Special Zones for Structural Reform to Take Off Without Resolving Contradictions

TSURU Kotaro
Senior Fellow, RIETI

Debates over the establishment of Special Zones for Structural Reform are fully set to commence. By the end of August, local governments had put forward a series of proposals that the Cabinet Secretariat will use to set policy toward the realization of such special zones. Even putting the specific content of these proposals aside, however, their very philosophy and key features seem fraught with contradictions. In this column, I would like to clarify the problems in this planned scheme, focusing especially on the viewpoints of prospective companies that would take advantage of a special zone's privileged conditions to launch a new, otherwise prohibited business.

Philosophy and Key Features of Special Zones for Structural Reform

To begin with, what is the definition of a Special Zone for Structural Reform? According to documentation by the Cabinet Secretariat, "certain areas are to be selected and designated special zones exempt from certain regulations, based on proposals put forward by local governments, so as to pursue structural reform in accordance with local characteristics." The intended effects of this scheme are to: (1) establish a successful model of structural reform so as to induce regulatory reforms in other areas that eventually lead to the revitalization of the whole Japanese economy, and (2) revitalize regional economies by creating and accumulating industries in line with the distinctive features of each specified region. Meanwhile, in contrast to past local development promotional measures, the Cabinet Secretariat cites the following three distinguishable features: (1) respective local governments play a primary role, presenting and implementing a plan under their own responsibility, (2) conventional-style fiscal measures are ruled out, and (3) reform measures are experimentally implemented in specified areas in accordance with the area's distinctive regional features so as to set a model the rest of the country can follow.

Evaluation of Special Structural Reform Zones from an Economic Perspective

How can we evaluate the government's plan to create Special Zones for Structural Reform from an economic perspective? This idea reminds us of Special Economic Zones in developing countries, privileged areas subject to special deregulation and liberalization to promote trade and foreign direct investment. These SEZ schemes are heavily relied upon to spur nationwide industrial development while minimizing the negative impact of trade and foreign investment liberalization, which would have been too damaging to domestic economies if implemented nationwide. Such a promotion of external transactions, however, is not the prime goal of Japan's planned Special Zones for Structural Reform.

One major goal of the Special Zones for Structural Reform is to bring about regulatory reforms on the national level. In this context, we seek the theoretical ground to this scheme in a model presented by Mathias Dewatripont and Gerard Roland, both professors at the European Center for Advanced Research in Economics and Statistics, that highlights the merits of gradualism as a reform strategy for a country in transition to a market economy. The model compares the costs incurred by the failure of a certain reform and the costs of returning to pre-reform conditions, or the reversal of the reform. Provided that a large-scale reform, despite the high uncertainty of its outcome, is to be carried out, the professors' model shows that a gradualist approach - decomposing a large-scale reform (into mutually complementary, optimum sequencing of reform segments) to minimize reversal costs, thereby, allowing trials and errors at smaller costs - can not only lower ex ante hurdles but create momentum for overall reform by accumulating small successes in the right sequencing. Such an approach can also be effective when a country experimentally introduces a reform in a certain area, and then, expands it nationwide. By limiting the geographical scope of areas to which a reform is introduced, the reversal costs can be kept low. And spreading the reform nationwide is relatively easy because the problem of complementarity would not arise when implementing a reform, which has already proved successful in one place, in other areas. Indeed, China achieved success in its economic reforms by taking such a gradualist approach, implementing certain reform measures in certain areas on an experimental basis and, when successful, then spreading them across the country. Also, Japan's Council for Comprehensive Regulatory Reform, in its interim vision of "special zones for regulatory reforms" unveiled in July, underlined the "trial" and "experimental" roles played by such special zones.

Questions Concerning Policy Feasibility and Philosophical Consistency of Special Structural Reform Zones

The concept of Special Zones for Structural Reform, thus, appears to be an effective policy which is also backed by a theoretical economics model. Several questions arise, however, concerning the policy feasibility and philosophical consistency of this scheme. An initial question is how to select a specific area to be designated a Special Zone for Structural Reform when more than one local government puts forward similar proposals. A key criteria would be "characteristics distinctive to a region," but it is not easy to provide objective standards for drawing a line to separate those qualified from those not. The government seems to be assuming municipalities as a unit for applying to the scheme. But then, how can it discriminate among proposals from cities, towns and villages within the same prefecture? It is not hard to imagine that such ambiguity within the selection standards and their scope would lead to rent-seeking battles involving politicians. This is even worse than rent seeking for budgetary allocations, where budgetary limitations would serve as a brake. Rent-seeking battles for government schemes that do not involve fiscal measures - such as deregulatory measures under the special structural reform zone scheme - would be endless. And this would inevitably bring the whole argument to the very starting point, raising the question: "What is wrong, in the first place, with nationwide deregulation?" Also, excessive emphasis on regional distinctiveness may hamper the spread of regulatory reforms nationwide. Even if a certain reform led to a successful result in a specific area, it may not be sufficient to set a model for the rest of the country when too much credit is given to the "special circumstances distinctive to the area." Worse than that, however, the regulatory authorities may use it as an excuse for not promoting the same reform elsewhere, saying it is not fit to be a nationwide reform. In such events, we cannot expect any multiplied effect intended by the scheme.

A second problem stems from the fact that this scheme, as aforementioned, pursues the two contradictory goals of: (1) stimulating nationwide reforms by making a special zone serve as a pilot case, and (2) promoting industrial accumulation. It is difficult, however, to achieve these two goals at the same time. For example, suppose that a certain area is designated a Special Zone for Structural Reform and a certain hitherto-prohibited business (such as casinos) is now allowed only in this special zone. Now, let us think whether a company operating in other areas will come and launch this business in the special zone. If a company wants to receive the benefits of the special zone, it must establish a foothold - setting up a branch office, for instance - in the special zone. This requires fresh capital investments and such capital investments, by their nature, are irreversible sunk costs. If the planned new business involves large-scale initial investments, the company - albeit having interest in the business - may find greater merits in waiting till the special deregulatory measures becomes available nationwide and enables the launch of the business in the areas of its operations. When companies see the possibility of a certain deregulatory measure within a special zone becoming a nationwide rule (posing high uncertainty over the continuation of the special zone), they are inclined to take a wait-and-see approach (by applying the real option theory). In other words, as long as the concept of special zones stands on the premise that a pilot case implemented in a special zone is to eventually be applied nationwide, the other intended goal of industrial accumulation is unlikely to be achieved. On the other hand, if companies anticipate that a certain special structural reform zone will be maintained for a prolonged period of time, they are inclined to launch operations in the special zone, resulting in major industrial accumulation in the area. If companies expect that the scale of external effects derived from such industrial accumulation will be large, their ex-ante behavior will be affected. But then, this poses a significant problem in terms of policy consistency.

Policy Agenda

An urgent policy agenda clarifies the goal of the Special Zones for Structural Reform, determining whether the scheme is intended to showcase reform experiments or to promote industrial accumulation. In the former case, the relevant regulatory authorities should, through their own responsibility, select target areas in a way that eliminates room for discretion and deliberation, rather than select proposals put forward by local governments. The prime purpose of these kinds of special zones should be to put certain regulatory reform measures to the test and collect necessary data for their nationwide implementation. Meanwhile, when focusing on the aspect of industrial accumulation, special zones of a smaller geographical scope tend to generate greater accumulation. But this would inevitably invoke fierce lobbying battles among politicians and other concerned parties. Furthermore, once preferential treatments are put in place, it would be very difficult to eliminate them as insiders and vested interest groups formed within a privileged zone would most certainly become a resistance force, posing a serious "exit" problem as pointed out by RIETI Senior Fellow C. H. Kwan (see note).

A series of themes that sounds attractive to concerned parties are heard in the ongoing debates on Special Zones for Structural Reform. But it is obvious that they are turning their eyes away from the policy inconsistencies and costs involved in this scheme. If the central government wants to emphasize "revitalization through knowledge and inventive ideas," it should first carry out decentralization, transferring fiscal and institutional authority to local governments. Even if local governments come up with brilliant ideas, they will be able to demonstrate only limited initiatives if the central government is to scrutinize their ideas. It should be noted that China has been able to expand its wave of reform from the coastal Special Economic Zones to the rest of the country because it had the necessary foundations, such as a region-by-region presence of self-contained industrial structures as a result of through decentralization that began in the late 1950s, long before the launching of its "reform and opening-up" policy.

September 3, 2002

September 3, 2002