The impact of rules of origin on trade flows
ABSTRACT "A great deal of post-war trade liberalization resulted from regional, preferential trade agreements. Preferential trade agreements cut tariffs on goods originating only in those nations that have signed the agreement. Therefore, they need 'rules of origin' to determine which goods benefit from the tariff cut. Rules of origin have long been ignored for two good reasons: they are dauntingly complex and at first sight appear mind-numbingly dull. The third standard reason for ignoring them - the assertion that they do not matter much - turns out to be wrong. We show that rules of origin are important barriers to trade. Moreover, such rules are emerging as an important trade issue for three additional reasons. First, preferential trade deals are proliferating worldwide. Second, the global fragmentation of production implies complex international supply chains which are particularly constrained and distorted by rules of origin. Third, the extent to which regionalism challenges the WTO-based trading system depends in part on incompatibilities and rigidities built into rules of origin." Copyright © CEPR, CES, MSH, 2005.
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ABSTRACT: In this paper, we empirically investigate the effect of diagonal cumulation on free trade agreement (FTA) utilization by exploring Thai exports to Japan under two kinds of FTA schemes. While the one scheme adopts bilateral cumulation, the other scheme does diagonal cumulation. Comparing trade under these two kinds of FTAs, we can examine the effect of diagonal cumulation without relying on not only the variation in cumulation rules across country pairs but also the variation across years. In short, our estimates do not suffer from biases from time-variant elements and country pair-specific elements. As a result, our estimates show around 4% trade creation effect of diagonal cumulation, which is much smaller than the estimates in the previous studies (around 15%).Journal of the Japanese and International Economies 06/2014; · 0.40 Impact Factor
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ABSTRACT: ABSTRACT Rules of origin are the criteria used to determine where a good,has been made,for the purpose of ensuring ,only the products of countries which are party to a ,preferential trade agreement,(PTA) obtain concessional entry under the agreement. Because origin rules act as non-tariff barriers to trade, their welfare impact is not easily measured or01/2005;
Economic Policy July 2005 Printed in Great Britain
© CEPR, CES, MSH, 2005.
Blackwell Publishing, Ltd.Oxford, UK
ECOP Economic Policy0266-4658 © CEPR, CES, MSH, 2005. 43Original Article RULES OF ORIGINPATRICIA AUGIER, MICHAEL GASIOREK and CHARLES LAI-TONG Rules of origin
A great deal of post-war trade liberalization resulted from regional, preferential
trade agreements. Preferential trade agreements cut tariffs on goods originating only
in those nations that have signed the agreement. Therefore, they need ‘rules of origin’
to determine which goods benefit from the tariff cut. Rules of origin have long been
ignored for two good reasons: they are dauntingly complex and at first sight appear
mind-numbingly dull. The third standard reason for ignoring them – the assertion
that they do not matter much – turns out to be wrong. We show that rules of origin
are important barriers to trade. Moreover, such rules are emerging as an important
trade issue for three additional reasons. First, preferential trade deals are prolifer-
ating worldwide. Second, the global fragmentation of production implies complex
international supply chains which are particularly constrained and distorted by rules
of origin. Third, the extent to which regionalism challenges the WTO-based trading
system depends in part on incompatibilities and rigidities built into rules of origin.
Our empirical results exploit a ‘natural experiment’ that was created by technical
changes to Europe’s lattice of rules of origin (ROOs) in 1997. This change, known as
‘diagonal cumulation’, relaxed the restrictiveness of rules of origin on trade among the
EU’s free trade agreement (FTA) partners without changing the degree of tariff preference.
Our analysis allows us to establish a lower-bound and upper-bound estimate of trade
impact of ROOs reduced trade among the EU’s trade partners. The lower bound we
find is something like 10% while the upper bound is around 70%. The second part
of the paper draws the policy lessons that arise from considering the implications of
our empirical findings. The most direct lessons are for FTA-writers. We argue that Europe’s
implementation of ‘cumulation’ is a good way of reducing the welfare-reducing impact
of overlapping rules of origin without gutting their fraud-fighting ability. We also suggest
a three-part procedure for establishing a more multilateral framework for rules of origin
which would be more transparent, flexible, administratively feasible and negotiable.
— Patricia Augier, Michael Gasiorek and Charles Lai-Tong
Rules of origin
RULES OF ORIGIN569
Economic Policy July 2005 pp. 567–624 Printed in Great Britain
© CEPR, CES, MSH, 2005.
The impact of rules of origin
on trade flows
Patricia Augier, Michael Gasiorek and Charles Lai Tong
CEFI FRE 2778, CNRS – Université de la Méditerranée; Sussex University and
GREQAM; CEFI FRE 2778, CNRS
Trade liberalization has been an important driver of growth and economic integration
worldwide. Much of this liberalization has taken place in the multilateral WTO/GATT
context, but a large fraction of the tariff-cutting resulted from regional, preferential
trade agreements. Preferential trade agreements, however, only cut tariffs on goods
originating in nations that have signed the agreement. To establish which goods get the
tariff preference (thus preventing tariff fraud) these agreements need ‘rules of origin’.
Rules of origin are usually ignored for two good reasons: they are dauntingly
complex and at first sight appear mind-numbingly dull. The third standard reason
for ignoring them – the assertion that they do not matter much – turns out to be
wrong. Evidence presented in this paper together with other recent work demonstrates
The authors would like to thank the referees of
for comments from David Evans, Peter Holmes, Sherman Robinson and Alan Winters, as well as discussants and participants
at a joint CGD-GDN workshop, and a joint IADB-DELTA-INRA-CEPR conference on earlier drafts of this work. We are also
very grateful to Barry Reilly for his advice, and finally, we would like to thank the
extremely helpful guidance on this paper and for his detailed suggestions and comments. Any errors or omissions of course
remain our responsibility.
for their helpful and constructive comments. We are also grateful
Managing Editor for his
570 PATRICIA AUGIER, MICHAEL GASIOREK AND CHARLES LAI-TONG
that rules of origin are important barriers to trade. Trade barriers are always a matter
of concern for economic policy makers, but rules of origin in particular are a trade
issue of growing importance for three very clear reasons.
The first and most obvious reason is the proliferation of preferential trade
deals worldwide – more than 150 such agreements have been officially launched
since the GATT was formed five decades ago; 100 of those were launched in the
last 10 years. Well-functioning preferential trade arrangements in Europe and
North America now cover about 40% of world trade, and East Asia appears
set to implement its own lattice of regional deals, so this figure could soon rise
The second more subtle reason involves the global fragmentation of production.
Staying competitive in today’s world frequently requires firms to set up a complex
international supply chain. But since such a large share of world exports are to
nations with preferential tariffs, much of this global production optimization is
constrained and distorted by rules of origin.
The third reason concerns the challenges that regionalism poses for the world
WTO-based trading system. The growth of overlapping and intersecting preference
trade deals, each with its own and differing rules of origin, has highlighted the
possible distortions created by those rules and of the incompatibilities among them.
Jagdish Bhagwati has referred to this as the ‘spaghetti bowl’ problem, with ‘preferences
like noodles criss-crossing all over the place’ (Bhagwati and Mayer 2003, p. 5). The
greater the incompatibilities and rigidities built into the rules of origin the more those
criss-crossing noodles serve to fragment and distort world trade, and the more likely
it is that preferential trading arrangements may make multilateral liberalization more
difficult to achieve.
1.1. If you can’t measure it, it doesn’t exist
While the potential for rules of origin to distort trade is simple to identify in theory
and frequently bemoaned by exporting firms, empirical evidence is scant. It is easy
to understand why. On the one hand, the rules’ technical opaqueness makes it
difficult to quantify the severity of particular rules of origin. For example, where the
main text of a typical Association Agreement between the EU and a Barcelona
process country is between 20–30 pages long, the annex covering the rules of origin
for thousands of individually mentioned products is close to 100 pages long; NAFTA’s
rules-of-origin annex is close to 200 pages. Moreover, one often requires detailed
information about the industry to understand the true impact of a particular rule.
On the other hand, even if one could accurately measure the severity of the rules,
intrinsic empirical difficulties make it hard to isolate the impact of rules of origin
(ROOs); ROOs are formulated and come into force concurrently with the preferen-
tial trading agreements, so it is exceedingly difficult to separate the impact of ROOs
separately from the impact of the trade deal itself.
RULES OF ORIGIN571
1.2. What the paper does
In the first part of this paper, we provide formal evidence of the impact of rules of
origin by exploiting a ‘natural experiment’ that arose due to a technical change in
Europe’s rules of origin – a change known as ‘diagonal cumulation’.
this change are complex, and the complexity is important for our empirics, but as an
introduction it is useful to think of cumulation as reducing the restrictiveness of the rules
of origin without changing preferences. This allows us to avoid both of the standard
empirical problems. Since the 1997 introduction of cumulation affects the restrictive-
ness of rules of origin without affecting tariffs, and it only applies to certain bilateral
trade flows, we can gauge ROOs’ effect by comparing the change in affected trade
flows with the change in unaffected trade flow, controlling, of course, for other factors.
Our empirical findings suggest that rules of origin do restrict trade in an important
way. Our indirect methodology establishes a lower bound estimate of 8–22% and an
upper bound estimate of 25–70%. These findings can be viewed as a contribution to
two distinct literatures. First, it provides a new line of evidence in the growing body
of work that demonstrates that rules of origin do indeed affect trade flows. Second,
in the context of the EU’s trading relations, our results strongly suggest that rules of
origin serve to restrict trade between the EU’s partners and those partners’ trade with
The second part of the paper draws the policy lessons that arise from considering
the implications of our empirical findings. There are two sets of lessons.
Rules of origins are a necessary evil – every preferential trade deal must have them
to prevent tariff fraud; the first policy issue concerns the design of systems that
minimize the evil. We argue that Europe’s implementation of ‘cumulation’ suggests
a good way of reducing the welfare-reducing impact of overlapping rules of origin
without gutting their fraud-fighting ability. The second set of lessons concerns more
global issues. Taken in their entirety, preferential trading agreements may help or
hinder multilateral trade liberalization – there are serious proponents of both views.
But in either case, the design of rules of origin can influence the extent to which the
proliferation of regional trade agreements helps or hinders multilateral liberalization.
We discuss a number of principles that would reduce the chances that rules of origin
will prove to be stumbling blocks to world trade integration.
The details of
1.3. Plan of the paper
The structure of our paper is as follows. Section 2 provides a primer on rules of origin
– what they are and the likely impact from a theoretical perspective. Section 3
introduces the necessary details concerning the ‘natural experiment’, namely the
Technically there are different types of cumulation which can be distinguished. These are bilateral, diagonal and full. The
differences between these are explained in more detail in Appendix 3. Much of this paper is concerned with diagonal cumula-
tion, and unless otherwise indicated, use of the term ‘cumulation’ in this paper is taken to mean diagonal cumulation.
572PATRICIA AUGIER, MICHAEL GASIOREK AND CHARLES LAI-TONG
Pan-European Cumulation System. Section 4 of the paper covers our formal empir-
ical work and Section 5 discusses the policy implications. The final section presents
Before turning to the body of the paper, we put our contribution in the context of
the existing literature.
1.4. Existing empirical evidence
There is only limited work on the empirical impact of rules of origin. Until very
recently, most studies either gave anecdotal evidence or cited Herin (1986) who
showed that a great deal of trade between the European Free Trade Association
(EFTA) and the European Union (EU) paid the non-preferential tariff despite the
EFTA-EC free trade agreements which would have, in principle, allowed them to
claim duty-free status. The assertion was that this indicated that the administrative
costs of the ROOs were greater than the tariff, so firms opted to pay the tariff.
Specifically, he found that non-preferential tariffs were paid on 21.5% of EFTA’s
imports from the EC, and 27.6% of EC imports from EFTA.
More recent work in the same vein by Brenton and Machin (2003) shows that the
Baltic States’ exports to the EU paid the non-preferential tariff on a substantial
proportion of supposedly tariff-free trade. They argue that a significant part of the
explanation for this derives from the restrictive rules of origin applied by the EU.
Inama (2004) provides similar evidence on utilization by poor nations that have, in
principle, the right to export duty-free to rich nations under the so-called Generalized
System of Preference (GSP) scheme. Using the examples of Canada, the EU, Japan
and the USA he calculates the rate of GSP utilization as falling from 55.1% in 1995
to 38.9% in 2001. This low level of utilization suggests that even where there are GSP
preferences, developing countries appear to have difficulties in actually realizing
tariff-free access to developed country markets, and that a key explanatory factor lies
with ROOs. Flatters and Kirk (2004) focus on South Africa, and argue that the South
African Development Community (SADC) rules of origin were heavily influenced by
highly protectionist domestic industries. They then provide a number of detailed
examples which illustrate the point.
More recently, studies by Estevadeordal (2000), and Estevadeordal & Suominen (2004),
. (2002), Augier
Carrère and De Melo (2004) have attempted to estimate the impact of ROOs on
In the context of the NAFTA agreement, Estevadeordal (2000) shows that ROOs
tend to be more restrictive the greater the difference between US and Mexican tariffs;
and that there is a strong correlation between restrictive ROOs and those sectors
with long phase-out periods for tariff liberalization. The conclusion therefore is that
restrictive ROOs tend to be more prevalent in those industries which also seek greater
RULES OF ORIGIN573
origin have a negative impact on the volume of preferential trade. Mattoo
assessed the African Growth and Opportunity Acts and suggest that the benefits to
Africa would have been approximately five times greater without the restrictive rules
of origin that were in place (in particular with regard to yarn).
(2004) use a sectoral cross-section model to focus on the impact of
rules of origin for textiles. Their results indicate that lack of cumulation of rules of
origin in textiles may reduce trade between non-cumulating countries by up to 73%
in 1995 and 81% in 1999.
Estevadeordal and Suominen (2004) employ a synthetic ROO restrictiveness index
compiled on the basis of the underlying features of ROO across a range of preferen-
tial trade agreements (PTAs). This index is then used in an augmented gravity model.
Their results suggest that rules of origin do serve to restrict trade, and that measures
that allow for a relaxation of their restrictiveness (such as diagonal cumulation, or
clauses) encourage trade. Unlike the preceding analyses Carrère and De
Melo (2004) address the issue of the costs of ROO compliance, also in the context of
NAFTA. They find that these tend to be lowest where underlying ROO refers to a
change in tariff classification, and tend to be highest where the ROO specified given
production processes. They also assess the consistency of their results with the synthetic
index derived by Estevadeordal and Suominen.
(2004), also in the context of US–Mexico trade, show that rules of
2. RULES OF ORIGIN: A PRIMER
This section provides readers with the background they need to understand how ROOs
can distort trade flows and how and why they may be used as protectionist devices.
2.1. The formulation of rules of origin
As mentioned in the introduction, rules of origin are an unavoidable aspect of free
trade agreements because the introduction of multiple tariff rates opens the door
to fiscal fraud. The EU, for example, charges a zero tariff on optical fibres imported
from Switzerland but a 2.9% tariff on those imported from Japan. To prevent tariff-
evading trans-shipment of Japanese optical fibres via Switzerland, EU customs
authorities need rules for determining whether the goods crossing the Swiss–EU
border are actually made in Switzerland. This is the job of rules of origin.
Globalization has made it much harder to determine a good’s country of origin. Most
exported goods contain a large measure of imported parts and materials and thus
may be viewed as originating from many different nations. The standard convention
is that a good is considered as having been made in the last country in which it
underwent a ‘substantial transformation’. There are three standard tests for substantial
transformation. Continuing with the EU–Swiss example for the sake of concreteness,
574 PATRICIA AUGIER, MICHAEL GASIOREK AND CHARLES LAI-TONG
Change in tariff classification
tariff classification than do spectacles so if this rule is applied, eyeglasses made
in Switzerland from optical glass imported from Japan are considered as ‘Made
in Switzerland’ as far as tariffs are concerned (because the imported input, glass,
falls under a different tariff classification than does the exported good, spectacles).
Value added content.
Under this rule, if at least
Switzerland, the good is considered as Swiss. The exact percentage varies across
products and preferential agreements; typical values range from 40% to 60%.
Specific production process rule
. This is where the rules can get really idiosyncratic.
For example, the EU considers ‘wood sawn lengthwise’ imported from Switzerland
to be Swiss if any ‘planing, sanding or end-jointing’ was done to it in Switzerland.
. For example, optical glass falls under a different EU
% of a good’s value is added in
These three tests can be employed together. To give the reader a taste for the
complexity and specificity involved, here is the EU’s rule of origin for ‘glassware of a
kind used for table, kitchen, toilet, office, indoor decoration or similar purposes’. The
glassware is viewed as originating in the exporting nation if it was:
Manufactured from materials of any tariff heading, except that of the product, or
Cut, provided that the total value of the uncut glassware used does not exceed
50% of the ex-works price of the product, or
Hand decorated (except silk-screen printing) of hand-blown glassware, provided
that the total value of the hand-blown glassware used does not exceed 50% of
the ex-works price of the product.
2.1.1. All-or-nothing and complexity.
nothing status. One can imagine that this facet of ROOs was adopted for simplicity’s
sake – it means that firms only have to track one feature of each imported component (the
component’s origin) rather than, say, tracking the source of all inputs into each of its
imported component. However, this all-or-nothing feature can have important distortionary
effects. Marginal changes in the source of even a minor component may cause a firm
to lose duty-free status for the entire value of its exports. One feature that greatly
contributes to the daunting complexity of ROOs – the ‘spaghetti bowl’ problem in
Bhagwati’s memorable words – is that each preferential trade agreement has its own set
of ROOs. (Box 1 summarizes the application of ROOs in different PTA arrangements.)
Importantly, ‘origin’ is treated as an all-or-
Box 1. An overview of rules of origin in regional trading
agreements (RTAs) European Union
The EU has in recent years tried to move towards a common set of ROOs
across each of its preferential trading arrangements. That common set of rules
is known as the Pan-European system and was introduced in 1997. In practice
(minor) differences across the EU’s regional arrangements still remain depending
RULES OF ORIGIN575
on when the original agreements were signed. Hence, for example, the ROOs
applicable to the Association Agreements with Egypt and Jordan are virtually
identical to the Pan-European rules, whereas the agreements with Morocco
and Tunisia are slightly different for certain product categories. The EU ROOs
use all of the above criteria depending on the product being considered with the
change of tariff classification and the minimum value being most frequently
(2004) show that in the Pan-EU system the change of tariff
classification rule applies to 33% of products listed, the value added rule applies
to 11% of products, 13% of products are covered by both of these criteria,
and 18% of products by the combination of either of these with the specific
production processes rule.
United States and the Americas
In the Western Hemisphere, there is generally more variation in the usage of the
different criteria than in Europe. The rules in the NAFTA agreement (and
then also in many other related agreements such as US–Chile, Mexico–Bolivia,
Chile–Canada etc.) are complex, requiring either a change of tariff chapter,
heading, or item depending on the product, and these are often combined with
one of the other criteria. In contrast in the Latin American Integration
Agreement there is a general rule involving a change in tariff classification
or a regional value added of at least 50% of the f.o.b. (free on board) value of
exports. Similar rules apply in CARICOM and in the Andean Community.
Where the EU is attempting to harmonize its ROO regimes across different
agreements, this is not the case for the US, where the regimes vary widely
between different agreements.
The use of simpler rules is often the case in many other regional integration
schemes. Some only use the change in tariff classification rule, e.g. Canada–
Israel, or CACM. Others focus primarily on the minimum value-content rule
(e.g. ANZCERTA, SPARTECA, ECOWAS, COMESA, MERCOSUR) which
can range widely. Hence this can vary from, for example, 25% domestic
content in the Namibia–Zimbabwe FTA, to 35% in COMESA, to 60%
domestic content for MERCOSUR. Other regimes, however, do introduce more
sectoral selectivity such as SADC, or the Japan–Singapore Economic Partnership
This box draws heavily upon WTO (2002a), and Estevadeordal and Suominen (2004).
These give a comprehensive discussion of the incidence of the different criteria across a wide
range of PTAs, as well as an analysis of some of the key differences in ROO regimes across
different regional groupings.
576PATRICIA AUGIER, MICHAEL GASIOREK AND CHARLES LAI-TONG
2.2. How might ROOs distort trade patterns?
Rules of origin may act as trade barriers via two main channels.
They impose administrative costs on exporters. In this way they act as transac-
tions costs that tend to offset the bilateral trade creation;
They may induce firms to switch suppliers in order to meet the rules of origin.
In this way, they tend to exaggerate the classic trade diverting effect of preferential
liberalization. The ROOs-as-transaction-costs effect is the easiest to understand,
so that is where we begin.
2.2.1. ROOs as transaction-costs: Impact on trade between FTA partners.
When a free trade agreement (FTA) is signed, two things affect the bilateral trade
between the partners. The bilateral tariff drops to zero, but firms need to prove
‘origin’ in order to get duty-free treatment. This leads to two simple points. First, the
administrative burden of ROOs tends to offset the impact of the bilateral tariff
liberalization. Second, the burden of the ROOs-as-transaction-costs channel is
limited by the level of the non-preferential tariff. After all, firms can avoid all the
ROO administrative costs by paying the non-preferential tariff. As a matter of fact,
a great deal of this goes on in Europe since non-preferential tariffs are fairly low (see
Table 1). This limits the potential for ROOs to distort trade between the partners.
This insight led to the first wave of empirical research on ROOs in the 1980s. As
was mentioned earlier, several researchers have shown that a great deal of bilateral
trade between FTA partners actually pays the non-preferential rate (the MFN, or
most favoured nation tariff, in the jargon). Here we present evidence that this is also
true of many of the FTAs signed by the EU.
Table 1 gives information on what is known as ‘utilization rates’ for a range of
southern Mediterranean countries (Meds), and three Central and Eastern European
countries (CEECs). Utilization rates are the share of exports from the listed countries
to the EU that are actually granted the preferential tariff rate, i.e. the proportion for
which ‘origin’ status has been established. Tens of thousands of goods are traded, so
it is necessary to summarize the information. What we do is group products at a fairly
disaggregated level, namely the two-digit level in the so-called Harmonized System
(HS) of goods classification (there are 96 two-digit groups), and then calculate the
proportion of two-digit sectors with utilization rates less than 25%, 50% and 75%
(respectively) for each country and year. Hence, if we look at the first row of the table
for the Czech Republic, it can be seen that in 1998 out of all the 97 two-digit sectors
12.63% of the sectors had utilization rates of less than 25%, 24.21% had utilization
rates of less than 50%, and 52.63% had utilization rates less than 75%.
There are several interesting features, which emerge from this table. First, the
utilization rates are typically very low, overall. ‘Origin’ was established for more than
75% of the exports in only about half of the product categories. In 20–40% of the
product categories, less than half the exports were granted ‘origin’ status (and thus
RULES OF ORIGIN577
eligible for the preferential tariff). One interpretation of this is that there is a great
deal of frustrated trans-shipment going on, i.e. goods made in, say, the US or Japan,
are being trans-shipped to the EU via the Czech Republic, but the rules of origin are
frustrating the fiscal fraud. More reasonably, we can view the Table 1 numbers as an
indication that firms in these countries find that the transaction costs involved in
establishing origin to be greater than the cost of paying the EU’s MFN tariff. In other
words, the low utilization rates indicate that the ROOs are offsetting a great deal of
the bilateral liberalization that would have otherwise happened when bilateral tariffs
were lowered under the various preferential trade agreements (FTAs in the case of
the CEECs, specifically Europe Agreements, and unilateral GSP preferences in the
case of the southern Mediterranean nations).
Utilization rates tend to be higher for the CEECs than for the Meds, and the
proportion failing to meet the three cut-off criteria for all of the southern Mediterra-
nean countries except perhaps Morocco tends to rise over time, whereas for the
CEECs (except the Czech Republic) it tends to fall. Thus, for example for Egypt,
whereas in 1998 15.96% of industries had utilization rates less than 25%, by 2001
Table 1. Utilization rates
Percentage of sectors with utilization rates
below a certain threshold
Czech Republic < 25
Egypt < 25
Source: Own calculations on data supplied by the European Commission.
578 PATRICIA AUGIER, MICHAEL GASIOREK AND CHARLES LAI-TONG
this appears to have risen to 27.08%. The corresponding figures for Poland are 16.49%
and 14.43%. Since the EU’s MFN tariff was stable or falling during this period (some
Uruguay Round cuts were still being implemented), this pattern suggests that the
administrative burden of ROOs was rising for the Meds, but falling for the CEECs.
There could be several reasons for this, and it is also well known that the data on this
is imperfect. Nevertheless, the simple fact that the rates are so low suggests that the
first distortionary aspect of ROOs – namely the extent to which they offset the
bilateral liberalizing effects of preferential arrangements – is important.
While the first channel through which rules of origin act as trade barriers concerns
the trade between the FTA partners – the EU and CEECs and Meds, for example –
the second channel affects trade between the EU’s FTA partners and third nations.
2.2.2. Supply-switching effects of ROOs: impact on third nations.
two countries sign a free trade agreement, they lower tariffs on bilateral trade while
simultaneously establishing rules of origin. As per the classic trade-creation-trade-
diversion analysis, the FTA will lead to some supply switching from third nation
suppliers to FTA suppliers; preferential tariffs change the relative price of imports
from partner nations versus third nations and so naturally induce supply-switching in
favour of partner-nation firms. The classic analysis only considers the impact of the
preferential tariff. As noted above, however, rules of origin can also induce FTA-based
firms to reduce their purchases of inputs from third nations.
Hub and spoke
empirical work, it is useful to present some facts concerning the tangle of bilateral
and plurilateral trade arrangements surrounding the EU. During the 1990s, the
period of our data, the EU had 15 members and economically speaking, was the
hegemon of Europe. The EU15’s GDP was about $10 000 billion while the next
largest non-EU economy (Switzerland) was only $277 billion; other non-EU economies
were significantly smaller. Since trade arrangements are all about market access, the
EU’s trade arrangements with its neighbours can be described as hub-and-spoke
bilateralism. (The large economy, the EU, is called the ‘hub’ and the smaller economies
are called the ‘spokes’, since a schematic representation of the pattern of bilateral free
trade agreements resembles an old-fashioned wagon wheel, see Figure 1.) Of course,
the hub-and-spoke picture is a radical simplification of the tangle of trade arrange-
ments in Europe and the Mediterranean. A hint of this complex can be seen in the
diagram. Some of the ‘spokes’ – i.e. nations that have bilateral free trade deals with
the EU – have free trade agreements among themselves, for example Iceland and
Switzerland are members of the European Free Trade Association (EFTA) and
Poland and Hungary are members of the Central European Free Trade Agreement
(CEFTA). And some of the spokes have unilateral preferential access to the EU; for
example, the EU15 granted substantial tariff preferences to Moroccan goods without
demanding that EU goods receive the same preference in Morocco.
To illustrate this point while simultaneously preparing the ground for our
RULES OF ORIGIN579
Supply-switching effects of ROOs
suppliers. The figure shows a small part of the hub-and-spoke system of bilateral
FTAs that surrounds the EU. Specifically, it shows two spoke economies, Country B
and Country C, which have signed bilateral FTAs with the EU. The export flows
between the spokes and between a typical spoke and third nations (RoW, short for
‘rest of world’) are shown with arrows. As the labels on the arrows indicate, the
bilateral FTAs tend to reduce trade between spoke-nation B and spoke-nation C for
two distinct reasons: (1) the preferential tariffs that each ‘spoke’ grants firms located
in the EU but not those located in the other spoke, and (2) rules of origin that lead
Figure 2 illustrates how ROOs may lead firms to switch
Figure 1. European hub-and-spoke bilateralism, c. 1996
Figure 2. Trade impact of rules of origin
580PATRICIA AUGIER, MICHAEL GASIOREK AND CHARLES LAI-TONG
firms in the spoke economies to prefer sourcing their inputs domestically or from the
EU for purely origin-establishing reasons.
This outlines the fundamental supply-switching effect of ROOs. Of course, the extent
to which such supply switching occurs will then depend on a number of further factors,
such as the nature of the underlying market structure (e.g., Vousden 1987; Krishna and
Krueger 1995), or on how ‘sufficient working or processing is defined’ (Krishna and
Itoh 1988), and of course on the costs of not being able to fulfil the originating
requirement, and in particular the height of the importers’ tariff (Hoekman 1993;
2002). Clearly then the rules may serve to protect certain sectors from
the degree of liberalization that might otherwise be implied by the free trade agreement.
These issues are also discussed in Brenton and Machin (2002), Falvey and Reed
(2002), Burfisher, Robinson and Thierfelder (2004), and Hoekman (1993).
As far as spoke-RoW trade is concerned, both the ROOs and the preferential
tariffs tend to depress exports from RoW to the spoke economies, but there is no
first-order effect on the exports of the spoke economies to the rest of the world. For
simplicity, we omit the impact on spoke-EU trade and RoW-EU trade. (Our empirics
focus on the spoke-spoke and spoke-RoW trade flows.)
The identification problem
flows in the same direction. The core difficulty in estimating the impact of ROOs on
trade flows lies in separating the classic effects of tariff preferences (trade creation
between partners and trade diversion with third nations) and the impact of the ROOs
that always accompany tariff preferences (reduced trade creation between partners
and exaggerated trade diversion with third nations). The impact of preferences on
trade diversion, however, only applies where the spokes offer preferential access
to the EU and not to the other spokes. If countries B and C also have a free trade
agreement between themselves, then the issue of trade diversion should not apply.
Similarly, if a spoke has an asymmetric trade agreement with the EU, where it is the
EU which is offering tariff free access to its market but not vice versa, then again
trade diversion should not be an issue (the spoke levies the same tariff on imports from
all sources, so no trade diversion arises with respect to its trade with third nations).
Another aspect of ROOs that suggests a way to separate effects is their extra-large
impact on intermediate goods. While the trade diversion arising from the tariff pref-
erence will affect final and intermediate goods equally, the ROOs tend to have a
much greater impact on intermediates than they do on final goods. Finally also,
ROOs may have a bigger impact on nations that rely more heavily on imported
intermediates, e.g. small nations.
As the figure shows, preferences and ROOs tend to affect trade
As far as our empirical work is concerned, the main points to retain are that rules of
origin are likely to:
RULES OF ORIGIN581
Reduce trade between ‘spokes’, i.e. nations with which the EU has a bilateral
FTA, while encouraging trade between the EU and each spoke nation;
Affect trade in intermediate goods more than final goods;
Affect small countries more than large since they are likely to depend more on
imported intermediate goods;
Affect trade more for those countries where vertical specialization is more
3. THE CUMULATION OF RULES OF ORIGIN: A NATURAL EXPERIMENT
By the mid-1990s, a network of trade agreements had almost completely eliminated
tariffs and quotas on European trade in industrial goods. This tangle of arrangements,
however, was not the same as continent-wide free trade due in a large part to rules
This ‘spaghetti bowl’ problem posed problems for European manufacturers. In
Europe, as elsewhere, staying competitive requires firms to scour the world for the
cheapest inputs. Frequently, this involved setting up a complex supply chain in which
components were shipped among many nations. In the mid-1990s, there were some-
thing like 60 bilateral FTAs in Europe, each with its own complex set of origin rules.
Such complexity made it difficult to optimize manufacturing structures, especially
given the all-or-nothing nature of ‘origin’. Some final goods have hundreds of
intermediate inputs, some of which pass through several nations during their pro-
duction. Since any given part can lose its origin-status each time it crosses a border
– and the origin of the final good depends in a complex way on the origin of each
component – the problem of multiple, complex ROOs became a nightmare for
European businesses. It could be very difficult if not impossible for a firm to be
absolutely sure how the outsourcing of one of its intermediate goods would affect the
origin status of its final-good exports.
It is exactly this complexity that led EU businesses to lobby for diagonal cumula-
tion in the form of the Pan-European Cumulation System. Pushed by their manufac-
turers, the EU15, the EFTA4 (Iceland, Liechtenstein, Norway and Switzerland), and
10 then applicant-nations in Central Europe decided to amend their various FTAs
by substituting a common set of rules of origin for those they originally contained.
Value could thus be cumulated between different European countries without
prejudicing the duty-free status of end products. The result was the Pan-European
Cumulation System (PECS), introduced in 1997 and extended to Turkey in 1999.
The PECS is not a minor event in world trade. PECS nations account for about
two-fifths of world trade and have an aggregate population of 554 million.
This bit of commercial history is critical to our empirical strategy. Note that what
was being liberalized with the cumulation system was the trade-distorting impact of
ROOs; there was no change in the preferential tariff rates. Given the focused nature
of the liberalization inherent in cumulation, changes between pre- and post-cumulation
582PATRICIA AUGIER, MICHAEL GASIOREK AND CHARLES LAI-TONG
trade flows can give us a lower bound measure on how distortionary the ROOs
where in the first place – lower bound since cumulation reduces the restrictiveness of
ROOs but does not fully eliminate it.
3.1. Expected trade impact of cumulation
Since the impact of cumulation is at the heart of our empirical contribution, and the effects
are somewhat complex, it is useful to illustrate the expected effects with a diagram.
Figure 3 shows the impact of adding cumulation to bilateral FTAs considered in Figure 2.
Recall that each bilateral FTA tended to reduce trade in intermediates between
the spoke economies (Countries B and C) since such inputs did not help firms based
in, for example, Country B with the ROO requirements for exporting to the EU
(typically their main market). Cumulation changes this.
Under the Pan-European Cumulation System, it is easier for inputs sourced from
C or B or the EU to count as ‘domestic’ as far as eligibility for duty-free treatment
is concerned. We should, therefore, expect a rise in spoke-spoke trade after the
implementation of cumulation, i.e. after the PECS started operating in 1997. Of
course, even with cumulation and harmonized rules, rules of origin continue to distort
trade flows in Europe. Cumulation reduces, but does not eliminate the administrative
costs involved in demonstrating origin. Moreover, the ‘specific production process’
ROOs continue to act as very high non-tariff barriers for certain inputs, especially as
regards imports from non-PECS nations.
3.1.1. Not for third nations.
sourced from third nations. We should not, therefore, as a first order impact, expect
Importantly, the cumulation does not extend to inputs
Figure 3. Trade impact of cumulation on trade flows