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.

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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