Rules of Origin in the World Trading System Antoni Estevadeordal Kati Suominen Integration, Trade and Hemispheric Issues Division Integration and Regional Programs Department Inter-American Development Bank PREPARED FOR THE SEMINAR ON REGIONAL TRADE AGREEMENTS & THE WTO WORLD TRADE ORGANIZATION NOVEMBER 2003

Facilitating or hindering trade: the role of rules of origin in RTAs I. Rules of Origin: Key Issues II. (a) Product-Specific Rules of Origin II. (b) Regime-Wide Rules of Origin III. (a) Measuring Restrictiveness of Product-Specific RoO III. (b) Constructing a Facilitation Index of Regime-Wide RoO IV. Empirical Analysis to Evaluate the Impact of RoO V. Policy Conclusions: Is Harmonization the Key to Mitigating RoOs Negative Effects?

Rules of Origin: Key Issues

Two types of RoO: non-preferential and preferential The justification for preferential RoO is to ensure that non-members do not obtain access to regional preferences (avoid trade deflection) However, RoO can be a powerful trade policy instrument: –RoOs effects in the S/R different than in the L/R –RoO can fully insulate an industry from the consequences of an FTA –RoO can protect intermediate good producers by favoring intra-PTA supply links –RoO can be used to attract investment in strategic sectors –Very limited theoretical and empirical work Details matter a lot! Objectives of RoO

Rules of Origin and WTO Non-Preferential Rules of Origin are being harmonized under Uruguay Round Agreements Preferential Rules of Origin would be a key element of discussion under Doha mandates on Regional Agreements (Rules Negotiations): We also agree to negotiations aimed at clarifying and improving disciplines and procedures under the existing WTO provisions applying to regional trade agreements. The negotiations shall take into account the developmental aspects of regional trade agreements.

Product-Specific RoO

Wholly obtained or produced Where only one country enters into consideration in attributing origin Substantial transformation Where two or more countries have taken part in the production process –Change in Tariff Classification (CTC) Requires the product to change its HS tariff heading, chapter, heading, sub-heading, or item in the originating country –Import Content Rule (MC) or Regional Value Content (RVC) Requires a MIN % of local value added in the originating country (or a MAX % of value originating in non-member countries) –Technical Requirement (TECH) Prescribes that the product must undergo specific manufacturing processing operations in the originating country Types of Product-Specific RoO

Source: World Trade Organization (2002). Frequency of Various Product-Specific RoO Criteria

The product-specific RoO of the EUs PANEURO system cover more than 65 PTAs, both across Europe and in EUs recent extra-regional PTAs with Mexico, Chile, and South Africa PANEURO model mainly combines CTC (usually CH) with RVC and/or TECH Product-specific RoO in Europe

Four RoO families can be identified: 1. LAIA, Andean Community, Caricom -across-the-board CH or VC 2. NAFTA, Mexicos FTAs, Can-Chi, US-Chi, Chi-Cacm -high degree of variation in RoO across products -different types of CTC in combinations with VC and/or TECH 3. Mercosur and its FTAs with Chile and Bolivia -mainly CH; also CH and VC or TECH 4. CACM -falls between NAFTA and Mercosur models: mainly CTC but also combinations Product Specific RoO in the Americas

RoO are based on an across-the-board VC criterion (usually RVC of percent) Alternative, across-the-board RoO usually involves a change in heading or change in subheading More complex RoO regimes emerging: -SADC -Japan-Singapore FTA -US-Singapore FTA -Chile-Korea FTA -Some moves to renegotiate RoO in Africa Product-specific RoO in Asia and RoW

Harmonization work carried out since July 1995 by the WTO and the World Customs Cooperation Council The most common RoO is change in heading; however, also important amounts of sectoral selectivity Some 90 (mainly political rather than techncical) issues affecting about 20% of tariff lines have yet to be resolved Main sticking points: -RoO in machinery: CTC- or RVC-based? -Disagreements over related trade policy issues (SPS, EEZ, trademarks, geographic indications, etc.) -Disagreements over role of RoO in anti-dumping Product-specific NON-PREFERENTIAL RoO

Distribution of CTC Criteria by Agreement

Type and Height of RVC Criteria Selected PTAs

RoO Combi- nations Selected PTAs

Regime-Wide RoO

Provisions adding leniency to RoO: –De minimis –Roll-up or absorption principle –Cumulation –Self-certification Provisions that may make RoO more restrictive: –Lists of operations insufficient to confer origin –No-drawback rule –Complex certification methods –Inefficient or non-transparent verification by customs Types of Regime-Wide RoO

Source: World Trade Organization (2002). Frequency of General RoO Provisions

Regime- Wide RoO Selected PTAs

Certifi- cation Method Selected PTAs

Measuring the Restrictiveness of Product-Specific RoO

Restrictiveness measured by Estevadeordals (2000) index ranging from 1 (least restrictive) to 7 (most restrictive) Construction of index: - Degree of CTC: CC more restrictive than CH, CH more restrictive than CS, etc. - Exceptions to CTC, RVC and TECH add to restrictiveness Measuring and Comparing Restrictiveness of RoO Regimes

Restrictiveness of RoO Selected PTAs

Sectoral Restrictiveness of RoO by HS Sections, Selected FTAs

Profiles of Sectoral Restrictiveness of EU, NAFTA, and SADC RoO by HS Sections

Sectoral restrictiveness is very similar across the main regimes Non-preferential RoO echo the PANEURO and NAFTA models Highest restrictiveness values in sectors with relatively high tariffs especially in EU and the US: –Agriculture –Textiles and apparel –Transportation equipment Trade-weighted restrictiveness of RoO deviates little from unweighted restrictiveness Comparing the Restrictiveness of RoO Regimes

Constructing a Facilitation Index of Regime-Wide RoO Provisions

Comprised of mechanisms that add flexibility to the application of the product-specific RoO Based on a scheme that considers five components: –De minimis –Diagonal cumulation –Full cumulation –Drawback –Self-certification Regime-Wide RoO: A Facilitation Index

Facilitation Index for Selected PTAs

RoO Innovations Further, it is important to consider innovative ad hoc features in some regimes that can alleviate the impact of stringent RoO: - differential application of RoO due to differences in the partners development levels (esp. drawback) - phase-in of the level of value content RoO (esp. footwear, vehicles) - permanent sectoral deviations from standard RoO (esp. from the PANEURO model in EU-Mexico and EU-Chile FTAs) - TPLs where RoO revoked on a certain amount of imports (esp. NAFTA-based regimes) - flexibility in the calculation of RVC (esp. when partner lacks domestic processing, as in Singapores FTAs): Stage1 Stage 2 Stage 3 Singapore Foreign Country Singapore Exported Conventional RoO Stage 3 = Local Content Recognition of OP Stage 1 + Stage 3 = Local Content

Measuring the Impact of RoO

Important growing pool of theoretical evidence: restrictive RoO distort trade, investment, and production patterns Increasing number of empirical studies assessing the economic impacts of preferential RoO on: –Firms administrative costs –Degree of utilization of RTAs (or GSP) conferred trade preferences –Trade patterns in final and intermediate goods Summary of Empirical Evidence

RoO are used legitimately as instruments to curb trade deflection –Estevadeordal (2000): Sectoral restrictiveness of NAFTA RoO positively and significantly related to MFN tariff differentials between US and Mexico –Sanguinetti (2003): Sectoral restrictiveness of MERCOSUR RoO positively and significantly related to MFN tariff differentials between Argentina and Brazil However, RoO are also used for political economy purposes –The restrictiveness of RoO in NAFTA(Estevadeordal 2000), Mercosur (Sanguinetti 2003), and EU (Suominen 2004) appears to be driven by the same political economy variables as drive tariffs Summary of Empirical Evidence: RoO and Trade deflection

Summary of Empirical Evidence: Firms Administrative Costs Koskinen (1983): Administrative costs of certifying origin in EC-EFTA FTA 1.4 – 5.7 % of value export transactions Herin (1986): Administrative costs of certifying origin in EFTA 3 – 5 % of value export transactions Holmes and Shephard (1983): Average export transaction EFTA to the EC requires 35 documents and 360 copies Today, official certification of RoO for a single shipment costs $7 in Chile, $6-$20 in Brazil, but free in general in EU countries Cadot et al. (2004): NAFTAs non-RoO related administrative costs approximate 2% of the value of Mexican exports to the US

A Summary of Empirical Evidence: Utilization of Trade Preferences Estevadeordal and Miller (2002): Canadas utilization rates of preferences to US market declined in sectors where NAFTA RoO became more stringent than CUFTA RoO Cadot et al. (2002, 2004): the mere 64% utilization rate of NAFTA preferences due in part to restrictive RoO Brenton and Manchin (2003): low utilization rates of the EUs trading partners in the textile sector owe to the excessive stringency of EU RoO Inama (2004): Evidence on low utilization rates due to restrictive RoO in GSP, ACP, and AGOA

Percent of total U.S. imports from Canada Rules of Origin and Utilization Rates: Canada-US FTA vs. NAFTA

Summary of Empirical Evidence: RoO and Trade Patterns Cadot, Estevadeordal and Suwa (2003): Mexican exports to the US have been undermined by restrictive NAFTA RoO Appiah (1999): CGE model shows NAFTA RoO distort trade flows and undercut welfare James (2004): NAFTA preferences and restrictive RoO have undercut Asian textile and apparel exports to US Flatters and Kirk (2004): Restrictive SADC RoO work against efficiency gains that members would reach through extra-regional outsourcing Augier, Gasiorek and Lai-Tong (2004): with no cumulation, trade has been 50% lower than expected; the impact is particularly notable in intermediate goods

Estimating the Effects of RoO on Trade Patterns: A Gravity Model Approach Estevadeordal and Suominen (2004): Estimate a gravity model for 156 countries, 100 PTAs and 20 years ( ) –Preliminary results: restrictive product-specific RoO: (1) curb aggregate trade and (2) divert trade in intermediates –Flexible regime-wide RoO facilitate trade, and hence counter the effect of restrictive product-specific RoO

Gravity Model Estimates: RoO and Bilateral Aggregate Trade Ln(Bilateral Trade) = b 0 + b 1 ln(GDP_PROD ij ) + b 2 ln(DISTANCE ij ) + b 3 ln(BORDER ij ) + b 4 ln(COMMON_LANGUAGE ij ) + b 5 ln(COLONIAL RELATIONSHIP ij ) + b 6 ln (COMMON COLONIZER ij ) + b 7 ln(FTA ij ) + b 8 ln(RoO_RESTRICTIVENESS ij ) + b 9 ln(RoO_FACILITATION ij ) +

Regression Results: Aggregate Trade and RoO (Cross-Section)

Regression Results: Aggregate Trade and RoO (Panel )

RoOs Effects on Trade in Intermediate Goods Ln(Bilateral Trade in Inputs) = b 0 + b 1 ln(GDP_PROD ij ) + b 2 ln(DISTANCE ij ) + b 3 ln(BORDER ij ) + b 4 ln(COMMON_LANGUAGE ij ) + b 5 ln(COLONIAL RELATION ij ) + b 6 ln (COMMON COLONIZER ij ) + b 7 ln(RoO_REST. FINAL Goods ij ) + b 8 ln(RoO_FACILITATION ij ) +

RoOs Effects on Trade in Intermediate Goods: Key Variables Dependent variable: total imports at the 6-digit level of intermediate products = products classified as intermediates by section of the Harmonized System and that are used particularly intensely in the HS section in question (as opposed to being used in other sectors) –Examples: man-made filaments in textile products; conveyor belts in vehicles Key independent variable: Average sectoral RoO restrictiveness of the 6-digit level final goods = key products classified as final by section of HS –Five sectors: chemicals, machinery, TV and radio transmitters, textiles, vehicles

Regression Results: Trade in Intermediates by Sector and RoO

Preliminary Results: Summary Both the restrictiveness and complexity of rules of origin reduce aggregate trade flows Regime-wide RoOand particularly the combined effects of such RoOdesigned to add leniency to the application of product-specific RoO boost aggregate trade Both the restrictiveness and complexity of rules of origin in FINAL goods significantly boost trade in INTERMEDIATES - Restrictive RoO in final goods may thus result in trade diversion in intermediate goods

EU and NAFTA-based RoO regimes will likely predominate in the future, particularly across Europe and the Americas Maybe an emerging Asian/trans-Pacific regime type? However, (1) harmonization of non-preferential RoO and (2) the possible de facto harmonization of preferential RoO due to the spread of the PANEURO and NAFTA models could facilitate future de jure harmonization of preferential RoO Conclusions: Future Clash or Harmonization of RoO Regimes?

Countries operating in two or more RoO theaters simultaneously will: –Complicate firms supply relations –Force specialization of production to a certain market(s) when RoO are strict –Increase transaction costs when certification methods diverge This is particularly the case for small exporters in small countries that are spokes to different RoO hubs (PANEURO model, NAFTA model, etc.): even slight differences in RoO can have a big impact on production decisions Thus, Dohas mandating harmonization of preferential RoO could benefit smaller developing countries in particular Conclusions: Why Harmonize Also Preferential RoO?

Harmonized non-preferential RoO would provide a readily available baseline for harmonizing preferential RoO Preferential RoO are restrictive only as long as there are MFN tariffs: the ultimate key to countering RoOs negative trade effects will lie in the success of multilateral liberalization Conclusions: How to Harmonize Preferential RoO and Further Mitigate RoOs Impact ?