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Open Water: Free Trade Zones – Game Changer In The Outsourcing Business?

This article was featured as the cover story in Issue 36 of Outsourcing Magazine. Click here to view the full issue.

Introduction

The past decade has witnessed an explosive rise of global outsourcing, an obvious corollary to globalization. Most analysts see this as the start of a trend that’s spreading to more supply side locations with even more significant upside in the coming years. This is likely to lead to two positive outcomes. One, further expansion of outsourcing to more corners of the world, from the present 50+ countries; and two, acceleration of outsourcing volume and value from $370 billion in 2010 to $479.3 billion by 2016, a nearly 30% increase that reflects a compound annual growth rate of 8.35%, according to Frost & Sullivan and Dubai Outsource Zone.

As services-led growth continues to prove itself as a valid and sustainable economic model, both countries with a tradition of outsourcing as well as newbie nations are likely to share this larger pie. Large outsourcing operations is no longer limited to countries like Brazil, India and China; today, this business concept also extends to relatively new and smaller countries like Nigeria, Ghana and Cambodia, who have also been able to scale up operations. In the last 30 years, global trade in merchandise and commercial services have increased by about 7% per year on average, reaching a peak of $18 trillion and $4 trillion respectively in 2011. Developing economies have played an increasing role on the world trade stage, raising their share in world exports from 34% to 47% between 1980 and 2011. If this trend continues, developing countries could be big gainers in the future.

A game changer in the outsourcing business is the ‘free trade zone’. Most countries that have sizeable outsourcing businesses today have successfully established such tax-sheltered enclaves. A recent World Bank study (Exporting Services: A Developing Country Perspective) counts the creation of special economic zones as a ‘top three’ initiative that can help build a successful global services business, the other two being long-term policy measures and policies affecting trade, investment and labor mobility in services. By strategically structuring these tax-sheltered enclaves and leveraging their strengths, countries can claim a share of the global outsourcing services business estimated to reach $450-$600 billion in 2016.

History of Free Trade Zones

Historians believe Ephesus in modern-day Turkey may have been the world’s first free trade zone. It was apparently set up 2000 years ago when the city’s Greek and Roman rulers opened its port to traders in a bid to fuel higher growth. That helped Ephesus grow rapidly into the second largest city in the Roman Empire, behind only Rome.

Modern free trade zones, sometimes called Foreign Trade Zones and Special Economic Zones, have replicated that success throughout modern history. So much so that almost every country seeking a growth thrust, including the United States, has chosen this path at one time or another. There are today at least 1,000 free trade zones in at least 116 countries, housing over 1,000 companies that generate billions of dollars in revenues and enriching the lives of millions.

Why FTZs?

The distinguishing feature of free trade zones, no matter what they are actually termed, is their tax-exempt status. These duty-free areas confer attractive privileges to resident businesses, notably duty-free import of capital goods and income-tax holidays. The FTZs also offer world-class infrastructure, enabling companies to match productivity levels of the developed world.

In recent years, as the competition to be viewed as a promising outsourcing destination has intensified, it is common to see countries falling over one another to set up FTZs. Their potential to attract foreign investment, expand employment and exports, and foster broader economic growth make FTZs an attractive tool regardless of geographical location. Still, not all countries are successful, and not all countries are equally successful. Consequently, it is critical for any country seeking to create an FTZ to choose optimal and effective ways to do so, leveraging both internal strengths and global business trends. In this context, India and the Philippines, and to a lesser extent Costa Rica and Colombia, have demonstrated an effective way of building an outsourcing industry through the use of FTZs.

India: Global Software Hub

India opened its Export Processing Zones in 1965, primarily to drive foreign exchange earnings. This initiative met with limited success because the focus was on manufacturing-led sectors, such as textiles, in which India enjoyed only a few advantages. In the 1990s, India improved upon this model by quickly recognizing the strength of its large pool of software engineers that could perform complex tasks at a fraction of the cost of similar labor in developed markets. In the summer of 1991, Software Technology Parks of India, a free trade zone exclusively for software exporters, was established. These enclaves offered software companies duty-free imports of costly computers, best available telecom infrastructure and long-term income tax holidays. In addition to attracting the world’s best technology companies to the country, this led to explosive growth of software companies and software exports, creating a virtuous cycle of growth. This brought unprecedented wealth to entrepreneurs, creating seven software billionaires, and enriched the lives of millions of middle-class families whose income earners found employment as software engineers. In its 20-year history, over 8,000 companies benefited from the STPI’s tax-exempt incentives and contributed to India’s growth.

In recent years, India has sought to replicate some of its software success in other sectors with the creation of broader Special Economic Zones. In 2005, initiatives sought to exploit the growing manufacturing and engineering capabilities of a resurgent India, to allow large Indian companies greater freedom in expanding their businesses and exports, and to simplify regulations. For example, companies were granted permission to self-certify their exports and imports. Since this period, over 500 SEZs have been registered.

Software companies that lost incentives offered by the STPI scheme, which ended in March 2011, have moved into SEZs in order to extend their gains and are expected to contribute significantly to the success of the new zones in the coming years. When India’s initial lot of 303 proposed SEZs become operational, they are expected to bring $68 billion in new investment and generate four million new jobs.

The Philippines: Call Center of the World

The Philippines, a medium-sized country with a population of 94 million, is a model country for services-led growth. Despite being a relatively poor country, its human capital is a source of great and sustainable strength. The majority of its people speak English and has skills that lend favorably to outsourced services such as call centers, accounting and finance, software and many others.

Still, the Philippines was relatively late in tapping free trade zones to boost its services exports. In 1991, it announced the first such project after the United States returned the Clark Air Base on Luzon Island. It became operational only in 1995, with a focus on high-end IT-enabled industries, aviation and logistics-related enterprises, tourism and other sectors. The same year, a variety of fiscal and non-fiscal incentives were introduced to the FTZ to attract foreign investors.

As of today, there are 340 Software Technology Parks and Special Economic Zones (SEZ) across the Philippines, two-thirds of which are in the services sector including tourism. The initiatives have paid off handsomely for the country often dubbed the ‘call center of the world.’ In 1999, services constituted only 9% of the country’s total exports; in 2009, it accounted for 21%; and in 2012, it accounted for 26% and accounted for over 7% of its GDP (World Trade Organization). In 2012, the outsourcing sector employed nearly 800,000 people and generated revenues of $13 billion. The country aims to raise this number to $25 billion by 2016, with a direct workforce of 1.3 million.

Costa Rica: Gateway to Latin America?

For over two decades, the free trade zone system has been the mainstay of Costa Rica’s export- and investment-led growth strategy. Over half of the country’s exports originate in eight free trade zones that have been established since 1990. The FTZs provide over 63,000 jobs.

With a population of only 4.8 million, this Central American country has successfully leveraged its key strengths: relative political stability, proximity to the United States and human capital. Its free trade zone laws have been built to be investor-friendly. The minimum required investment is only $150,000 when establishing a unit inside a free trade industrial park and $2 million when it is established outside. The threshold investment is lower in less developed areas, decreasing to $100,000 and $500,000 respectively. Costa Rica provides a number of tax holidays and only stipulates that 50% of services be exported.

So far, manufacturing and produce have accounted for the bulk of Costa Rica’s exports from its free trade zones. However, services are increasing as a share of total exports. ICT (information, communication and technology) exports constitute 32.2% of services exports, or about 2 billion dollars (USD).

In recent years, Costa Rica has sought to boost the services sector by tapping its human capital, notably 94% literacy and bilingual capability, to attract outsourcing companies. Financial outsourcing and software development are rapidly growing sectors, even as the country targets typical BPO operations, positioning itself as a near-shore, low-cost center.

Colombia: Poised for Growth

Colombia is a nation of 47 million in a hurry to erase its drug-riddled past and catch up with the rest of the world. In recent years, its drug wars have ended and the South American nation has enjoyed relative political stability and growth. In 2010, World Bank called it Latin America’s most business-friendly country.

Today, the country has a robust, and growing, infrastructure, and a large pool of human capital. The capital city of Bogota is on par with Bangalore in terms of engineers that graduate from its colleges each year, according to Santiago Pinzon, executive director of the ANDI, or National Association of Colombian Businesspeople. Allied with the country’s telecom infrastructure and the population’s bilingual skills in Spanish and English, Colombia has most of the skills necessary to build a large outsourcing services business.

Well-equipped with a much improved investing climate, Colombia has positioned itself to employ the magic bullet for growth – the free trade zone. In 2007, the country introduced FTZs in a bid to attract foreign investment and meet the country’s aspirations for growth. It established two types of FTZs – a Permanent Free Trade Zone, in which a company or agency administers a demarcated zone in which a number of other companies conduct their industrial, commercial or service activities; and a Special Permanent or “Single-Enterprise” FTZ, under which new companies could enjoy the same facilities even though geographically located outside the territory of the Permanent Free Trade Zones.

Colombia offered two major fiscal incentives – a reduced 15% income tax rate; and zero-rated VAT for goods purchased both within the FTZ from other “FTZ users” or outside of the FTZ. The incentives don’t quite match those given out by many other competing countries. The Philippines, for example, gives a long income tax holiday, after which the preferential rate is 5%. In the Latin American region, the Dominican Republic offers income tax waivers for up to 15 years and Costa Rica up to eight years.

Colombia’s 113+ FTZs have attracted $8.12 billion (USD) in cumulative foreign investment since 2007. But most of the investments have been in oil and mining. Juan Pablo Rivera Cabal, the CEO of a free trade zone in Bogota, believes that in order to build traction in other industries, notably services, it might be reasonable to review the current incentives in light of what other countries are offering and what global corporations expect.

The reluctance to eliminate or even lower taxes, for example, may be short-sighted because creation of new ‘clean’ jobs directly helps the economy for a longer period of time. Also, the single-tenant regulation on FTZs restricts development. It would be simpler to classify buildings as FTZs with multiple tenants sharing common, and better, infrastructure. This is especially important because global sourcing companies look for multiple destinations within a country so that they can tap local advantages such as proximity to universities, urban areas and choice of high-quality buildings.

Cabal believes foreign companies and outsourcers also expect incentives with regard to labor because the services business is labor-intensive. These could be in the form of the government accepting training costs or providing social benefits to workers. Similarly, Pinzon believes the way ahead would be for Latin American countries to make a joint pitch for the region.

Conclusion

It is never too late for any country to enter the global outsourcing business, as the experience of Nigeria and Ghana, for example, reveal. This is on account of several factors, among them abundant human capital with varied skills, rapid spread of technology, low barriers to entry and the sheer dynamics of the sourcing business in which global corporations are forever scouting for newer locations and talent, not to mention lower costs. With effective policy tools such as FTZs, countries have a good chance of making their own fortunes in the outsourcing services business.

About the Author: Atul Vashistha

Atul is the Chairman and CEO of Neo Group, a firm he founded in 1999. Neo is recognized globally as a leading supply and outsourcing analytics, monitoring and advisory firm.
01-02-2014|Articles0 Comments