The Struggle to Save the Soviet Economy, part 6
A special economic zone is an admission of defeat
A special economic zone is an admission of defeat. If you say "This one region will be free of all of our rules, and so it can have spectacular economic growth!" then that would force a reasonable person to ask why those rules exist at all.
Do the rules exist to protect human rights? Perhaps you have a law that says "Corporations are not allowed to discriminate against LGBQT individuals on the basis of their sexuality." Very good. Are you saying that this fundamental right is something you're willing to sacrifice? Here will be a zone where it is okay to discriminate against LGBQT individuals?
What about protections of religious faith? Should you set up a zone where it is okay for corporations to discriminate against people on the basis of religion? So if a business leader is an anti-semite, in most of the world they will face lawsuits for their bigotry, but inside this one zone they can proudly have a rule that says "No Jews allowed."
Maybe you have a rule that is supposed to protect the environment? Don't dump industrial pollution into the river, except in this one zone, where you can definitely dump as much industrial waste as you want, and if that causes brain damage in some of the children in that zone, that's cool, because humans in this zone have no fundamental rights.
But wait, what if you have a bunch of rules that everyone agrees are very stupid rules? Perhaps you have an environmental committee and also a tree committee and also a forest committee and also a river committee and you realize that these committees are redundant, and all of the work of these committees could easily be consolidated into a single committee, probably the environmental committee, which is well setup to absorb the others? Oh but wait, some of the people on the other committees are powerful or have powerful friends, so you cannot get rid of any of these stupid committees. So instead you say "We will set up special economic zone, where none of these committees will have any power!"
So instead of fixing the real problem, you try to go around it, because you simply lack the power to fix the real problem. You want to simplify the bureaucracy, but you can't, so you try to set up a zone where the bureaucracy has no power.
No matter what situation applies, a special economic zone is an admission of defeat. Maybe you are trying to dodge your own bureaucracy because you lack the power to reform it, or maybe you've decided to betray your people and undermine their fundamental rights because the economy is in such desperate shape that you'll take the money and you think some of your citizens will take the money, or you're willing to use violence against them to force them to work in these zones. No matter how you look at it, if you set up a special economic zone, you are admitting to some kind of critical weakness.
And then there is the deeper irony: most special economic zones fail. The special economic zones in China were a rare exception and seemed to only work because China's wages were unusually low relative to other countries. But in Latin America and the USSR, special economic zones mostly failed, partly because they were eventually sabotaged by all of the bureaucracy they were trying to run away from, and partly because the wages in these countries, while low, were not low enough to provide the kind of incentive that the very low wages in China offered.
The Struggle to Save the Soviet Economy:
Mikhail Gorvachev and the Collapse of the USSR
By Chris Miller
©2016
Page 107-108
Slow trade growth disappointed Soviet reformers. The USSR’s economy was one of the world’s largest. The Soviet Union had wealthy and influential diasporas, including Russians in New York, Armenians in France, Ukrainians in Canada, and Koreans in South Korea who could easily deploy their capital and expertise in the USSR if they sensed an opportunity for profit - and many eventually did so during the 1990s. Despite these advantages, regulatory holdup meant that the Soviet Union’s initial experience with joint ventures was unimpressive. Leading economist and Gorbachev adviser Abel Aganbegyan noted that while the USSR has less than 200 ventures with foreign firms, China had several thousand, involving twenty times more foreign capital than in the USSR. The problem, Aganbegyan argued, was the USSR’s investment climate. “In other socialist countries where conditions for the creation of joint enterprises are more favourable,” he noted, referring above all to looser regulations, “there are considerable more of them….Hungary for instance already has more than a hundred joint ventures, while Poland has around 700….But the most obvious example to study is China, where there are more than 5 thousand enterprises with a total capital of 20 billion dollars. I think we shall need hundreds, maybe thousands” of such ventures, he argued. One way to provide a quick boost to foreign investment, Aganbegyan suggested, was to create special economic zones. He hoped these zones could overcome the regulatory hurdles faced by would-be foreign investors by devolving regulatory power to local governments, cutting Moscow-based bureaucrats out of the regulatory process. “We are also looking at the possibility of creating zones where conditions for joint enterprises will be particularly favorable,” he explained. “Such zones exist in China, and have on the whole been successful.” In fact, Aganbegyan noted, “we have examined the possibility of creating such zones in the Far East.”
Could Special Economic Zones Work in the USSR?
It was not until Mikhail Gorbachev launched perestroika in 1985 that Soviet officials began to make the case that the USSR could learn from China’s experience with special economic zones, or that the Soviet Union should create its own zones for foreign investors. One of the first analysts to support the creation of special economic zones in the Soviet Union was A. I. Iziumov, an analyst at the USA-Canada Institute. Iziumov visited China in 1986 and was impressed with China’s foreign economic connections. After returning home, he drafted a memo on China’s foreign trade policies, which was sent to high-level officials in the Soviet Union’s economic policymaking bureaucracy.
Like analysts from the Far East Institute, Iziumov and his colleagues were surprised by the rapid change in China’s relations with foreign investors. In just seven and a half years since China began actively seeking foreign investment, the country had initiated 6,850 projects with the participation of foreign capital, with a total of $21 billion invested. Iziumov reported that investors included firms from the United States, Japan, Australia, and West Germany, but over 70 percent of capital in the early years came from investors of Chinese descent, especially from Hong Kong, Singapore, and elsewhere in Southeast Asia. Many of the initial ventures were in services such as tourism and hotels, though Iziumov also noted manufacturing projects, such as new West German and American car factories - whose combined production he expected to reach 100,000 cars a year by 1990 - as well as Japanese factories making color TVs. On top of that, Iziumov pointed out, China was beginning to participate in high-tech production, assembling “more than 30,000 personal computers with the help of international partners.” Indeed, China’s partnerships with foreign companies were growing increasingly diverse, with the first mixed-venture bank opening in Xiamen in 1986.
Iziumov attributed much of China’s success in attracting foreign capital to its new legislation, which greatly improved the country’s attractiveness to foreign businesses. He reported on the provisions that convinced businesses that investing in China was secure and profitable. Foreign ventures were organized as limited liability companies, he notes, meaning that “they are liable only for their capital,” helping to reduce investors' risk. Tax rates were low, with income taxes at 30 percent for mixed ventures and between 20-40 percent for entirely foreign-owned enterprises; repatriated capital was taxed at only 10 percent. On top of low taxes, China simplified its regulatory system by letting local councils, rather than the central government, make decisions about small- and medium-sized investments. Shanghai, for example, was granted the right to approve all projects smaller then $30 million without consulting Beijing.
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Page 114-117
...To do that, the Soviet government was loosening regulations governing trade. New regulatory flexibility would be coupled with “the establishment of special joint enterprise zones in the Far East.” Soviet trading partners would be very interested, Gorbachev promised, noting “statements in the Chinese press on the possibilities of developing Chinese-Soviet-Japanese trilateral economic activity in mutually advantageous conditions,” and promising a willingness to cooperate closely with the Chinese on matters relating to the special zone. “Dear comrades,” Gorbachev concluded, “we are only at the beginning of the path to the future of the world’s great Asian and Pacific region.”
It was no coincidence that when policymakers in the USSR began planning a special economic zone, they immediately focused on the Soviet Far East. Vladivostok, the region’s capital, is not far from the border with China, and only several hundred miles from South Korea and Japan - so it was well placed to take advantage as Asia’s economic growth created new possibilities for trade. Between 1983 and 1987, for example, the Soviet Far East’s fertilizer trade with China expanded twenty-fold. Some analysts saw similar possibilities in the export of frozen fish to China. Meanwhile, Soviet industries in the Far East, facing a persistent deficit of labor, were eager to employ Chinese workers in their factories.
Businesses from other countries were excited about the prospect of opening up a new export market. The Soviet Far East’s rich natural resources - lumber, fish, minerals, oil, and gas - offered many opportunities. Japanese business delegations visited the region, seeking to assess possibilities for trade and to establish contacts with Soviet leaders. Niigata, a Japanese prefecture, created a special fund to finance investment in the USSR, and its governor, Kyoshi Kaneko, toured Khabarovsk, Vladivostok, and Nakhodka. New airline and shipping routes were established between Vladivostok and Niigata. Representatives from the Japanese embassy in Moscow met with officials at Gosplan, the state planning agency, to inquire about opportunities for Japanese businesses. One Japanese firm, Toho Securities, submitted its own proposal for a special economic zone to the Soviet government. The Far East’s main impediment to investment, argued Minoru Watanabe, executive secretary of Japan’s Chamber of Commerce and Industry, was that “for an entrepreneur to play an active role, a minimum of two factors are needed: a good infrastructure and settled legislation. At present these do not exist.”
Soviet policymakers set out to address these issues. On December 2, 1988, the Council of Ministers issued a decree providing a framework for the creation of special economic zones. The decree created tax incentives for Soviet enterprises in the Far East that established joint ventures with foreign firms. Taxes were cut from 70 percent to 30 percent of a joint venture’s profits. In addition, no taxes on profit were levied for three years after the venture first declared a profit. The decree also authorized subsidized rent and credit. However, much of the administrative work - as in China - was left to regional authorities.
The Communist Party Committee of Primorsky Krai, the region in which Vladivostok is located, soon began planning to open such a zone in the city of Nakhodka, located on a great bay where the Partizanskaia River reaches the Sea of Japan, only fifty miles southeast of Vladivostok. The entire town as well as the surrounding territory was designated a free enterprise zone. The city was an obvious choice. It was a trading post even during tsarist times, and at the turn of the twentieth century hosted European and American merchants. Most trade between the Soviet Union and its Asian neighbors flowed through the port, and even before the special zone was created, the port processed 25 million tons of trade each year. Because Nakhodka was home to the Dalintorg Foreign-Trade Association, Primorsk Maritime Company, and several timber enterprises, all of which engaged in international trade, the city had experience working with foreign businesses. Nakhodka had four ice-free ports, one of which alone could process 40 million tons of trade, so there was room for expansion. The city also boasted sizable industries, including fishing, fish processing, and ship repair, which produced one billion rubles of output annually. On top of this, the city had space on which to construct the “industrial, transport, storage, administrative, dwelling and recreation facilities” that a full-fledged special economic zone would require.
Though the local government actively supported the establishment of a special economic zone, and though opinion polls showed that a “large majority” of the local population also backed the zone, the project struggled to get off the ground. Officials targeted investment in processing raw materials such as “timber, metallic ores, fish, sea products” and in serving as a hub for expanded trade between the USSR and its Asian neighbors. The city attracted some large investments, including from a Chinese timber firm and from Hyundai, the Korean conglomerate.
But where China’s special economic zones were teeming with new businesses from the moment of their founding. Nakhodka struggled to make progress. One factor was structural differences between the Soviet and Chinese economies. When China opened its first zones in Shenzhen and elsewhere, Chinese wages were among the lowest in the world, so businesses had a strong reason to build new factories there. Soviet workers’ wages were lower than wages in the West, but they were significantly higher than in China. Indeed, in the Soviet Far East, businesses faced a labor shortage and hoped to import cheap Chinese labor. The situation was the opposite in China: Shenzhen had plentiful labor but needed foreign capital; Nakhodka’s businesses needed cheaper labor. There was never any chance that the Soviet Union could attract serious investment in textiles or basic manufacturing - the type of industries that drove growth in many East Asian countries.
But the USSR’s relatively high wages were not the only reason Nakhodka was underperforming. Proponents of special economic zones blamed Soviet bureaucrats for giving local authorities insufficient flexibility. By mid-1990, fed up with rules that prevented the types of policies sought by foreign investors, the Russian republic-level government declared the creation of a zone in Nakhodka. All state-run enterprises in the zone were to be made independent from the ministries that controlled them. Foreign investors received additional rights to invest in banks and to lease land. Local governments, under the new legislation, received authority to determine the zone’s “fiscal system and tax privileges.” The Nakhodka city council responded by announcing plans to cut profit taxes to 10 percent. Authorities hoped that the subsequent five years would see investment in “engineering and transport infrastructure and building facilities” as well as tourism and agriculture. Officials planned an airport, a trade center, an international hotel, as well as a telecoms and exhibition center, which were to be finished by 1992.
But the regional government’s pro-business shift came too late. As Nakhodka was ramping up efforts to attract foreign capital, the Soviet Union was dissolving around it. Fearing chaos, investors stayed away, even though in subsequent years many promising industries were sold for a fraction of their future value. No matter how well designed, Nakhodka’s special economic zone could not function in a vacuum. Investment depended on the stability of the Soviet economy and efficacy of its government. By the time the special economic zone in the Soviet Far East had finally freed itself from overbearing officials, the country was disintegrating. Even in the atmosphere of economic depression, by 1993 Nakhodka had attracted foreign investors from 29 different countries, who financed 271 local businesses. That was evidence that Nakhodka’s officials were correct that foreign firms saw potential in the country’s industries. Indeed, over the course of the 1990s and 2000s, foreign investment played a major role in transforming some of Russia’s largest industries, from autos to energy to technology. But the wave of foreign investment that eventually arrived was delayed by the economic crisis of the early 1990s. No matter how carefully Nakhodka officials crafted their business climate, they struggled to attract business interest amid the implosion of the Soviet state. In Nakhodka, the handful of new investment projects that occurred helped soften the pain caused by the economic crisis. But a Soviet Shenzhen this was not.
The Fate of Soviet Special Economic Zones
In the end, there was no tremendous inflow of foreign capital to the Soviet Union, nor did the USSR and its successors enjoy a manufacturing renaissance spurred by foreign trade and investment. By the early 1990s, special economic zones were associated more with tax evasion than with economic reconstruction. As the central government continued disintegrating in the early years after the collapse of the Soviet Union, local and regional governments in Russia took advantage of special economic zones to help individuals and corporations reduce their taxes, much as offshore banking centers such as Bermuda and the Cayman Islands do for multinational corporations today. A zone created in Ingushetia - a small, conflict-ridden province surrounded by the Caucasus Mountains and located far from international trade routes - was estimated to have cost the Russian government $5 billion in lost tax revenue in 1994. This was no path to economic rejuvenation. Yet abuses such as this are evidence not that the Soviet Union’s foreign trade strategy failed but that the central government’s ability to enforce basic rules had all but collapsed.
Had the Soviet Union not disintegrated amid a terrible economic crisis, special economic zones might have yielded some benefits. Indeed, as late as 1991, Soviet specialists were carefully developing their understanding of how to make such zones work. In May 1991, for example, the Institute of the World Economy and International Relations hosted a seminar, “The Creation and Functioning of Special Economic Zones: Comparative Analysis of the Experience of the PRC and the USSR.”