Special economic zones: a compliance conundrum

By Humberto Vivas, The Red Flag Group®

Special economic zones (SEZs) have been a powerful booster to the economies of many countries, particularly those in affluent geographic or trade areas. SEZs allow transactions to be completed quickly by skipping the paperwork and bureaucracy that governments normally demand, while they also work as a bridge between markets and economies that are politically or geographically distant or unstable.

There are two major types of SEZs, with different objectives and activities.

Free trade zones, such as the Colón Free Zone in Panama and the Free Zone of Iquique in Chile, are typically located in ports or border areas and are aimed at supporting trade by primarily focusing on re-export activities.

Export processing zones, which are normally located on the outskirts of cities or isolated areas, mainly process or manufacture specific products. Export processing zones have increased in popularity and significance over the last two years, especially zones that specialise in the technology sector, such as China’s large high-tech parks of Zhengzhou and Guangzhou.
While there are indeed many advantages to SEZs, they are complex business environments to deal with, and there are myriad risks involved.

In the SEZs located in the Americas, one of the most relevant and common vulnerabilities is the lack of controls – both official and unofficial. Because the goals and purpose of SEZs are centred around high productivity, local governments have more lax controls and tend to ‘look the other way’.

When products are imported into non-SEZ territories, where there are heavier controls, misconduct is often uncovered. Local authorities and international bodies such as the Financial Action Task Force (FATF) are aware that SEZs are more prone to attempts at smuggling, violations of intellectual property, tax evasion, acts of corruption, bribery and money laundering schemes, forcing the receiving countries to be on the lookout to remove themselves from misconduct and reputational damage.

The potential risks in every SEZ can be very similar, but the impact of those risks, the way they occur, their frequency and attempts to mitigate them can vary greatly, depending on the region and type of industries managed in a SEZ.

Breaches are more likely to occur without proper controls

A company operating in a SEZ is typically exempt from several legal obligations, including taxes, customs paperwork and operation licences. While the number of items to comply with is quite reduced (compared to their counterparts in regular trade areas), government agencies in SEZs tend to use less resources and implement a lesser number of inspections. Moreover, since free zones are normally located far away from urban centres, there are transportation and logistics limitations. In some instances officers schedule multiple visits at once so their strictness and completeness when inspecting in situ can be decreased, in other instances items to verify are checked remotely, and in others they simply remain unchecked. This relaxed attitude towards regulation can be particularly risky.

For a company that is repeatedly involved in wrongdoing, and whose illicit conduct remains undetected for long periods, this unregulated behaviour can become a cultural shift towards non-compliance. This not only affects the direct business environment, but the behaviour spreads like a virus to third parties, damaging their transparency and potentially ending with fines and disciplinary actions, negatively impacting the companies’ reputations.

Fast, cheap and out of control?

In the highly-productive culture of SEZs, numbers are priority. According to Panama’s National Statistics and Censuses Institute, the 3,712 companies operating in the Colón Free Zone registered a total of nearly US$10 billion in exports and US$9.7 billion in imports in 2018, representing 1,731,000 thousand metric tons of freight forwarding – that means a yearly average of US$5.4 million in transactions and 400 metric tons of freight forwarding per company. Such volumes and ranges of transactions tend to make companies lower their vigilance, skip processes and ignore administrative controls.

The FATF has stated in its reports on Central America that these characteristics are prone to undermine the companies’ management integrity by subverting their priorities, causing their corporate governance elements to be underestimated and meaning that less resources are allocated.

These conditions also make the companies vulnerable to receiving payments from questionable sources. While the predominant tendency points to the disappearance of cash, the tolerance of cash use in some SEZs is still high, increasing the incidence of crimes such as tax evasion and money laundering.

Establishing patterns and business profiles

While SEZs are supposed to be limited, they keep increasing in number, amounting to an estimate of 4,000 worldwide and 300 in Latin America alone. In the United States, SEZs produced over US$84.6 billion in exports in 2015 – thus their relevance to the world trade.

Despite these huge numbers, building benchmarking data for companies operating under this special regime is complex. Keeping track of the business and financial performance of the companies is difficult because any local compulsory requirements for the disclosure of such details tend not to be rigid, hindering the building of data and making it particularly difficult to establish points of comparison. Additionally, many of the zones are not 100 percent open to the public, with people requiring special licences or justification to gain access.

Only a robust amount of data and a sophisticated data analysis system, combined with years of experience, can integrate enough business intelligence to differentiate what is normal from what is not and successfully identify the red flags.

Will more regulations help?

Regulations alone are never enough – if not applied or enforced properly, they can actually make things worse.

In an isolated environment such as a SEZ, this can be especially true. Overregulating an industry or sector has the potential of affecting its rentability, productivity and attractiveness to investors.

Well-designed and smartly-implemented legislation can be effective, but only if it allows actors to operate under reasonable conditions without complicating operations. If too much pressure is added, one or both of the following scenarios could occur:

  • the industry or sector could weaken or disappear
  • new and creative ways of evading the controls and the system itself could be created, giving rise to malpractices that are more difficult to detect.

We have seen this before, when the FATF and Organisation for Economic Cooperation and Development tried to combat issues in certain business environments across the Americas. They demanded reforms in a short period of time, and the local governments adapted those reforms in full, without granting a proper period of implementation, considering the viability or impact it would have on the businesses operating in those zones, or consulting the local work unions and regulatory bodies that know the industries better than anyone. This history repeats over and over, with regulations that are way behind the phenomenon they are trying to control.

Managing the risks

To manage the risks that come with SEZs, it is a good idea to have resources with the relevant on-ground experience, country and industry knowledge.
Carrying out ongoing surveillance of the SEZs through monitoring of watchlists and regularly conducting in-depth due diligence research on the SEZs is essential. When doing so, the most important factors to keep in mind include:

  • the country’s regulatory approach and impunity levels
  • the area’s efficiency when prosecuting certain types of crimes
  • local levels of tolerance to bribery and corruption
  • the predominant goods categories that are traded or manufactured in the SEZ
  • the main markets involved in the import–export equation.

Implementing proper compliance management programs and training all key positions in the company, especially those with sensitive responsibilities, will demonstrate that the company’s culture is strong enough to resist the threats of the business and regulatory environment and that its controls are not just on paper but are truly implemented.

Last but not least, it is important to make sure that the company applies and enforces similar measures with its third parties. According to regulators, the actions of these third parties are the actions of the companies that hire them, so proper controls need to be in place to avoid misconduct and subsequent fines and penalties. Third parties should not just comply with the local regulations, they should exceed them by obtaining anti-bribery and corruption certifications.

Because regulations are not standardised across SEZs, this heightens the risk levels of the free zones of each country; however, with the right controls and measures in place, SEZs represent a great business opportunity by providing a wide array of resources and services that, when used wisely, can serve to fast track a business.

Explore how our products and services can help you manage risks and compliance. Visit at www.redflaggroup.com or email us at info@redflaggroup.com if you have any enquiries.

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