Not so special

Private equity real estate investors are funneling capital into Indian special economic zones. But there are significant risks that not everything will go according to plan with these controversial developments. By Dave Keating

It has been a busy year so far for private equity investment in Indian real estate. The first six months of 2007 have already seen deals announced worth approximately $755 million (€561 million), according to The Indian Express. The month of June saw the Indiareit Fund invest Rs 250 crore ($61 million; €45 million) in Paranjape Schemes' 138-acre township in Pune. And Trikona Capital's Trinity fund invested $75 million for a 49 percent stake in Luxor Cyber City, which is located in a special economic zone outside of Delhi.

Though these investments are just the most recent examples of private equity investment in special economic zones (SEZs) and integrated townships, SEZs in India have been enormously controversial. Some government officials have been asking recently why IT companies, which are doing quite well already, should receive the economic benefits offered by SEZs. The Indian government introduced its SEZ policy in 2000, allowing the zones to operate as foreign territories for the purposes of trade operations, duties and tariffs. As of 2007, more than 500 SEZs have been proposed, 220 of which have been created. The ones that have been established have gained somewhat of a notorious reputation for displacing peasant farmers from their land, and their rapidly rising number has drawn the ire of the World Bank, which has questioned the sustainability of establishing so many SEZs.

India's government currently insists that special economic zones are here to stay, but it is not inconceivable that the political pressure on these developments could rise to a level that would make them a real headache for investors.

Trikona, along with many other investors, is betting that SEZs will see a flood of traffic once existing fiscal benefits for IT companies expire in 2009—as defined in the Software and Technology Parks of India Act (STPI). Many analysts are predicting that there is little chance the law will be extended, and that in two years' time, SEZs will be the only facilities offering economic benefits to IT developers and lessees.

However, many inside and outside the IT sector are raising concerns over the prospect of such companies being “forced into” special economic zones. Because SEZs are located outside major urban areas, some IT companies worry about their ability to hire high-quality manpower. In addition, SEZ regulations require companies to start completely anew in the zone rather than transferring existing physical assets from their previous location, which would mean a huge amount of money would be required for the move. Given these difficulties, Indian IT companies may be successful in either persuading the government to extend the STPI tax holiday or devising some sort of secondary solution that would not force them to relocate. If such a compromise was reached, it would be bad news for Trikona Capital and the other investors who have poured money into IT-focused developments in SEZs.

Beyond the IT sector, SEZs may be a risky bet in general. The displacement and environmental damage caused by some special economic zones have enraged not only local peasant farmers, but some revolutionary groups as well. In June, Maoists in India announced an economic blockade of SEZs with possibly more violent attacks to follow. And it isn't just revolutionaries who oppose these new economic zones. Indian finance minister P. Chidambaram has expressed reservations over the SEZ program, warning that they could encourage tax-paying businesses to move to the tax-free zones, resulting in a huge loss of income for the government.

India's government currently insists that SEZs are here to stay, but it is not inconceivable that the political pressure on these developments could rise to a level that would make them a real headache for investors. Though SEZs in China, the first nation to introduce them in the early 1980s, have been successful, the result of their implementation outside of a command economy remains to be seen.