‘Docking’ RTAs in the APEC region

Earlier this week, I spoke at the APEC Senior Officials Meeting Trade Policy dialog in Da Nang on the subject of ‘integrating’ existing regional trade agreements in the APEC region. It’s a project that is fraught with difficulty due to the inconsistent rules of origin, and different preferences in the existing agreements. There is, however, one example of a regional agreement that is being created by the ‘docking’ of preferences among existing ‘free trade agreements’. It’s a projectbeing sponsored by the European Union.
I prepared a presentation for the Senior Officials and some notes.  The content of the notes is below. The presentation is available here



Why are we trying to do this?


Integrating (‘harmonizing’, ‘docking’)FTAs is even more complex than negotiating FTAs. So we’d better be clear why we want to do it before we start. As it turns out, there is a different path towards the Bogor goals that is much less technically demanding and would take much less time than the integration of FTAs. We’ll come to that at the end of the talk.

What sort of integration are we talking about?


By ‘integration’ of FTAs I mean a program that aims at the universal ‘docking’ of the 40 existing (70+ potential) FTAs in the APEC region. That is, extending the same market access preferences among members of different FTAs throughout the period of FTA implementation and at the end of the implementation period. This amounts to the revision of restrictive ROOs to allow ‘cumulation’ of productoriginating in any of the partners to the ‘docked’ FTAs for the purpose of conferring regional origin. Once their product is counted as ‘originating’ throughout the docked FTA then every member will have access to the preferences offered within the FTA.

Even if there were no other aspects to FTAs than the market access preferences, this ‘docking’ would be difficult to negotiate. There is at least one excellent example of such a process under-way elsewhere in the world, but it may be an exception that ‘proves’ the difficulty of this project for APEC.

Modern, comprehensive FTAs have many provisions other than the goods access schedules affected by ROOS. Is it possible to separate the ‘docking’ of the access schedules and the integration or harmonization of the other provisions of the FTAs? I’m going to leave that question for later discussion.

Does everyone have the same goal?


We can imagine that there is only one reason for attempting to integrate FTAs that now exist in the APEC region: because integration seems like a step towards the Bogor goals (and more stand-alone FTAs are a step away). The problem is that the enthusiasm of APEC member economies to take on the complex, time-consuming task of FTA-integration is probably qualified by the motivations for the FTAs themselves.

Let’s look for a moment at what those various motives are.

Economic integration?


Analysts agree that the best rationale for an FTA/RTA is to better integrate the economy with those of its trading partner(s). Economic integration has the same benefits as overnight economic growth (size of the market) and a quick boost to the efficiency of production (more specialized production in a greater range of activities). But it brings with it the full pain of adjustment … Even stretched out over time, few governments feel the need to take on difficult adjustment, except in times of ‘crisis’. So high quality FTAs that are comprehensive and completed in a short time-frame (10 years) are a small minority and all link economies that were already trading intensively before the FTA was negotiated (Europe, NAFTA, ANZ, Chile-USA). The economic integration objective is, however, consistent with the logic for full and universal ‘docking’ of regional FTAs.

Deeper but narrower?


The most commonly stated reason for an FTA or RTA: bringing economies closer together in the least painful fashion by going further than on an MFN basis (‘deeper’), but in ‘non-sensitive’ sectors. The ‘deeper but narrower’ motivation leads to agreements that are almost impossible to integrate because they are uniquely narrow and variously deep. It may extend to some selective ‘docking’ of additional RTAs/FTAs, but is incompatible with universal docking even within the APEC region, especially with those FTAs that are (more) comprehensive.

Foreign policy objectives?


Whatever they say, governments pursue FTAs/RTAs more for foreign policy reasons than for any other: to give more substance to an important relationship, to express a geo-strategic role (a ‘hub’)or to create an outlet for expansive regional ambitions. Many FTAs succeed in these terms whatever the ratio of black-to-red ink on the trade ledger. Some ‘docking’ might fit with these motives. But it’s difficult to imagine universal docking being on the agenda of any but a dominant regional power (e.g. the EU in the context of the Euro-Mediterranean FTA).

The opportunity


Why pursue the integration of regional FTAs now? We can imagine some good reasons. For example, the IMF warned earlier this month that the global economy is much closer to a substantial ‘correction’ in external balances than it was the last time the IMF said this (last year). If you think that, like the boy who cried ‘wolf’, they will eventually be right about a substantial correction bringing exchange rate realignment in the wake of a crisis in global demand, then a project to better integrate the economies of the APEC region would make sense. It could be one way to start dealing with the cause of the imbalances and to make the most of the opportunities that will arise after the ‘correction’ (which could be smoother and smaller). Because integration is an inherently complex undertaking requiring many different negotiations that could take years, the sooner a start is made the better.

Officials tend to think about resource opportunities, technical challenges


Although precaution is often a great motivator, it’s unlikely that this argument will move integration up the political agenda. More likely the agenda will be determined by opportunity.

‘Suspension’


So far, the inaction in the Doha negotiations is nothing exceptional. There’s never much action in August and, whatever ‘suspension’ means, we know that Mr Lamy has no powers to impose it. The negotiations will start again (possibly have started again). But it will be clear by about December whether they have any reasonable prospect of delivering verified schedules of commitments by the date in May when the current TPA deadline becomes final. After December we could be looking at a real ‘suspension’ for several years, assuming there is no TPA extension. This period will be marked by disappointment and resolution to take alternative routes toward one or other of the different goals we’ve just considered. An ‘integration’ program would certainly be an attractive opportunity (more attractive than an expansion in the number of RTAs?).

The political opportunities matter more


I’m willing to predict that the political reaction to a longer hiatus in the WTO negotiations will be ‘balanced’. My observation is that business lobbies and institutional leaders have made much stronger calls for progress in the negotiations than have governments. In any case, governments aren’t going to give themselves much grief over things that, individually, they can’t fix. The APEC opportunity will appeal strongly to member governments as an alternative opportunity to reassure business that they are still pursuing globalizations rewards

The exhaustion of ‘TPA


But if a Doha hiatus is due to the exhaustion of the US President’s “Trade Promotion Authority” practical steps towards integrating regional FTAs will probably be confined to the Western half of the APEC region for at least a couple of years (and may be overtaken by a revived Doha negotiation after, say, 2010).

Best practices


I can assume that everyone here is familiar with the “Best Practices” principles so I won’t recap them. I will, however, say that they form at best a prologue to any practical program of integration. Their attraction is that they comprise clear, intuitively attractive policy recommendations that have won universal endorsement. The recommendations look forward, applying to the negotiation of future FTAs or the completion of existing negotiations. But an assault on the problems of integrating existing FTAs needs some heavier artillery, able to deal with the messy, complex, deeply-entrenched defences of most existing FTAs.

ROOs underlying model


Why the ‘military’ metaphor? Because FTAs are not like a series of self-contained towns that we want to join with roads to make commerce easier; they are more like a series of fortresses designed to defend preferential access and prevent the loss of market rents. Every integration strategy but one—that I’ll describe a little later—means breaching the defensive walls by determined and (politically) courageous attack on preferential margins and the businesses that benefit from them. The walls of these fortresses are built from Rules of Origin.

A business model, not a trade model


The underlying model for a rule of origin is a business model. It’s not about trade or foreign policy, its about commercial advantage in a competitive business environment. The ROOs problem is an expression of the archetypal market failure problem: the incentives operating on the private actors whose energy and political influence helped create the conditions for the FTA in the first place are such that they are likely to maximize private gain from the Agreement at the cost of—or, at best while under-investing in—the social gain.

Business: exclusive access = profit margin


Exporting businesses, with the exception of commodity traders, don’t spend much time worrying about tariffs. Surveys (World Bank among others) show this over and over. Consumers pay tariffs. As long as third country competitors are paying the same duties, tariffs are an annoying fixed cost (which is why they matter more to commodity traders whose margins are small relative to the fixed cost) but have no competitive impact. What businesses want is an exclusive margin that is not available to competitors; a competitive advantage. Restrictive ROOs are the price of achieving this advantage as well as its guarantee. Conceptually, it’s a simple sum: “Present value of the expected margins minus lobbying costs minus the PV of expected ROO administrative costs”. On the importing side of the equation the motivation is different but the logic is the same: the ROO is still seen as a defense against competition, limiting the breadth of the preference.

Trade: open entry/exit = greater range of substitution = maximize welfare at higher levels


The benefits of trade to the economies of RTA partners have, of course, a completely different logic. The logic of trade considers competition a good thing. But that’s not the logic of FTA/RTAs. Does the business sector impose ROOs on governments or the other way around? Neither, I suspect; between governments and the private sector lobbies that are much more prominent in FTA negotiations than in any multilateral negotiation there is a mutual—but differently founded—interest in ‘exclusivity’.

Business interest


The business logic of ROOs is the biggest single hurdle—although far from the only hurdle, in practice— to an FTA integration strategy. A head-on assault—for example, deciding to ignore business interest in favor of the social interest in more open, competitive markets—is the sort of thing that most Finance Ministries and academic analysts will recommend. This is a fine idea but it has a sorry history. A more likely way to succeed with an integration strategy the creation of some other incentive that replaces the business logic of ROOs (competitive advantage). I know of one case in which this approach seems to work but the challenge is to find a way to apply it in the APEC region. Observation of how firms manage inconsistent ROOs, however, suggests to me that for individual firms the value of the competitive advantage conferred by FTAs with restrictive ROOS approximates to the value of the margins in only one or perhaps two markets.

Businesses optimize choice among ROOs


It’s important to understand better how businesses deal with the problem of overlapping ROOs to determine how they would react to the simplification that integration implies. My observation from talking to managers in the APEC region (Australia, Sri Lanka, Bangladesh, Malaysia, Thailand) Eastern Europe (Hungary, Bulgaria, Croatia) and Africa (Kenya, Uganda, Zimbabwe, South Afri ca) is that businesses are likely to ‘optimize’ where ROOS force them to make a choice between accessing different preferences. Managers consider the relative value of compliance and MFN trade. In some cases, the margin of preference, the competitive advantage and expected volume of trade is may be too small to justify the compliance cost. In this case, supply under MFN conditions removes ROO considerations.

Where preference margins are potentially valuable, businesses develop product and manufacturing strategies that take account of the customer and regulatory requirements including ROO in their most important market first and then try to juggle component variations and compliance costs in less important markets to take advantage of preferences where feasible and profitable. In other words, they treat the choice as an optimization problem. Frequently the problem is trivial because existing contractual arrangements make the choice of markets (and ROO compliance) obvious.

Managers evaluate margins after book-keeping, re-tooling, inventory costs


Where business is able to make a choice among FTAs or between preferential and MFN access to a market, the optimization problem requires them to consider much more than regulatory compliance costs. Frequently, in sophisticated RTA administrations, the regulatory costs are being contained by techniques such self-assessment of preference eligibility with random verification and accounting separation rather than physical separation of non-originating components in inventory.

The more difficult choices for managers concern the costs of product development to meet restrictive origin requirements; meeting customer specifications in seasonal or variable supply industries without access to non-originating supply; re-tooling for batch production of originating goods for different markets etc. Most businesses are easily persuaded that CTC is a simpler system to manage without loosing the exclusivity of a ROO. CTC has the advantage that origin is conferred by the degree of transformation as seen through the prism of the HS rather than by more complex value-adding calculations eg. ex-factory cost proportions as the criterion for ‘substantial transformation’ where ROO compliance is affected by the variable costs of inputs (a big factor in the food industry).

Firms take account of few ROOs


My hypothesis is that only a small number—perhaps one or two—FTAs actually impact on the export marketing activities or production decisions of most firms even in economies where there are multiple FTAs to choose from. ROO-restricted preferences in secondary markets must either align with the primary ROOs or the preference is passed up.

Production networks may favor some ‘docking’


The (probably) limited number of ROOS that actually impact on production or marketing decisions limits the resistance of exporting businesses to integration. There are also some businesses that will actively seek more integration or ‘docking’ of RTAs; especially those that participate in a production network whose customers are located in one or more of the RTA partners. Within a production network, at least as far as the inputs and outputs of the network are concerned, the business logic of the ROO does not hold. Of course, these business may have other production and trade interests that are not part of the production network where the logic of the ROO reasserts itself.

ISI an example of MNC production network influence


Described by US officials as one of the most significant aspects of the Singapore-US FTA, the Integrated Sourcing Initiative effectively removes the Agreement’s ROO tests for a limited number of products shipped between Singapore and the USA that were already duty-free under the WTO Information Technology Agreement (and for certain medical products also duty-free before the SUSFTA). The impact of the ISI is to allow MNCs from the US and Singapore to locate ‘network’ production facilities elsewhere in the region, or the world for that matter, for processing or even transshipment through one economy or the other.

Difficult to say how important production networks are


They appear to be widespread, elaborately organized and increasingly characteristic of highly competitive, low-margin industries such as textiles, pc’s and consumer electronics as well as some industries characterized by network scale where there is small number of global producers (automobiles, aircraft). But the high degree of intra-industry trade characteristic of other manufacturing sectors does not necessarily indicate a ‘production network’. Nor do networks imply an interest in FTAs’; networks operate successfully on the basis of ‘inward’ and ‘outward’ processing and duty-drawback arrangements or export processing zones.

An example of ROO ‘docking’


There is some encouragement for a potential APEC program of FTA ‘docking’ in the EuroMed RTA now being created by the EC and its partners in bilateral Mediterranean Association Agreements. The EuroMed program is applying the pan-European model of cumulation of origin to the wider Mediterranean region (41 economies), eliminating ROO restrictions. But this model seems to work by replacing the business logic of ROOs with something of greater value. I suspect that it works only in a ‘hub and spokes’-configured RTA.

PanEURO-Mediterranean model


Begining in 2003, the EC is facilitating a series of ‘docking’ agreements among Mediterranean economies that already have an ‘Association’ agreement with the Community. This is a significant initiative that, once complete, will effectively extend the pan-European origin-model that operates inside the EC itself to all of the members of the ‘Euro-Med’ region.

Terms of docking


In brief, any Association country already has access to the EC market on preferential duty-free terms (subject to certain conditions including the ‘no-drawback’ rule on non-originating components incorporated in exports to the EC). The preference-receiving imports are considered ‘EC origin’ materials for the purposes of trade among members of the EC; that is they may be ‘cumulated’ with e.g. French origin goods for the purpose of ‘single market’ sales anywhere in the Community. Under the terms of the Euro-Med agreement, the Association countries are encouraged to negotiate a series of bilateral free-trade protocols among themselves extending the identical ‘cumulation’ rules to each other covering all bilateral trade The incentive to do so is that the EC will consider any goods incorporating materials originating in countries that have such protocols as originating goods.

In other words, the pan-Euro cumulation rules will apply throughout the Euro-Med region. The EC has added further incentives in the form of simplification of treatment of non-originating goods from outside the region (subject to the ‘no-drawback’ rule) including the use of only two duties (5% and 10%) on non-originating components on import into the EC.

Potential members of the RTA


Algeria, Bulgaria, Egypt, Faroe Islands, Iceland, Israel, Jordan, Lebanon, Morocco, Norway,Romania,Switzerland(includingLiechtenstein), Syria, Tunisia, Turkey and West Bank and Gaza Strip and the EC (25)

‘Geometry’


The EC describes the arrangement as ‘diagonal geometry’ of cumulation. Another way of describing the model is a ‘hub-and-spoke’ arrangement in which the Euro-Med protocols for cumulation of origin are the completion of the ‘rim’ among the spokes.

Use of ‘business logic’


The logic of an exclusive competitive advantage that normally underlies a ROO is overwhelmed by the advantages of improved terms of access (simplified, liberalized treatment of non-originating components) to the largest, wealthiest market in the region

Would the EuroMed model work in APEC?


We can test the hypothesis by considering its application to some existing and proposed FTAs. The following example places China at the ‘hub’ of a network of FTAs with ASEAN (as a group), Australia and New Zealand.

The same preferences among ‘spokes’ as with the ‘hub’


Preferences between ‘hub’ and ‘spokes’ in the current China-ASEAN, China-Australia and China-NZ negotiations are—as far as I know—undecided they are probably not comprehensive free trade. China has made it clear that it is reluctant to extend duty-free access on agricultural products, for example. It seems likely that Australia will seek to maintain protection for its garment industry until at least the end of the current industry plan in 2015.

For Australia and New Zealand, the comprehensive free-trade terms of CER would become tantamount to MFN terms of access if they extend the preferences in that agreement to China or to ASEAN. This would be a major step for each economy but perhaps not impossible to imagine if the corollary were the same preference—that is, duty-free access—to ASEAN and China For ASEAN, free trade in merchandise is not yet complete within the region and there seems to be no plans for comprehensive free trade with China or with ANZ

The same ROO among ‘spokes’ as with the ‘hub’


If the margin of preference extended to China and to the other ‘spokes’ is comprehensive free trade in goods and services then there seems to be no reason not to have the same ROO among the spokes and between the spokes and hub

The incentive


In the case of EuroMed the incentive for the same terms of access among the spokes as with the hub is that the hub is such a dominant trading partner across all goods trades that extending the same preferences to the other spokes seems a relatively small step and the incentive of still better terms of access to the hub is potentially effective (the ‘spoke-to-spoke’ protocols are not, however, all in place yet).

Questions


(1)

If China were to offer ASEAN, Australia and New Zealand the same market access deal on goods that the EC offers the Mediterranean Association countries on condition that they extended the same terms ‘spoke-to-spoke’, would this remove opposition to comprehensive free trade among Australia, NZ and ASEAN? Would the offer be ‘picked-up’ by the spokes?
(2)

Would there be any benefit for China in offering comprehensive free trade to the ‘spokes’? Or do the perceived threats to e.g. agricultural employment in China still predominate?

An optimistic view


The examples suggest that the hypothetical ‘docking’ using the EuroMed approach is not out of the question, but it’s far from confirmed. If, however, the ‘EuroMed’ proposition fails in this case, what hope is there for the broader—and even more radical—Bogor goals that extend, for example, to services trade? In order not to finish this talk on such a pessimistic note, I’d like to offer some observations that suggest something like the EuroMed project may be possible in the APEC region in the future.

We tend to focus on the hard cases in ROO


When we think about the difficulty of ‘docking’ FTAs and the rigidities and restrictiveness of ROO, we tend naturally to think of the hard cases such as the NAFTA provisions on textiles. Most ROO based on CTC operate much more simply and transparently. The business logic remains, even with this simpler means of deciding origin—ROO are still intended for purposes basically inimical to the logic of trade—but simple ROO do make the negotiation of docking less difficult should there be a sufficient incentive found.

Anesthetizing the MFN decision


As in the EuroMed case, an offer from a dominant partner to the ‘spokes’ can have the effect of ‘anesthetizing’ trade-exposed sectors in the spokes to the MFN-like extension of preferences among themselves. This was, after all, the logic of MFN itself: once you have negotiated terms with your most important trading partner for a particular trade (the ‘initial negotiator’), the exchange of those same terms with less significant suppliers or markets is not a major step. It’s the size of the preference (‘free trade’)that is difficult, not the breadth of its subsequent application. Of course, it remains an open question whether the ‘hub’ business groups would find the pain of free-trade access by the spokes quite so anodyne. In the APEC region we already have the world’s first and third biggest traders (USA and China) and soon it will be the first and second. Plus, of course, Japan. An offer from those giant economies to all other APEC members might be sufficient to initiate a ‘EuroMed’ result. But if such an offer were on the cards then the original Bogor goals would be much closer than anyone imagines.

The bigger the goal the less complex the agreement


RTAs emerge, as we have observed, from a political context. An approach to ‘docking&rsq uo; existing and future RTAs along the lines of the EuroMed model would need determined political support, in China, and the USA, especially. The negotiations would, even so, be long and extremely complex (I am ignoring, too, the integration of other aspects of the existing agreements). In my view, however, the EuroMed Agreements offer the only example of a comparable ‘docking’ effort and deserve our closer study and, possibly, emulation if RTA integration is the direction in which APEC heads. But even as we contemplate the difficulty of creating the political environment (if it can be created) and undertaking the technical work for an RTA ‘docking’ project, we should reflect that is/was a global agreement on offer that challenged APEC economies even less on the political level and much less on the technical level that we have so far been unable or unwilling to complete. Finally, the Bogor Goals contemplate a decision that would cut through most, if not all, of the complexity of ‘docking’ and even the complexities of the Doha Round by making bilateral FTAs, sub- regional RTAs and all the machinery of the ‘modalities’ irrelevant.

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