A Brexit Turkey (part 2) - Are Rules of Origin insurmountable ?

Some bad ideas seem reluctant to die. The Institute of Directors (IoD) have published a Customs Union proposal (based on Turkey's Customs Union agreement with the EU), which as discussed in my last post, would result in the UK having no control over tariffs or Free Trade agreements (FTAs).

Rules of Origin (RoO)

So what is IoD's argument for a Customs Union ? Essentially it comes down to preferential RoO (Rules of Origin). Outside the Customs Union, assuming an FTA is agreed with the EU, UK exporters will be required to prove goods are substantially sourced or manufactured locally in order to qualify for preferential tariffs (so importing a product from a third country like China and sticking a UK badge on it does not qualify for preferential tariffs !).

The IOD suggest that many exporters fail to take advantage of preferential rates in FTAs, deterred by the cost/complexity of preferential RoO. To avoid the complexity, they simply pay the tariff. The inference is that a UK-EU FTA would see companies failing to utilise the FTA and incurring tariffs - a problem avoided by a customs union with the EU.

However there are plenty of grounds for questioning this rather simplistic narrative:

• IOD cite a literature review of RoO and utilisation of FTAs. However the review itself contains statements such as “Research on RoO, however, is in its infancy “ ... “studies on FTA usage are very limited in scope" etc.  
• IOD cite a survey of their own members suggesting low use of preferential rates in third country FTAs. But a recent report on utilisation of EU FTAs published by UNCTAD found utilisation at 66% by EU member states and 90% by third countries exporting to the EU market. 
• Commenting on the UNCTAD report, Lucian Cernat (Chief Economist, DG Trade European Commission) suggested information / assistance to SMEs would help EU exporters better utilise FTAs. This echoes UK research by Peter Holmes & Nick Jacob (Sussex University) finding "a substantial minority of firms are unsure of how RoOs work and the options available to firms for compliance."
• IOD cite an EU assessment of Turkeys CU stating the following RE costs of RoO:  "Based on empirical evidence that third country exports still use preferences even when EU duties are low (in the range of 2% to 3%), it has been decided to retain a conservative cost of 2%". 
• The research by Holmes & Jacob also suggests that cost of compliance with preferential RoO was not as costly as previously thought, with much of the cost being an up-front investment to upgrade/set up systems.

RoO & Car Industry

IOD raises concerns for the car industry, quoting Japan's message to the UK & EU: "the introduction of inconvenient rules of origin could delay and increase the costs of logistics operations, which would have a significant impact on business operations".

Even from this snippet, it is plain to see that Japan's concern is with logistics and speed through customs clearance, rather than the cost of RoO compliance. This is even clearer when the full context is examined, where Japan requests that the UK & EU "maintain the simplified customs clearance procedures between the UK and EU, especially the framework for the mutual recognition of AEOs ... Changes in customs clearance procedures for exports to the UK and the application of complicated procedures due to the introduction of inconvenient rules of origin could delay and increase the costs of logistics operations".

Japan also raise the issue of achieving RoO content thresholds when supply chains are distributed across the EU. They request that cumulative RoO apply in future UK-EU27 trade, which means components/processing sourced from either the UK or EU-27 count as "local" in the RoO determination - such "bi-lateral cumulation" is standard practice in FTAs. The fact that Japan raises cumulation indicates they are not requesting or expecting a future UK-EU customs union.

RoO & Chemicals Industry

IOD also raise concerns over the impact of RoO on the UK chemicals industry. Steve Elliott, Chief Executive Officer, Chemical Industries Association, in evidence to a House of Lords Committee described RoO as : “a substantial level of bureaucracy ...  in our case there could be several stages of synthesis involved … would clearly outweigh the benefit of duty-free sales”. (Tariffs for chemicals are typically around 6%).

The EU, EFTA and various other Balkan, African and Middle-Eastern states are signed up to Pan-Euro-Mediterranean (PEM) preferential rules of origin, which state that :

• Chemical products (Harmonised System chapters 28-38) are "sufficiently processed" to qualify as local origin if non-local content is below a given threshold (varies by material but typically 40% or lower of product value). 
• Products incorporating non-local content that have been "sufficiently processed" count as 100% local when subsequently used as input to manufacturing another product. 
• PEM rules also allow for "Accounting Segregation" to cater for use of interchangeable stocks of local and non-local material as input in manufacturing a product.

75% of UK chemical imports are from the EU, suggesting that most inputs to UK chemical manufacturing will be of UK or EU origin, hence qualifying as local origin under bi-lateral cumulation as part of an EU-UK FTA. UK chemical products will likely meet the RoO threshold to qualify for preferential rates.

So determining whether a product qualifies as local origin depends on knowing the source and cost of inputs to the manufacturing process - i.e. the core business processes of supply chain management and accounting. Where non-originating materials are used in the chemical industry, they would have to be tracked through several stages of processing - but tracking & auditing use of materials in the manufacturing process is surely standard practice ?

60% of UK chemical exports are to the EU. Hence 40% are to the rest of the world - is none of this via preferential RoO ? Switzerland has an FTA with the EU and is a non-EU destination for UK chemical exports - is no advantage taken at all of preferential rates ? It is also worth noting that Switzerland has a successful chemical / pharmaceutical industry (larger than the UK's) integrated into European supply chains - despite the fact that Switzerland is outside the EU Customs Union and so faces preferential RoO barriers.

It is hard to believe that the UK chemical industry makes no use of preferential RoO or is incapable of doing so. If third countries like Switzerland make use of preferential RoO for chemicals, then the UK chemical industry should take a leaf out of their book, make a one-off investment to upgrade systems to cater for RoO in order to utilise current third country FTAs as well as a future UK-EU FTA.

Conclusion

The argument that low FTA utilisation proves RoO is too burdensome is contradicted by the high utilisation reported by UNCTAD, and observations by Holmes/Jacob and Cernat that advice / information on RoO would boost exporters use of FTAs.

Indeed, IOD themselves state: "Rules of origin are not insurmountable for business – indeed they currently apply to trade with a number of existing countries outside the EU." If companies invest in systems to provide RoO compliance for third country FTAs (an increasing proportion of UK exports), then RoO compliance for EU trade is a relatively small additional step.

A customs union with the EU cannot be justified by RoO. I will examine alternative arguments and alternative options to a Customs Union in my next post.

--0--

Posts in this series:

A Brexit Turkey part 1 - No UK Trade Policy

A Brexit Turkey part 2 - Are Rules of Origin insurmountable ?
A Brexit Turkey part 3 - Customs Union is not a Brexit solution

A Brexit Turkey (part 1) - No UK Trade Policy

Some bad ideas seem reluctant to die. Leaving the EU Customs Union has been stated government policy since Theresa May's Lancaster House speech, confirmed by the 2017 General Election manifestos and several parliamentary votes. Earlier this month, Theresa May again confirmed that the UK would not be part of any Customs Union with the EU after Brexit. Yet now we have the Institute of Directors (IoD) putting out a report with yet another Customs Union proposal.

The Turkey model

The IoD proposal is essentially the "Turkey" model, "a" customs union bi-lateral agreement with the EU. This has been dismissed as a Brexit option on many previous occasions because of the glaring problems of the Turkey model:

• Described as a "partial" Customs Union, in reality this covers all industrial and processed food goods, i.e. substantially all goods except basic agriculture products (meat, dairy etc.).
• The tariff rates for these goods are set by Brussels. Turkey has to sit out discussions at WTO/GATT on tariff reductions.
• Turkey does not benefit from any EU Free Trade agreements (FTA), but third countries who have an FTA with the EU gain tariff free access to Turkey, without offering any reciprocal access to Turkey. Turkey considered ending its Customs Union agreement at the prospect of the EU sealing an FTA with the USA (the now defunct TTIP).
• Turkey is obliged to harmonise with EU trade policy and negotiate FTA's with third countries to match EU FTA's. Unfortunately, a number of third countries have refused to negotiate with Turkey, as they already have tariff-free access to Turkey by virtue of their FTA with the EU.

So much for an independent trade policy. The Turkey model would leave control of trade policy in the EU's hands. The EU will effectively be able to sell tariff-free access to the UK without any involvement or reciprocal benefit for the UK. Why would any third country bother negotiating with the UK when tariff-free access would be obtained by negotiating an FTA with the EU ? For that matter, why would countries like South Korea agree to grand-father their existing EU FTA into a UK bi-lateral FTA when it can get tariff-free access to UK for nothing ?

This issue of FTA asymmetry prompted the EU and Turkey to start negotiating with 3rd countries in parallel. In one case, (Malaysia), Turkey has sealed an FTA ahead of the EU (EU-Malaysia talks stalled over a dispute) - meaning Malaysian goods have tariff-free access to the EU by trans-shipping via Turkey.  The EU is aiming to address FTA asymmetry via an upgrade to the Turkey Customs Union agreement which will provide Turkey with observer status at EU FTA negotiations.  But the relationship is still clearly based on Turkey following the EU's lead on FTA's.

So it is difficult to see how the EU would grant the UK freedom to negotiate its own FTAs while in a customs union. Would the EU tolerate an UK-USA FTA that meant USA had tariff-free access to the EU market without the EU getting tariff-free access to the USA ? Of course not.  

Trade in Services

The IOD sugarcoat their "partial" customs union proposal by pointing out areas where the UK would be free to negotiate - tariffs for basic agricultural goods and more interestingly services.  However, the freedom to negotiate on services is hardly an argument for a customs union, as such freedom also comes with an FTA or the WTO option. It is in fact an argument against the Single Market - which would tie our hands on services regulation. Is this a tacit admission of defeat in the argument for retaining single market membership ?

Conclusion

The proposed Customs Union with the EU would be far worse for trade policy than EU membership, where at least the UK benefits from EU FTA's and has a vote. A Customs Union does not confer freedom to negotiate on services, that only comes by leaving the single market (which the IOD have opposed).

So what is the argument for a Customs Union ? IOD rest their case on Rules of Origin (RoO), which I will examine in my next post.

--0--

Posts in this series:

A Brexit Turkey part 1 - No UK Trade Policy

A Brexit Turkey part 2 - Are Rules of Origin insurmountable ?
A Brexit Turkey part 3 - Customs Union is not a Brexit solution

End of Project Fear ?

Will we ever see an end to Project Fear ?

At the height of the EU Referendum campaign, George Osborne's Treasury produced a report predicting that even the act of voting to Leave the EU would cause immediate economic disaster. Even arch-Remainer Kenneth Clarke has poured scorn on these Treasury figures.

Even EU officials in Brussels believe Project Fear is overdone, as Nick Gutteridge (Brussels reporter) observed: "I’m yet to speak to a single EU diplomat or official who thinks the economic fallout for the UK from Brexit will be anywhere near as bad as many British commentators predict." Even in Brussels, the expectation is a CETA plus outcome and no Brexit recession.

There is a problem at the root of Project Fear - it is an attempt to argue that a marginal increase in cost of trade with the EU trumps all other concerns (political & economic), even when exports to the EU account for just 10% of UK economy. This is exactly the same argument made for the euro - "10% of our economy depends on EU, 3m jobs at risk" . Allegedly, the UK retaining the £ would result in the City & UK car industry decamping en-masse to the EU to escape the cost of currency exchange in UK-EU.  Some 15-plus years on, it is clear that these economic forecasts were pure bunkum.

Of course, any forecast over a timescale of 15-years will almost certainly be proved wrong. Yet, in recent weeks we have seen leaked Treasury forecasts, suggesting UK GDP could be 8% lower over a 15 year timescale due to Brexit, paraded as "facts" by Remain supporters.

It should also be noted that this forecast of 8% does not imply a recession, rather it is a forecast of slower growth, i.e. 1.5% per annum rather than 2% per annum in coming decade or so, so an economy worth ~£2tn at start of a year will only increase by ~£30bn instead of ~£40bn over that year, so that each year economic activity is ~0.5% GDP or £10bn lower than the counter-factual scenario.  Interestingly, UK membership of the EU also costs ~0.5% net per annum, i.e. ~£10bn economic activity taken out of ~£2tn UK economy and diverted to activity in Brussels or other EU member states. 

It's not clear whether the Treasury forecasts have allowed for the gain from ending UK's net EU contributions in their forecasts. But it is interesting to compare the Remain campaign description of these 0.5% per annum contributions as a small price to pay for the economic benefits we get in return (as in a £70bn per annum trade deficit with the EU).

Given UK exports to the EU account for just 10% of UK GDP, the forecast 8% loss of GDP is equivalent to losing 80% of our exports to the EU. While there will be a marginal increase in cost of trade with the EU, but this does not mean that UK exports to the EU will effectively cease - just as marginal costs arising from rejecting the euro did not mean the loss of 3 million jobs.  By contrast, a 2017 paper by World Bank & UNCTAD economists suggested UK exports are "price inelastic" and that in the event of a No Deal scenario, UK exports to the EU would drop by no more than 2% - a negligible impact.

The Treasury also forecast that a Free Trade Agreement (FTA) with the USA would provide only 0.2% GDP gain over the same timescale. The USA economy is larger than the EU27 and with all the trade benefits of EU membership, UK exports to EU27 are about 3 times larger than UK exports to the USA. Yet the Treasury forecast suggests a GDP impact from Brexit and reduced EU trade would be some 40 times larger (not 3) than GDP impact of an FTA with USA. The Treasury forecast seems to assume that trade with the EU is uniquely beneficial to UK growth.

Historical data does not support this assumption that EU membership has been uniquely beneficial:
- In 2012, to commemorate 20 years of the Single Market and removal of internal customs borders, the EU Commission published a report claiming a 2% GDP gain (averaged across the member states). Even that figure is inflated, as the economic downturn from 2008 onwards was ignored.
- A similar study by European (and generally pro-EU) think tank Bertelsman concluded that the UK had only gained 1% GDP (with Germany the winner with a gain of 2.3% GDP).
- In the same period 1992-2012, the UK economy grew by 67%. The introduction of the Single Market & removal of Customs Borders within the EU barely registers.

Economies and markets will always adjust to shocks such as Brexit. Trade and commercial activity will divert to the domestic economy and markets with the Rest of the World. In fact, there is a strong case that the UK needs to pivot away from an EU-centric economy:
- The EU's share of the global economy is in decline (having halved from a high of 30%, less once UK leaves).
- As even the EU Commission concedes, 90% of global growth will be outside the EU in coming decades.
- The share of UK exports to the EU (as opposed to the rest of the world) has steadily declined from a high of 55% at the turn of the century to 43% today, less if the Rotterdam/Antwerp effects are taken into account.
- UK trade with the EU has shown a persistent and widening trade deficit, whereas UK trade with the Rest of the World is broadly in balance.

All of which is a long way round to saying overblown economic scare stories, which have no foundation, take no account of other gains, ignore the 90% of economy that does not export to the EU - are pure distraction.  As we well know, the decision to leave the EU was to restore national self-Government & reject a future as a mere province in the Brussels bureaucratic empire. The whole sorry story of our entanglement with the EU has been attempts to deny the true aims of the EU coupled with Project Fear (right back to 1975 Referendum). June 23rd 2016 was the end of that.