Should Struggling Countries Let Investors Run Their Cities?

Last month, the Honduran Congress approved the creation of independent commercial cities called Employment and Economic Development zones (or "ZEDE" for their Spanish acronym). Supporters of the ZEDEs, including Honduran President Porfirio Lobo Sosa, hope they will offer an alternative to the corruption and governance challenges that hamstring Honduras's economy. They believe that replacing parts of Honduras's ineffective regulations with new rules and institutions overseen by international experts will stimulate much-needed competition, economic growth, and foreign investment.

Striving to create sort of a Hong Kong on the Caribbean is controversial, however, and detractors fear that the ZEDEs will fail, undermine the country's already weak institutions, and also hurt the land rights of marginalized indigenous groups.

Honduras is one of the poorest and most insecure countries in Latin America: an estimated 60 percent of the population lives below the poverty line, and it has the highest per-capita homicide rate in the world, according to the UN. Income inequality, broken institutions and corruption are the norm. Honduras also suffers from political instability and a culture of impunity, which were reinforced by a recent military coup. Past reform efforts have failed in large part because of opposition from a small group of entrenched elite families that control key state institutions and entire sectors of the economy.

Against this backdrop, the government has sought out new approaches to tackling Honduras' problems. It started to explore the concept of charter cities in 2009 after the president's chief of staff viewed a TED talk by the famous economist Paul Romer on the subject.

According to Romer, autonomous economic zones attract investment, create jobs, and promote economic activity. They do so by adopting separate, investor-friendly regulatory environments governed by other countries with proven track records (e.g. the U.K. or Canada) instead of the often-corrupt local institutions. A zone's adoption of another country's regulatory regime provides the stability, predictability, and transparency that businesses seek out. It also allows the host nation to experiment with new (and hopefully superior) regulatory regimes before deploying them throughout its territory.

Romer rejects the notion that such zones are neocolonial because they do not rely upon two key underpinnings of colonialism -- coercion and condescension. Local leaders remain sovereign. They elect to invite another country to assist with the administration of the zone, specify the scope of authority ceded to the other country, and determine how that country is to be compensated. Romer cites Mauritius's decision to use the Privy Council -- the U.K.'s highest court -- as the court of final appeal in Mauritius as a successful example of outsourcing certain administrative procedures to other countries. The arrangement promotes investment in Mauritius by giving investors confidence that any disputes related to their investments will be resolved fairly by the experienced and neutral Privy Council as opposed to less-respected local courts.

The Lobo Administration seized upon this concept as a potential answer to Honduras' economic and political woes, and it has worked over the past three years to build such zones on Honduran territory. In early 2011, the Congress passed a law allowing for the creation of ZEDEs, which was subsequently struck down as unconstitutional by the Supreme Court.

A new law was drafted to address the concerns of the Supreme Court and included a series of constitutional amendments to allow for the creation of such zones and the grant of autonomous judicial power to them. That law was approved on June 12 and Honduras is now moving forward with the establishment of the first of 12 planned ZEDEs. Local residents are scheduled to vote on them in November 2013.

According to Shanker Singham, an international trade and competition expert advising interested parties on this initiative, the ZEDEs are inspired by Romer's ideas but add significantly to them. Honduras is focused on how an autonomous regulatory regime can unleash the forces of competition and generate substantial wealth creation.

The structure of the ZEDEs ensures that Honduras itself--not only outside investors--derives maximum benefit from them. As investors and businesses begin to locate their activities in a ZEDE, its land becomes more valuable (just as it did in Singapore, as that small nation became a hub of economic activity), which generates wealth for landowners, including the local government, investors, and so on. Similarly, the economic activity within the ZEDE generates profits in the form of taxes, concession fees, and equity stakes in new ventures. The government receives a sizeable share of this money. Honduras would also benefit from the new jobs created in and around the zone through existing international businesses that relocate there and from new businesses that form there. Economic growth is possible because the vested interests that traditionally benefit from lack of competition (and oppose reform efforts) do not exist in these as-of-yet undeveloped areas. After all, no powerful family would have had any reason to use its money and influence to obtain, for example, a monopoly in a barren part of the country devoid of commercial activity.

Under this vision, each ZEDE would be governed by a board that would have authority to establish the zone's regulatory system (which is independent from Honduras' existing laws). The Board would be comprised of elements of the host government and investors, as opposed to an outside government. The board delegates the day-to-day management of the zone to the administrator -- an outside technocrat -- who is given authority to oversee an investor-friendly environment. The administrator also works with a developer on the physical development of the zone's land (a goal of the ZEDEs is to promote construction on previously unused land). The recent constitutional amendments help ensure the regulatory autonomy of the zone and the government's commitment not to intervene in its affairs.

The broad contours of the concept have historical precedent. There are several well-known examples of successful zones, including the City of London, Hong Kong, Dubai, and the Bahamas. In the City of London, there is a board comprised of aldermen and the Lord Mayor; the aldermen are chosen via direct election by both individuals and businesses that operate in the City, and the City has long had rights and privileges that distinguished it from the rest of England, such as the ability to regulate its banks independently and keep its markets open seven days a week, instead of the much more limited hours of other markets in the country.

In Hong Kong, which followed a different path to "one-country, two-systems," there is a legislative council whose members are chosen by a small group of HK citizens who are themselves elected to represent various professional and other organizations. In the Bahamas, a private entity (the Grand Bahamas Port Authority) acts as both developer and regulator under an agreement with the Government of the Bahamas. There are a host of special economic zones in China and elsewhere that are also designed to stimulate investment and business growth. For these reasons, several countries are currently working to establish ZEDE-like areas, including Morocco and Georgia.

Not everyone in Honduras supports the creation of ZEDEs, however. Some lawyers, activists, and other opponents stress that ZEDEs are an affront to Honduran sovereignty. They even argue that the creation of separate judicial systems jeopardizes rights enshrined on the Honduran Constitution. Indeed, weak institutions may enable the ZEDEs to be captured by corporate interests that take advantage of Honduras instead of growing its economy. They also fear that the limited land rights of indigenous Garifuna groups will be further threatened.

Even if these criticisms prove to have merit, ZEDEs may be a smart move for Honduras. It may very well be easier to solve the country's systemic governance challenges -- which drive its poor economic outlook and dire public security situation -- by starting afresh, even within small parts of its territory.

The new regulatory systems in the ZEDEs could set an example for the rest of the country to emulate. Starting with ZEDEs in small, undeveloped parts of Honduras allows for the fine-tuning of their rules (which are new to the country) and avoids confronting entrenched interests (i.e. the handful of families with a stranglehold on Honduras's economy) that blocked previous reform efforts. That way, the success of the ZEDEs could be proved before potentially expanding them to larger swaths of Honduran territory.

Only time will tell if ZEDEs help Honduras tackle the myriad challenges facing its weak state or further undermine its tenuous stability. Creating a new Hong Kong or Dubai on the Caribbean may be difficult, but even incremental success could catalyze much-needed economic growth and improvements to the rule of law in Honduras, not to mention set an example for other developing countries to follow.