The existing literature on international debt has analyzed the effects of different policies on the debt servicing problems of developing countries and these policies range from depreciation of the nominal exchange rate to creation of an export oriented trade regime. In a dynamic setting, this article analyzes the effects of yet another policy measure, namely creation of Free Trade Zones (FTZ), on the level of outstanding debt of an economy. Our analysis shows that in the short run, if skilled labour is a substitute for the imported input and foreign capital in the FTZ, then production incentives to the FTZ through reduction in tariff rate on the imported input used by this zone (while maintaining the rate for the rest of the economy) reduce the level of outstanding debt. In the long run, however, the effect of giving additional incentives to the FTZ on the level of outstanding debt crucially depends upon one additional factor namely, the responsiveness of fiscal deficit to the level of outstanding debt. The welfare of the country may also improve due to creation of an FTZ.
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