Photo: Bloomberg
Photo: Bloomberg

Special governance zones as reform labs

So far, India's experiments with special economic zones have focused more on giveaways than a reset of bad rules

There has been a clamour, especially among economic liberals, for radical reforms at the national level since Prime Minister Narendra Modi got elected. This discounts the underlying political economy of the country and the difficulty of doing even the manifestly obvious. As European Commission president Jean-Claude Juncker put it, “we all know what to do, we just don’t know how to get re-elected after we’ve done it".

Sub-national reforms offer a politically feasible path, something the Modi government fully understands. Bold reform experiments require two fundamental conditions to succeed: They need to be done at a unit of reasonable size and scale, and the experimental unit must have a manageable political economy. States are one sub-national option, cities the other. A proper understanding of Deng Xiaoping’s reforms in China is a useful starting point for this conversation.

In the late 1970s, it came to Deng’s notice that several thousand young Chinese risked their lives by crossing illegally into Hong Kong. Instead of a typical government response of cracking down, Deng tried to understand why. Clearly, economic opportunity in Hong Kong was the driver. Deng was equally impressed by the rapid modernization of Singapore, most of whose Chinese residents were descendants of landless peasants from Guangdong and Fujian.

It became obvious to Deng that the operating system (OS)—the rules and economic governance system—in Hong Kong and Singapore was far superior to the OS of mainland China, and drove wealth creation in both places. The easy-sounding solution was to reboot the mainland with a better OS, but anyone who has tried to migrate an office from Windows NT to UNIX, say, knows just how difficult it is in reality.

Deng did not try radical reforms in large cities like Beijing or Shanghai either, which had existing rent-seekers who depended on the dysfunctional OS for a living. Instead, the pragmatic solution was to demarcate a large area no one really cared about, a sleepy fishing town called Shenzhen, and reboot this region with a new economic governance system. The new governance system allowed the market system to coordinate economic activity, protected private property and allowed foreign investment, to name just three major reforms.

By 1980, three more zones had been set up in Zhuhai, Shantou and Xiamen. Having multiple zones allowed for the possibility of failure, but out of sight and out of mind, containing the political and economic risk. The timing was perfect, as wealthy Hong Kong was losing competitiveness in labour-intensive industries, and these industries needed a new home.

The results are clear. According to the Shenzhen Statistical Handbook, in 1981 the population of the greater region was about 310,000 and produced a gross domestic product (GDP) of approximately $160 million. By 2011, the population of Shenzhen had shot up to 10 million, while GDP had grown to over $120 billion. In per capita terms, GDP went from $760 per person to $17,160, a 22x jump.

More recent numbers suggest that Shenzhen’s GDP is now around $270 billion and per capita income is up to $25,000. The success of Shenzhen was the demonstration that set the stage for radical reforms all across China. Deng’s axiom that it was okay for “some people to get rich first" offered political air cover for these bold experiments.

By comparison, India’s experiments with special economic zones (SEZs) were mostly a failure because they drew the wrong lessons from Chinese SEZs, and focused more on giveaways (taxes, real estate, etc.) than a fundamental reset of bad rules. It is important to note here that Deng’s preferred names for the special enclaves were “special zones" and “special districts". Under pressure from his conservative rival Chen Yun, who insisted that the experimentation might creep into politics (threatening the party’s primacy), Deng inserted the term “economic" to send a message to local bosses that tinkering was to stay in the realm of economic governance.

One other major difference between the Chinese and Indian experience is that the Chinese set up fewer zones, but at scale, close to port infrastructure. Given this fact and the requirement for favourable political conditions, it is better to tinker with the governance systems of cities, both greenfield and brownfield, with adequate political cover. The focus needs to be on fundamentals like empowered local officials, factor market reforms, law and order, education reforms, etc.—not concessions and giveaways, which are symptomatic of crony capitalism.

In this context, noted economist Paul Romer suggests a two-part test for genuine reform. The first, geographic, tests whether the suggested reform (liberal labour laws, for instance) needs to be contained in a geography or can grow to the rest of the country. If it can grow, it’s genuine reform. If not, it’s a concession.

The second, temporal, tests if the reform needs to be time-limited. For instance, do tax incentives need to be limited to 10 years or can they be granted in perpetuity? If they need to be limited, it’s obviously a concession, not a reform.

For a start, Union territories and smart cities could be ideal vehicles for reform experiments given their favourable political economy. Two or three of each could be demarcated as demonstration projects where serious reforms are undertaken, and the successful ones can then be replicated across the country.

Large-scale special governance zones have the potential to become politically viable engines of economic growth in India, especially as wages increase in China. It is an idea whose time has come.

Reuben Abraham is CEO and senior fellow, IDFC Institute.

Comments are welcome at theirview@livemint.com

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