Rwanda as a Free Trade Zone: An Inquiry into the Economic Impacts Agricultural Policy Development Project Research Report No. 11 Cambridge, MA Lexington, MA Hadley, MA Bethesda, MD Washington, DC Chicago, IL Cairo, Egypt Johannesburg, South Africa July 2002 Prepared for United States Agency for International Development/Rwanda B.P. 2848 Kigali, Rwanda Abt Associates Inc. Suite 600 4800 Montgomery Lane Prepared by Bethesda, MD 20814-5341 Dean A. DeRosa Vernon O. Roningen Title Rwanda as a Free Trade Zone: An Inquiry into the Economic Impacts Author(s) Dean DeRosa and Vernon Roningen Date July 2002 Contract Number PCE-I-00-99-00033-00 Task Number 800 Cognizant Technical Officer Andy Karas Strategic Objective Strategic Objective # 3: Increased Ability of Rural Families in Targeted Communities to Improve Household Food Security Contractor Abt Associates Inc. 4800 Montgomery Avenue Hampden Square, Suite 600 Bethesda, MD 20814 Tel: (301) 913-0500 Fax: (301) 652-3618 This report was made possible through support provided by the Office of Economic Growth, Agriculture and Trade, Global Bureau, U.S. Agency for International Development, under the terms of Contract No. PCE-I-00-99-00033-00. Dean DeRosa is principal economist of ADR International, Ltd., an economic research and policy consulting firm located in Falls Church, Virginia U.S.A. (www.adr-intl.com). Vernon Roningen is an economic consultant and the developer of VORSIM, computer software for economic modeling in the Microsoft Excel spreadsheet, headquartered in Arlington, Virginia U.S.A. (www.vorsim.com). Assistance and helpful comments received from Andy Cook, John Mellor, Gordon Straub, and the participants in a seminar held to discuss the draft report in Kigali, Rwanda, June 10, 2002, are gratefully acknowledged. The opinions expressed herein are those of the author(s) and do not necessarily reflect the views of the U.S. Agency for International Development. Contents Abstract .................................................................................................................................................ii Executive Summary ............................................................................................................................iii 1. Introduction................................................................................................................................1 2. Free Trade Zones in Economic Theory and Practice .............................................................3 2.1. Free Trade Zones in Economic Theory .............................................................................4 Background and Political Economy Setting......................................................................4 Neoclassical Theory ..........................................................................................................6 2.2. Free Trade Zones in Practice.............................................................................................8 EPZs in East Asia -- Warr Study.......................................................................................8 EPZs Worldwide -- World Bank Studies...........................................................................9 Mauritian EPZs -- An African Success Story?................................................................10 3. Rwanda Trade Simulation Model ..........................................................................................12 3.1. The Model .......................................................................................................................12 Import Demand................................................................................................................13 Export Supply..................................................................................................................13 International Payments Equilibrium................................................................................14 3.2. Trade Liberalization and Its Impacts ...............................................................................14 3.3. Database and Parameter Values ......................................................................................16 4. Quantitative Analysis and Results..........................................................................................18 4.1. Free Trade Zone and Related Scenarios ..........................................................................18 Free Trade Zone Scenarios..............................................................................................18 Related Scenarios ............................................................................................................18 4.2. Simulation Results...........................................................................................................19 Free Trade Zone Scenarios..............................................................................................20 Related Scenarios ............................................................................................................22 5. The Way Ahead........................................................................................................................24 Bibliography........................................................................................................................................27 Figures and Tables ............................................................................................................................. 34 Abt Associates Inc. i Abstract This paper investigates the potential economic impacts of establishing a free trade zone (FTZ) in Rwanda. Review of economic theory and developing country experiences with export processing zones provides a basis for a simple economic model that is applied to recent data on Rwandan trade, protection, and production inputs. Simulations indicate the superiority of adopting an economy-wide FTZ for economic welfare as well as expanded exports and employment, the latter especially in agriculture. Extended simulations indicate that political support for an economy-wide FTZ might be increased by simultaneously reducing foreign aid inflows, to maintain if not improve price incentives for production in import-competing sectors. They also indicate greater fertilizer use would significantly increase production and exports of vegetable crops while dramatically increasing rural employment owing to horticulture's high labor intensity. ii Abt Associates Inc. Executive Summary The bold proposal to establish Rwanda as an economy-wide free trade zone (FTZ) would provide the country with a trade policy regime on a par with those in place in Hong Kong and Singapore, in order to improve Rwanda's export performance, diversify its production and exports, and promote greater employment and higher self-sustaining economic growth in the country. This paper illuminates the potential economic impacts of the Rwanda FTZ proposal, first by reviewing the economic theory of free trade zones and the relatively widespread experiences of developing countries with export processing zones, and second by quantifying the impacts of the proposal using an applied economic model of Rwanda's international trade in primary commodities and manufactures. In the absence of significant market imperfections or policy distortions such as production subsidies favoring one industry over another, free trade is widely regarded as the first-best policy for both less developed and more developed countries. Economic theory has focused mainly on the implications of export processing zones (EPZs) which eliminate tariffs and other trade restrictions for small groups of exporters situated within "fenced" enclaves and supported by outward-oriented foreign direct investment (FDI). Economic theory finds little support for establishment of export processing zones. At best they are found to have no effect on the host country, and at worst (when foreign direct investment is involved) they can decrease the economic welfare of the host country. The record of developing country experiences with EPZs since the 1970s may offer a more realistic assessment of EPZs. Theoretical models may not capture real world conditions and circumstances faced by developing countries, such as underemployment of labor in the host country and the importance of imported inputs to EPZ firms. However, in spite of the leading role that outward- oriented FDI has come to play in the new global economy, providing a catalyst for technology and innovation, developing higher labor and management skills, and encouraging policy reforms in emerging market countries, the evidence of a similar role played by export processing zones in developing countries is rather weak. Indeed, there is little evidence of significant spillover effects emanating from EPZs to the domestic economy or even substantial employment gains. Moreover, evidence suggests that EPZs can be very costly to public finances, in terms of resources necessary for provision of not only modern utilities and other infrastructure services but also management and administration. At best, World Bank studies emphasize that EPZs are useful for reducing the anti- export bias of import substitution policies in highly protected developing countries. Furthermore, an early seminal study concludes that most successful emerging market countries have adopted more efficient strategies for reducing this bias and promoting export performance, including unilateral trade liberalization. The Rwanda trade