZs are supposed to generate. In Table 1 the independent variables and their expected signs are displayed.

(b) The sample

Although EPZs are common in developing countries, a relatively large number of the zones exist only on paper, have never taken off or have been abandoned by investors due to political unrest or suchlike. Some employ only a couple of hundred people while others are engaged in activities such as warehousing. oil supply or financial services. far from the original EPZ intention. We have chosen to include in our sample the countries accounting for the greatest part of EPZ employment. According to ILO/lJNCTC (1988), 14 countries accounted for 94.5% of worldwide EPZ employment in 1986. These are Mexico, Singapore, the Republic of Korea. Hong Kong. Malaysia, Taiwan Brazil, Macao, Mauritius, Tunisia, the Philippines, the Dominican Republic, Sri Lanka and Egypt. Because of lack of data we have excluded Macao and Taiwan. We have further chosen to exclude Brazil since its EPZ is in effect an “import-processing zone.” producing only for the local market. The remaining exporting countries in the sample, the control group, consist of the other developing countries which do not have EPZs. I7

Table 1. Expected sips of the variubles in the gravity model

Variable Sign ReaS3n

GNP of i, (Yi) Population of i (Ni) GNP of j (Yj) Population of j (Nj)

+ Potential import demand; demand for varieties +I- Increasing degree of specialization. less need to trade

+ Export supply, number of varieties +I- Large countries may trade with an additional number of goods due to division of

labor. Large countries are more self sufficient. Distance (D) _ Transportation costs and economic proximity

EPZ (Z,) + EPZs promote exports


The industrialized countries’ trade policy toward the developing countries is likely to influence the developing countries’ exports and therefore, the choice of importing countries may affect the results. In order to avoid the problem of the exporting countries receiving different preferential treatment from the importing countries, the importing countries have been limited to the EU (12) countries since the EU pursues a common trade policy.

(c) Empirical analysis

We begin by exploring whether the presence of EPZs is positively related to exports. A log linear version of the gravity equation is estimated for each year between 1980 and 1992 using ordinary least squares (OLS), allowing us to observe differences in the effect of EPZs on export by year. The sample size varies from year to year due to the availability of trade data and of GNP and population figures’s Total import data are obtained from the EU’s External Trade Statistics. GNP and population data were taken from World Tables (World Bank, 1993). The distance figures used are straight lines between capitals of the trading countries and were computed from data in The Times Atlas of the World (1985).19

The statistical results are presented in Table 2. Overall, our version of the gravity model performs well, explaining some 65% of the variance of the export flows to the EU. Importing and exporting country GNPs have the expected sign and are significant at the 1% level throughout the study period, except for GNP (EU) in 1992. The two population variables show both positive and negative figures over the years. The distance variable performs

as expected with a statistically significant trade- hampering effect during the whole study period, and the EPZ variable is positive and statistically significant at the 1% level in all years of the study. The regression only explores the statistical relationship between EPZs and total exports, no causal linkage is established. The available data preclude us from using a causality test, leaving us to observe that the empirical results are consistent with the idea that EPZs, on average, have a positive influence on the developing countries’ total exports.

The strong positive statistical relationship between the EPZs and exports, indicating that the EPZs facilitate the increase of total exports of the host country, needs to be given further attention. The EPZ variable in Table 2 only indicates the average effect of EPZs on the exports of the 11 developing countries with EPZs in our sample. We therefore introduce a separate dummy for each country with EPZs, instead of a common single EPZ variable as in Table 2, which gives us the opportunity to discern possible variations in the export effects of the EPZs both by country and year.

The statistical results of these regressions are, including the size of the coefficients of the binary variables for the developing countries with EPZs, presented in Appendix A. The performance of the GNP and Population variables and of Distance remains more or less unchanged in comparison with the results of the first regressions in Table 2. The coefficients of the binary EPZ variables can be used to quantify the importance of the EPZs in generating exports. Considering Table 3, two distinct groups of countries are clearly discernible. First, a significant and positive impact is found for Hong Kong, Malaysia, Mauritius, Singapore and Sri Lanka

Table 2. Gravity model regression results, 1980-92, single EPZ variable”

Year/Variable 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

GNP (EU) I,43 I ,67 I,93 I,50 I,62 I,24 0,84 0,96 0,56 0,68 0,39 0.59 0,84 (5.51) (6,92) (6.70) (5.66) (5.48) (5317) (5334) (6,28) (3,84) (4.41) (244) (3.57) (2.56)

Pop (EU) -0,29 -0.48 -0,78 -0,27 -0,43 0.00 0,35 0,16 0.54 0.44 0,82 0,56 0,25 (1.08) (1.82) (2.40) (0.89) (1,26) (0,Ol) (I ,78) (0.87) (3.04) (2,36) 4,14) (2,75) (0,72)

GNP (Dev C.) 1.24 1,02 I ,06 1,ll 0,92 1,03 0,90 1,oo I,01 I ,07 I ,09 I,04 0,98 (17,75) (13,84) (13.32) (16.69) (12,43) (14,66) (14,94) (17,03) (17,47) (19.67) (19.87) (18.79) (17,07)

Pop (Dev C.) -0,22 -0,Ol -0,03 -0,08 0,19 0,06 0.15 0.06 0,Ol 0,Oo -0,02 0.07 0,ll (2,63) (0.07) (0,33) (0,97) (2,21) (0.74) (2.10) (0,94) (0.14) (0.07) (0,27) (1,19) (1,57)

Distance -0.67 -0,70 -0.67 -0,83 -0.78 -0.72 -0.55 -0.82 -0.63 -0.47 -0,45 -0,57 -0,39 (5324) (523) (4,92) (6,46) (5939) (5,94) (4.80) (7,66) (5,96) (5306) (4390) (6.01) (3326)

EPZ 0,65 0,88 0,94 0,76 0,95 0,72 0,66 0,94 0,83 0.6 I 0.66 0,82 1,15 (2.61) (3.34) (3343) (3303) (3,59) (2.74) (2.67) (3.92) (3.64) (2,86) (3,ll) (3,82) (5215)

Constant -17,89 -18,50 -19,63 -18.11 -IS,42 -17,71 -15,62 -15.06 -13,91 -15.63 -15,26 -15,38 -16,37 (14,48) (16,17) (16,07) (17,88) (16,06) (17,15) (18,52) (17,85) (16,48) (18,58) (1954) (19.17) (11,42)

Adj RZ 0,67 0,63 062 0,65 0,6 1 0,63 0,6 0,62 0.6 0,65 0,63 0,65 0.65 No. Obs 579 647 669 675 672 683 850 872 880 866 871 846 682

a All variables are in logs. The binary variables take on the value 2 in the case of export processing zones and I otherwise. Heteroskedasticity consistent t-statistics in brackets.


Year

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 I992

Dom. Egypt Hong Malay. Maur. Mexico Philip. Singap. South Sri Lanka Tunisia Rep. Kong Korea

+9,7*** -29,6 76,2*** 71,8*** 86.0”** -83,5*** 2.5.6 79,7”“* 35,l &jJ)“W -7.6 -82,2*** 20,9 83,8*** 73,5*** 85,4*** -74.x*** 21.5 84 8**‘* 49,, *!i: 5*,,‘““:‘: 34.4 -84,3*** 23,4 82,7*** 72,7*** 91 6*** -79.14:~

-39,4 82,3*** 73,6*** 86:1*** 16.4 79:7*** 42,(j+? 66,{)“*:” 12.2

-73.3** -7o.s** 19.9 79.0*** 37.0 66.6”“* 7.1 -62,9* -21,1 88,1*** 75,8*** 900*“* -55.9* 9.3

-IO,6 81,5*** 69,0*** 87:4*** -69.0*** 7.4 86.6**” 31.6 5s. I :I** ~- IO.4

-71.7s 78,2”** 19.0 54,,*.* x.7 -71,8** -33 7 85 ?*** 68,3*** 77,3** -594”’ X.8 -66.2** - 1718 84:8*** 75,1*** 86,7*** -4;),2

x4,3*** 48 ()**-L 3Y,Y’- 6.4, 13.8 85,6**” 66 I**” 46 0”s

-36.2 -32,0 81,1*** 755*** 81,3”** 67,4*** 64:4***

-42,7 10.9 *jJ*** &,*“L ’ IX.3

J,.,” -2.7 -54,1* -0,9 79 7*** -67.3**:‘;

6,,4*** 647*** 8,;3*** -64,4”** -20.X 77,2**” 12.1 40,3:;- 51.5”

-50.5** l4,8 -IS Y 79 8*“” 70,4*** 72,9*** 87&j*** -66.3”** -I.; 84:3*“*

-7.1 16, I p so 6”” -47.7 0,3 15.7 5(),2”‘” &.I -3.3 3.8 72,2’** 76,4*** 90,0*** -69.7**” 15.x g7,2*** I I.0 fg)“*“; f)8 [p:**

a The figures in Table 3 has been calculated the following way: First. in order to estimate how large expons would have been in absence of EPZs, total host country exports was divided with 2,‘, where .j is the estimated coefficient of the hinary EPZ variable. (Since the model is estimated in logs, the binary variables take on the value 2 and 1 instead of I and 0 as is common). Second, the difference between total exports and estimated total exports without EPZs was divided with total exoorts (estimated total exoorts without the EPZs in case of negative parameter estimates) and multiplied with 100 to get

A

the relative importance of EPZs in total exports. * Significant at the 10% level. ** Significant at the 5% level. *** Significant at the 1% level.

throughout the entire study period. Second, the coefficients for the Dominican Republic and for Mexico are negative in all years, and statistically significant in most of the years measured. The other countries display a somewhat mixed result. In the case of Egypt and the Philippines, the effect of EPZs is insignificant in all years, and in Tunisia, the effect is insignificant in nearly all years. South Korea shows mainly positive effects of the EPZs but in several years the effect is insignificant.

When the importing countries are restricted to the EU, the statistically significant negative sign and the insignificant coefficients of the EPZ coefficients for Mexico and the Dominican Republic could be expected to be explained by intraregional trade with the United States. A large proportion of the foreign direct investment in the EPZs, or maquiladorus as the Mexican counterpart to EPZs are commonly called, in Mexico and the Dominican Republic originate from the United States, which use the cheap labor to manufacture or assembly goods intended for export to the US market. Domestic entrepreneurs fostered within the affiliates of the US multinationals therefore learn the channels and the ways in which primarily exports to the United States is accomplished. In addition, the geographic proximity to the US facilitates market entrance for new, domestic exporters outside the zones. We therefore incorporate the US among the importing countries in order to investigate if the results obtained above remain stable, although problems may arise since the EU and the United States encounter developing

country imports with different trade policies. The results are, however, not significantly altered by the inclusion of the United States among the importing countries and the EPZ coefficients remain negative for both the Dominican Republic and Mexico in a majority of the years2” Thus, the overall results do not seem to be significantly altered by the choice of importing countries.

A salient feature of the countries with u significantly positive coefficient for the EPZ variable, that is, Hong Kong. Malaysia. Mauritius, Singapore and Sri Lanka, is their outward-oriented trade policy. characterized by a low degree of trade restrictions. The countries also share several of the beneficial microcharacteristics such as favorable location and access to relatively high-skilled labor. A notable exception is South Korea. where a strong outward orientation does not coincide with a positive EPZ effect. This seemingly odd result may be explained by the small part the EPZs have played in the country’s trade strategy. When South Korea embarked on its export-led development path in the early 196Os, all conceivable measures to promote exports were used, EPZs being only one minor part of the program. Economy-wide. duty-free imports were allowed. reducing the need for and effect of special duty-free zones. As a result. in 198.5, manufactured exports from the EPZs amounted to


only 2.9% of South Korea’s total manufacturing exports and in 1986 less than l%, or 36,000 persons, of South Korea’s total manufacturing employment were engaged in EPZS.~’ Hence, rather than indicating the failure of the EPZ concept, this indicates the success of the other measures. After all, for a country wishing to liberalize trade, partial trade liberalization as EPZs aims at is only a second-best alternative to economy-wide liberalization.

At first sight, the significant positive EPZ coefficients found seem to be in line with the idea that outward orientation and favorable micro characteristics facilitate a beneficial impact of the EPZs on exports. But, if the EPZs coincide with outward orientation, the EPZ variable may actually proxy trade orientation and capture export expansion due to an overall export-oriented trade regime. The weak performance of the South Korean EPZ variable contradicts this proposition, though. We also observe that EPZs are present both in countries commonly perceived as being outward oriented as well as inward-oriented. By incorporating a trade policy variable into the analysis the issue could be further addressed. Ideally, we would like to use a measure which not only determines net outward orientation but also takes possible changes in the trade policy over time into account for the approximately 80 developing countries in our sample. Unfortunatel~i finding such a proxy variable is very difficult. Finally, since the EPZs could influence the host country’s trade policy it is not really advisable to hold trade policy constant by a binary variable. Bearing all these impediments in mind we still incorporate a binary variable according to the Greenaway and Nam (1988) classification to obtain a crude indication of whether the results are altered if trade orientation is included among the explanatory variables.2” It is found that the size and significance of the coefficients of the countries with statistically significant positive EPZ variables, as well as the coefficients of the other countries, remain essentially the same.24 Still, the effects are quite large, raising question of whether relevant explanatory variables have been omitted from the analysis.

Both in the Dominican Republic and Mexico, the EPZs have performed well in the sense of attracting foreign direct investment and achieving high export volumes. The microcharacteristics are also favorable in both cases. In Mexico, for example, the maqui- ludorus are located close to the US border, reducing transport costs and stimulating US investment by their proximity. But, in contrast to the countries with a positive significant EPZ-coefficient, the Domini- can Republic and, until the mid-1980s when trade barriers were markedly reduced, Mexico have chosen to pursue an import-substituting trade strategy outside the EPZs, thereby emphasizing the enclave structure of the EPZs and making it more

difficult for the EPZs to have a beneficial effect on non-EPZ exports. A dual structure with an exporting, mostly foreign, enclave separated from the protected import substituting sector is created. In neither case do we find a significant positive effect of the EPZs on total exports. On the contrary, several years exhibit a significant negative relationship. This puzzling result may, at least in the case of the Dominican Republic and perhaps for the first half of our sample period for Mexico. possibly be explained by the fact that the EPZs have permitted the countries to continue with an import-substituting industrial structure, rather than undertaking economic reforms. In that case, the amount of total exports would have been substantially larger in an alternative scenario without EPZs, since the existence of EPZs allowed protectionist trade policies to be maintained in the rest of the country. As previously discussed, this could be the case when the EPZs provide substantial export earnings and employment opportunities. In both the Dominican Republic and Mexico the EPZs play such a role in the economy.

The Dominican Republic has relied to a large extent on its EPZs to yield export earnings, and has not worked to remove the severe obstacles to industrialization prevailing in the rest of the economy. Anti-export biases, problems in obtaining foreign exchange, difficulties in importing intermediate goods and so forth hinder production for both the local and the foreign market. The EPZs in the Dominican Republic could in some sense be regarded as a success but despite, or perhaps owing to, significant export earnings and employment creation, reforms in the rest of the country are late.2s Also in Mexico. maquiladoras have been an important source of employment and a substantial foreign exchange earner. Next after oil, the maqui- Zudoras are the country’s second largest export earner. In Mexico, however, trade policy reforms were initiated in the second half of the 1980s and when those reforms have gained momentum, we would expect the maquiladoras to have a positive impact on exports. So far this has not occurred and since we only have data until 1992 one explanation for the significant negative signs in the late 1980s and early 1990s could be that the policy change is not yet reflected in the data material.26 Another possible explanation to the lack of positive export effects of the EPZs on Mexico’s exports is that the gravity model poorly tits trade flows involving natural resources such as oil. The reason being that the source of trade is mainly related to the exporter’s resource endowment and not to the exporter’s national income.27 Finally, the significant negative coefficients on the dummies for Mexico and the Dominican Republic could also be regarded as anomalies. Although it is possible that the EPZ could have a negative impact on non-EPZ exports, it


is less likely that EPZs should reduce the total amount of host country exports.

The Bataan EPZ on the Philippines was established in 1972 and is a typical example of failure because of regional development objectives and subsequent poor location, far from major cities and transportation channels. A couple of other zones have been constructed in the late 197Os, but still no significant positive influence could be detected.** Tunisia moves from an insignificant mostly negative relationship at the beginning of the period to a positive significant relationship at the end of the period. An explanation for this record could be Tunisia’s trade policy change, originating in the mid- 1980s. It was not until a severe balance-of-payment crisis struck Tunisia in 1986 that the country decided to turn toward a more open and market-oriented development policy. The reforms have been gradu- ally undertaken and the transformation is still underway.‘” The positive and significant coefficient in 1989. 1990 and 1992 could indicate that the overall trade policy environment is now such that the EPZs have a positive impact on total exports. The coefficient is further increasing in magnitude over time. Unfortunately. it is not possible to investigate if this is a continuous trend since data are unavailable for the subsequent years. Finally, the impact of the EPZs on Egypt’s exports is insignificant in all years.

(e) A dynamic catalyst effect of the Malaysian EPZs?

Above, we asked whether EPZs have an impact on host country total exports. The answer was found to be yes and the results indicate that a catalyst effect may be present in countries with an overall outward- oriented trade strategy and favorable EPZ micro conditions. In the case of a positive impact on total exports, we wonder whether this effect only equals the exports from the EPZ itself, or whether the zones induce additional exports from the host country, i.e. if a catalyst effect is present. Further, in the case of a catalyst effect, we are also interested in how it develops over time. It is possible that a dynamic effect is present, if the export creating effect increases over the years. This would be the case if the EPZs start a snowball effect, inducing more and more exports over time.

We estimated above the EPZs’ impact on total exports and in Table 3 these estimates were quantified as shares of total exports. It is also possible to express the effect in pecuniary terms. By doing so we may be able to compare the effect of EPZs on total host country exports with the exports only from the EPZs in order to isolate the catalyst effect. Data on exports from EPZs over time exist only for Malaysia, and we therefore turn to this

country in order to highlight the catalyst effect.“” Malaysia began to abandon its initial import- substituting development strategy in the late 1960s. Its first EPZs were established in 197 1 and new zones have been authorized since then. The zones have been located close to major cities, are served by a good infrastructure and have thrived in a favorable business climate. Export growth has been considerable and in 1982, for example, EPZ exports accounted for more than 52% of total manufactured exports from Malaysia.3’

In Figure I. we display Malaysia’s total exports to the EU, Malaysia’s total EPZ export to the EU and the estimated impact on total exports of the Malaysian EPZs. The difference between the estimated impact on total exports and the EPZ exports in the figure is a measure of how much exports the EPZs have stimulated in addition to their own exports. As can be seen, export creation is substantially larger than exports from the zones over the entire sample period, pointing at the prevalence of a catalyst effect. Thus, the experience of Malaysia supports the hypothesis of a positive catalyst effect from the establishment of EPZs. As may also be seen in Figure I. there is no evidence of an increased effect over time, i.e. a dynamic effect of the EPZs on total exports could not be found in Malaysia. The difference between the Malaysian EPZ exports to the EU and the estimated gross trade creation ecfect remains more or less the same.

5. CONCLUSIONS

This paper shows that EPZs have increased total exports of several developing countries. The effect varies across countries, and those countries with an outward-oriented trade strategy are more likely to experience a positive impact on exports. It is further shown that in the case of Malaysia the export- generating effect of the Malaysian EPZs is larger than the exports from the country’s EPZs, indicating the presence of a catalyst effect. This result is consistent with the concept of idea gup.s put forth by Romer (1993a) and indicates that EPZs may contribute to economic development by the bringing of export know-how to the host country, thereby reducing the idea gap present in many developing countries. The catalyst effect could be expected to increase over time, as suggested by Romer’s ideas, but the test for Malaysia does not support this hypothesis. In contrast, the effect is fairly constant over time. Due to data limitations, the existence of a catalyst effect could only be analyzed for Malaysia. As data become available, future work on this topic could therefore include empirical analyses of the existence of a catalyst effect in additional countries.


500

0

- Total Malaysian exports to the EU - - - Gross trade creation

..-..-. Malaysian EPZ exports to the EU

Catalyst effect

I

,... .,**

*..* *_._._.........-.-..

-~~-.-...__.._________~._......--~-~~-....-.- . ..-

I I I I I I I I I I 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

Year

Figure 1. Total Malaysian exports, EPZ Exports and estimated EPZgross export creation, 1980-1990. Notes: Since the Malaysian EPZ export data are not divided according to destination, we make the assumption that the share of the Malaysian EPZ exports to the EU is equal to the share of total Malaysian exports to the EL!

Figures on Malaysia’s total world exports were obtained from World Bank (1992).

NOTES

1. The debate regarding the link between trade and GNP growth is, however, not yet solved. See for instance the recent work by Helleiner (1995) and Levine and Renelt (1992) in which the relationship is questioned.

2. See for example Hamada (1974), Hamilton and Svensson (1982) Miyagiwa (1986), Young (1987, 1992) and Miyagiwa and Young (1987) who argue that EPZs are generally welfare-reducing and Warr (1989) who argues that EPZs at best have a very limited positive impact on the host country. An exception is Devereux and Chen (1995) who argue that EPZs in many cases are welfare-improving. See Johansson (1994) for an overview of the literature.

3. The term is borrowed from Romer (1993a).

4. See also Rhee and Belot (1990).

5. In addition the issues of working conditions and wage levels within the EPZs have been a matter of debate. For a discussion see Romero (1995).

6. See for example Warr (1987a, b, 1989) and Spinanger (1984).

7. The countries and industries are BangladesNgar- ments, Indonesia/plywood, Colombia/flowers, Zambia/ uni- forms, Honduras/condiments, India/diamonds, the Ivory

Coast/semi-processed cocoa, Jamaica/garments, Guatema- la/shoes, Hungary/software and Brazil/aircraft.

8. Others are UNCTC (1990). The World Bank (1992), and Johansson (1994).

9. A discussion of the developmental effects of EPZs can also be found in e.g. Sklair (1988) and UNCTAD (1993).

10. For instance, a case study of the Dominican Republic by Mathews (1994) indicates that labor with higher skill levels is in many cases recruited from the non-EPZ sector. See also the discussion in Kaplinsky (1995).

11. For a more thorough discussion of the possible pitfalls, see for example the World Bank (1992) and UNCTAD ( 1993).

12. See for example Wall (1993).

13. See also the discussion in Hirschman (1970, 1992) regarding exit vs. voice, which is applicable to this problem. The establishment of EPZs could be viewed as a sofr exit, lessening the demand for changes of the policy regime.

14. For more details on the background and the foundations of tbe model see Wang and Winters (1991),

Baldwin (1994). Oguledo and MacPhee (1994) and Deardortf (1995).


majority of the developing countries in our sample are to be classified neither as outward, nor as inward, oriented. Moreover, since two-thirds of our study covers a period later than 1984, the relevance of Greenaway and Nam’s (1988) classification for our study may fade over time.

15. See for example Bourdet and Nilsson (1995) for the case of trade preferences and Hamilton and Winters (1992) for the effect of integration.

16. See e.g. Learner and Stem (1970, pp. 146147).

17. See Appendix B.

18. Zero trade flows have been excluded as have countries lacking observations on GNP and population.

24. The results may be obtained from the authors.

25. For a discussion of the EPZs in the Dominican Republic, see e.g. Kaplinsky (1993). See also the interchange between Willmore (1995) and Kaplinsky (1995).

19. See Nilsson (1994, Appendix A).

20. The results may be obtained from the authors.

21. The World Bank (1992).

22. See, e.g., Evans (1990) for a discussion on the difficulties associated with these measures.

26. See e.g. Ros (1995) and Sklair (1988) for a discussion of the Mexican trade policy reform and the Mexican maquiladora program.

23. One attempt to determine net outward orientation, which is far from perfect, is Greenaway and Nam (1988) who classify 39 developing countries as strongly and moderately outward and inward oriented based on their performance over 1973-84. Our sample includes some 80 developing countries and covers 1980-92, so a vast

27. See Baldwin (1994, p. 85).

28. A recent review of the EPZs in the Philippines is provided by Remedio (1996).

29. See, e.g., GATT (1994) for an overview of Tunisia’s trade policy.

30. The data are from Sivalingam (1994).

3 1, Sivalingam (1994).

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EXPORT PROCESSING ZONES

APPENDIX A

Table 4. Gravity model regression resulrs, I YSO-92 *

2127

Variable/Year 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

POP (EU) -;),31 -;),50 -;),82 -;),32 -6.48 -6.04 0133

(:::)

0:14

(::)

0152 (4’46) 0145

(2’45) 0:83

(3’64) 0:55

(2’59) 0:26

(1.15) (1,92) (2S7) (1,06) (1.44) (0.14) (1,69) (0,79) (2,93) (2,41) (420) (2,76) (0,76) GNP (Dev. C.) 1.23 1.00 1.05 1,lO 0,88 1,Oa 0,8S 0,95 0,96 1.04 1.07 I,02 0.96

(16,47) (12.85) (12,59) (15,47) (11,28) (13,42) (13,31) (15,OS) (15.25) (17.23) (17,44) (16.30) (14,95) POP (Dev. C.) -0,17 0,05 0,02 -0.02 0,27 0,12 0,22 0,14 0,08 0,06 0,04 0,14 0,17

(1383) (0.53) (0722) (0.20) (2795) (1.42) (3,Ol) (1396) (1.12) (0,97) (0.54) (2-01) (2,30) Distance -0,77 -0.75 -0.70 -0.94 -0,92 -0,79 -0,65 -0,93 -0,75 -0.46 -0.43 -0,60 -0.36

(4,89) (4.72) (4,30) (6,02) (5,23) (5,39) (4,79) (7.27) (5,93) (4,07) (3,83) (5.15) (2,42) Dominican -1,72 -2,49 -2.67 -1,91 -I,43 -I,82 -1,83 -1,56 -0,65 -I,12 -I,01 -0.94 -0,05 Rep. (3,02) (3,72) (3,03) (2,52) (2,19) (1.95) (1,99) (2.02) (1,Ol) (1,71) (1.98) (1.59) (0,ll) Egypt -0,51 0.34 0.39 -0,72 -0,34 -0.16 -059 -0.28 -0,56 -0,Ol 0.23 0,OO 0,06

(0,82) (O/M) (0.58) (1,36) (0,74) (0,34) (1,28) (0,5S) (1,09) (0,03) (0,53) (0,Ol) (0.13) Hong Kong 2.07 2.62 2.53 2.50 3,08 2,43 2,81 2,12 2,40 I,62 I,37 1.76 I,85

Malaysia (4.53) (5380) (5.65) (5.10) (5,87) (4391) (6389) (731.1) (5.53) (3380) ‘;B;’ ‘;J;’ (;J;)

1,82 1.92 1,87 1,92 2.05 1,69 I,66 2,Ol 2.03 I ,49 (6,15) (5,60) (5,24) (4,87) (4,97) (4,26) (5.50) (6,53) (6,15) (4,63) (4:00, (5:61’1 (6:07)

Mauritius 2,84 2,78 3,57 2.84 3,32 2.99 2,14 2.9 1 2.42 2,30 2,42 3,Ol 3.32 (3,90) (5.75) (5,54) (5,42) (6,91) (3.99) (2,47) (3,531 (2,95) (3,12) (3.45) (5,85, (7.42)

Mexico -2.60 -1,99 -2,26 -1,76 -1,18 -I,69 -1.30 -0.74 -0.80 -1,61 -1,49 -I,57 -1,72 (6,76) (3,Ol) (2,99) (2.53) (1.90) (2.98) (2,28) (1,18) (1,42) (3,56) (3,48) (3.56) (3,39)

Philippines 0,43 0,35 0.26 0,32 0.14 0,ll 0,13 0.21 0.17 -0.34 -0,25 -0,02 0.25

(1.31) (0,89) (0766) (0.72) (0.32) (0.27) (0.36) (0.52) (0,35) (0,88) (0.62) (0.04) (0.70) Singapore 2,30 2,72 2,30 2,25 2,90 2,20 2,67 2,79 2,57 2,13 2.31 2.67 2,97

(5.10) (6.64) (5.18) (4.59) (5,14) (4.53) (6,61) (8,12) (6.78) (6.50) (5.85) (7.24) (6,83) South Korea 0.62 0,97 0.79 0.67 0.55 0,30 0.94 1,56 I ,33 0.19 -0,ll 0.25 0.18

(1,641 (2.52) (2319) (1,53) (1325) (0,85) (3,08) (4,73) (3,73) (0.58) (0.33) (0.71) (0.50) Sri Lanka 1.52 I,28 I,56 1,58 1,16 1,12 0.73 0,89 0,78 0,74 0,89 1.01 1,45

(3.02) (2,82) (3,65) (3,46) (2.83) (2.56) (1,85) (2,38) (1,77) (1,70) (1,88) (2.38) (3,50) Tunisia -0,ll 0.61 0.79 0,ll -0,16 0,13 0.10 0.29 -0,04 1,04 I,02 0,69 1,65

(0,21) (0,92) (1,15) (0,17) (0,21) (0,19) (0,16) (0.50) (0,08) (2,49) (2,211 (1,43) (3,31) Constant -17,84 -18,63 -20,Ol -18,10 -18.31 -17,80 -15,32 -14.70 -13.46 -15,79 -15.52 -15.45 -16,76

(14.41) (15,93) (16,05) (17,39) (15,40) (16,57) (17,30) (16.48) (14,94) (17,56) (18,47) (l&07) (11,60) Adj. R2 0,68 0,65 0,63 0,66 0,62 0,64 0,61 0,63 0,61 0,66 0,64 0,6(1 0,6h No. Obs 579 647 669 675 672 683 850 812 880 866 871 846 682

* All variables are in logs. The binary variables take on the value 2 in the case of export processing zones and I otherwise. Heteroskedasticity consistent t-statistics in brackets.

Appendix B - overleaf


APPENDIX B

Table 5. List of non-EPZ countriesa

Algeria Antigua and Barbuda Argentina Benin Bhutan Bolivia Botswana Brazil (Manaus) b Brunei Burkina Faso Burundi Cameroon Cap Verde Central African Republic Chad Chile b Colombia Comoros Congo Dominica Equador Equatorial Guinea Ethiopia Fiji Gabon Gambia Grenada

Guinea Papua N. Guinea Guinea Bissau Paraguay Guyana Peru Iran Quatar Iraq Romania Israel Rwanda Ivory Coast Sao Tome and Principe Kenya Saudi Arabia Kuwait Seychelles Laos Sierra Leone Leshoto Solomon Island Libya Somalia Madagascar St Vincent and the Grenadines Malawi St. Christopher and Nevis Mali Sudan Malta Surinam Mauritania Swaziland Morocco ’ Tanzania Mozambique Uganda Namibia Uruguay ’ Nepal Vanuatu Nicaragua d Venezuela Niger Western Samoa Nigeria Zaire Oman Zambia Panama ’ Zimbabwe.

a The zones in countries with superscripts b and c are sometimes referred to as EPZs. They are not EPZs in a traditional meaning and we have decided to incorporate these countries into our control group. b Zones primarily for services and warehousing. ’ Zones processing imported inputs but selling primarily to the domestic market. d Nicaragua has an EPZ but it has not been in operation since 1983.

Export processing zones as catalysts

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