Grandfathering Free Trade Agreements and Rules of Origin: What might appear bilateral is in fact trilateral!

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27 September 2017

Dr Peter Holmes Reader in Economics and Dr Michael Gasiorek is Senior Lecturer in Economics at the University of Sussex and Director and  Managing Director of InterAnalysis respectively. Both are Fellows of the UKTPO.

With respect to the post-Brexit period, the UK needs to sort out its trade relationships not just with the EU but also with non-EU countries. In regard to the EU, Mrs May’s stated objective is for an “implementation” period during which “access to one another’s markets should continue on current terms”,  such that “businesses and public services should only have to plan for one set of changes in the relationship between the UK and the EU”.  However, for this to be possible, the UK will also have to deal with the relationship with non-EU countries.  In this blog, we focus on an important aspect of Free Trade Agreements (FTA) which centres around something which is a bit technical and often not well understood – called “Rules of Origin” (RoOs).[1]

There are more than 50 countries with whom the EU, and therefore the UK, currently has a FTA.  In 2015, these countries accounted for over 15% of total UK imports and exports. If the UK leaves the EU without any agreement with these countries all this trade could be negatively affected as the UK would have no legal option but to switch to trading on less advantageous market access conditions. In the first instance, this implies that the UK will face and also impose Most Favoured Nation (MFN) tariffs on trade with these countries in accordance with WTO rules, which require MFN tariffs to be charged to all countries with which you do not have a full FTA (with some very limited exceptions).

Copy and paste?

“Grandfathering” means either seeking to continue applying existing EU treaties with third countries that the UK is a party to as an EU member state or seamlessly signing new bilateral FTAs with effectively the same terms. The idea of “grandfathering” is to say: “as an EU member we already have an agreement with these countries, such as Korea, so let’s just agree that we can apply the same agreement between the UK and Korea in the post-Brexit period”.  This is a nice idea and on the face of it very logical. Some countries have expressed a willingness, at least in principle, to proceed on this basis.

But there are several reasons why this might not prove so easy. Partner countries might easily seek to extract further concessions in particular sectors or areas of policy. Similarly, there is a lack of clarity as to whether this grandfathering is intended as a new permanent state of affairs, or as part of a transitional arrangement. The willingness of UK partner countries to go down this route may well depend on this, as well as on the state of play of UK negotiations with the EU. If it is intended as a permanent arrangement then this will be played out in the UK’s domestic politics: There will be those that will argue that the point of Brexit was for the UK to choose the types of FTAs it wants and not just to take on all the old FTAs. Moreover, mutual recognition of standards and certification would not automatically apply if the UK did not have the same rules as the EU post-Brexit

Furthermore, the EU is likely to insist that EU trade treaties can only be applied to EU member states, so it seems likely that in reality, it will be necessary to sign new bilateral agreements. However, even if the partners had no new demands it may well require more than just a simple cutting out “EU” and pasting in “UK”.  This is where Rules of Origin (RoOs) turn out to be hugely important.

The technicalities

Imagine the UK grandfathered the EU-Korea agreement, which consequently allowed for continued free trade between the UK and Korea. As with all FTAs, the free trade is contingent upon exporters proving that their goods are produced in their country. Hence, for the UK to export cars to Korea, the firms in the UK have to be able to prove that the cars really were produced in the UK.  Now in today’s world, producers often use a lot of imported intermediates to produce a given good. So, we need some rules to determine how much can be imported and used by the UK producer for the good to still be considered a UK good. Indeed, EVERY Free Trade Agreement needs to include such rules about what goods can qualify for preferential market access, and these are known as Rules of Origin[2]. The RoOs are crucial to facilitating bilateral trade, for example, between the UK and Korea.

These RoOs really matter for industries with international supply chains where the exporters produce their goods using imported intermediates. Normally bilateral FTAs (e.g., between Country A and Country B) allow inputs imported from Country A to be “cumulated” with Country B’s inputs into its exports to Country A. So, EU components going into Korean cars, which are then exported to the EU, would be included in determining whether the cars are counted as Korean and vice versa. The producer can add (cumulate) the value of both the EU and the Korean inputs in working out if the good qualifies for originating status.

But it gets more complicated when a firm uses imported inputs from a non-partner country and then wants to export them to an FTA partner.  For example, with respect to the EU-Korea agreement, how many Chinese components can go into a Korean car such that it is still eligible for duty-free access to the EU?  A common rule is to say that at least 40% of the value of the product, such as machinery, has to come from domestic inputs/activity.^[3] These rules need to be agreed upon for every product which is traded, and this can be very tricky.

Let’s explore this a bit further by way of an example. Suppose that:

Initially, pre-Brexit:

• The UK exports machines to the EU where 30% of the value of the product comes from domestic UK inputs, and 20% are Korean inputs, and post-Brexit the UK would like to keep this trade going.
• The EU has a FTA with Korea – which therefore means that Korea can export to the EU (most products) duty-free, providing they meet the 40% rule and vice versa.

In the post-Brexit world:

• The UK and Korea grandfather the EU-Korea agreement such that there is now a UK-Korea FTA – which means that Korea can export to the UK (the same products) duty-free, providing they meet the 40% rule, and vice versa.
• The UK signs a FTA with the EU.

In the pre-Brexit scenario as an EU member state and because the EU is a Customs Union, the UK can export those machines which use Korean inputs to the EU. In the post-Brexit world, you might think that because Korea can export the same inputs to the EU duty-free, the UK could continue to export machines which use those inputs to the EU duty-free. But that is not necessarily the case at all. Even if the same Korean inputs are exported to the UK and used in UK exports to the EU they are unlikely to count for originating status. If they do not count then UK machines cannot be exported duty-free to the EU because only 30% of the value of the product comes from domestic UK inputs, and so the EU’s tariffs will have to paid.

Although this situation is the norm in many trade agreements, there are ways round this problem. It is possible for the EU to agree that the Korean inputs used by the UK producers could count for determining origin (and vice versa). This is normally known as ‘diagonal cumulation’, and a deeper version of this is known as ‘full cumulation’.  But note: the EU has to agree to this! This means that to have such diagonal cumulation it must be negotiated by and with all the countries concerned: the UK, Korea and the EU.  Hence, as well as agreeing with Korea that the EU-Korea agreement can be grandfathered, the UK would need to agree with the EU that the EU would accept the Korean inputs for originating purposes. Similarly, Korea would need to agree that UK exports which used EU inputs could be also accepted for originating purposes. Otherwise, trade could not continue on “current terms”.

Implications and impact

That provides a quick overview of the technical stuff. But, how big an issue is this? And how easy might it be to agree on cumulation? With regard to the former: if you exclude gold and precious stones the UK currently imports close to $80 billion intermediate goods from non-EU countries (let alone the import of services). The key sectors importing these intermediates are machinery and mechanical appliances, electrical machinery, and vehicles. Without agreement on Rules of Origin and their cumulation, it is very likely that trade in these products would be affected.

With regard to the second question, consider the following:

• Currently, the EU only allows for diagonal cumulation where all the countries concerned have adopted EU rules of origin.[4] If they stick to this principle the UK would have to adopt the EU’s RoOs. How acceptable would this be to the UK?
• Currently, in many EU agreements, such as the EU-Korea agreement, there is no provision for diagonal cumulation. Even in the existing EU-Canada agreement, there is only the possibility of limited diagonal cumulation with the US, and this is only in the event that the EU and the US sign a ‘compatible’ Free Trade Agreement.

It might appear that grandfathering the EU-Korea agreement is simply a bilateral issue between the UK and Korea. However, if the UK wants to maintain the same level of access to the EU market for any goods using Korean inputs, it also needs to negotiate the cumulation of Rules of Origin with the EU.

What is bilateral is in fact trilateral… if you want to maintain conditions for business on “current terms”.

Obtaining diagonal cumulation for any FTA, let alone every single FTA we currently have under EU membership is going to be difficult. Even if the UK does obtain diagonal cumulation all UK exporters will now need to prove their goods qualify as originating in the UK when they are exported to the EU.

The preceding also shows that grandfathering existing agreements will not simply be ‘cut and paste’ because the UK’s interests in being able to maintain the structure of its value chains are almost certainly different from those the EU had when it negotiated the original treaties.

Footnotes

[1] In this note we also focus on the difficulties associated with maintaining access on current terms to the EU for trade in goods only and do not deal with the equally tricky issue of trade in services.

[2] Note Rules of origin are not normally needed for a custom union as there is a common external tariff.

^[3] See https://medium.com/@SamuelMarcLowe/explaining-cumulative-rules-of-origin-2c13fb4dfca1 for a fuller and easy to read explanation of rules of origin.

[4] This applies in two cases – what is known as the Pan-European rules of origin; and also the rules applied to the Western Balkan countries.

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