# How Restrictive are ASEAN's Rules of Origin?

Date November 20, 2015 Lili Yan ING (Economist, Economic Research Institute for ASEAN and East Asia (ERIA)) URATA Shujiro (Faculty Fellow, RIETI / Professor of Economics, Graduate School of Asia-Pacific Studies, Waseda University) AMBASHI Masahito (Consulting Fellow, RIETI / Economist, ERIA)

## Summary

### Introduction

Lili Yan ING

I would like to discuss the Association of Southeast Asian Nations' (ASEAN) trade policy. I will principally highlight free trade agreements (FTAs). Rules of origin (ROO) are a major component of FTAs, and we can describe the use of FTAs by analyzing the rigorousness of their respective ROO. In this session, I would like to discuss "How Restrictive are ASEAN's Rules of Origin?" This is a paper I wrote jointly with Professor Olivier Cadot. This paper presents the ROO in the ASEAN and ASEAN+1 FTAs. It also presents a tariff ad-valorem equivalent of ASEAN's ROO.

ASEAN countries have been active in forming FTAs; by January 2010, ASEAN had six FTAs. One is the ASEAN Free Trade Area (AFTA), and there are five ASEAN+1 FTAs with ASEAN's main trading partners: China, Japan, South Korea, India, Australia, and New Zealand. In November 2011, an ASEAN+6 FTA, a so-called regional comprehensive economic partnership (RCEP) was initially put on the table.

ASEAN has trade agreements with countries that account for approximately 60% of its imports. East Asia has advanced production networks. Asia accounts for more than 50% of the world's automobile production, 62% of liquid crystal display screens, 86% of smartphones, and 100% of digital cameras. Much of this production is based on production networks. Many countries are engaged directly and indirectly in producing final goods.

On one hand, we have an increasing number of FTAs, and on the other, there has been a rise in trading tasks. ROO stand in the middle. On one hand, they can boost both the formation of FTAs and trading tasks. On the other hand, ROO can make those two trends incompatible. For example, one country can have many FTAs, but if they have very strict ROO, businesses will be unable to use them. ROO play a key role in that they can induce businesses to use FTAs or reduce them to a statistic if businesses find it very difficult to comply with the ROO.

### Stylized facts

How do ROO work?

First, there are product-specific rules. Product-specific rules specify the minimum degree of local transformation needed to qualify for preferential treatment. They typically take a limited number of legal forms, each of which has advantages and disadvantages for exporters: changes in tariff classification, regional value contents, or technical requirements. Changes in tariff classification (CTC) impose that when a final good is produced using intermediates imported from outside the bloc, it ought not to belong to the same category as those intermediates. Regional value contents (RVCs) can take various forms, including a maximum share of imported intermediates in total intermediates or a minimum share of local value added in the product's price.

Second, regime-wide rules--essentially cumulation rules, the other ones being of secondary importance--specify the treatment of intermediates imported from other countries in the same bloc or countries with special status in terms of cumulation. There are three broad types of cumulation: bilateral, diagonal, and full. Under bilateral cumulation (a clause that applies only to bilateral FTAs), if an exporter from A exports to B, only intermediates from A or B count as local. Under diagonal cumulation, in an FTA between A, B, and C, when exporting to B, A can count intermediates from C as local. Full cumulation is the most complicated, in particular, in the case of a multi-stage production process. Consider an FTA between three countries A, B, and C and the following production process. A firm in A imports $25 of intermediate products from the rest of the world (ROW) and does a first transformation involving$25 of local value added. The firm then exports the resulting product, still an intermediate one, to B for $50. In B, another firm again transforms it, adding$10 more of intermediates imported from the ROW and $40 of value added. Finally, the product is re-exported to C for$100. Assume that between the intermediates imported from the ROW to A and the transformed intermediate exported from A to B, there is no change of tariff classification (CTC), whereas between the intermediates imported into B and the final good exported from B to C, there is a CTC. But in practice, many businesses cannot really comply with full cumulation in the sense that if they want to do so, there must be complete traceability with regard to how much is paid for the imports from A to B and for the imports from B to C. Most of the time, businesses prefer not to use full cumulation as they don't want to disclose complete information on how much they paid.

ROO can only be binding when tariff preference margins are substantial. Tariff preference margins are defined as the difference between most favored nation (MFN) tariffs and preferential tariff rates. The lower the preferential tariff rates an FTA is able to offer, the higher the preferential tariff margins that can be enjoyed by businesses, and the more likely it is that businesses will use the FTA. The use of FTAs depends very much on these margins.

### Empirical framework

Set up:

Consumers have homothetic preferences with a constant elasticity of substitution across varieties of goods. Suppose that country $$i$$ exports $$n_i$$ varieties to country $$j$$ and let $$x_{ijk}$$ be the quantity of variety $$k$$ exported from $$i$$ to $$j$$ (in tons), $$p_{ijk}$$ its CIF price, $$E_j$$ the total expenditure in country $$j$$, and $$s_{ijk}$$ its share in country $$j$$'s expenditure. So, we have price times export equals share of expenditure in country $$j$$ on variety $$k$$.

For example, let's look at a Japanese auto manufacturer operating in Indonesia: Toyota Motor Corporation. The manufacturer produces vehicles in Indonesia and exports them to Vietnam. The price of Toyota vehicles exported from Indonesia to Vietnam multiplied by the quantity of exports from Indonesia to Vietnam equals the share of Vietnamese income spent in Vietnam on automobile production.

Companies base themselves in a particular country first because of cost and second due to the availability of a comparative labor advantage in that country. This equation tells us about price compared to the productivity of labor in a particular country. To be able to capture the story of ROO, we factor in trade cost--the price paid by consumers in Vietnam for a product, which is equal to any trade cost multiplied by the original price. Consumers in Vietnam have to pay a certain amount of money for a car that is imported from Indonesia, which is equal to the price of production in Indonesia multiplied by the trade cost.

The trade cost that we are interested in covers tariffs and ROO. We want to know the extent to which ROO benefit businesses and enable them to enjoy tariff margins. A company without an FTA has to pay the applicable tariff, but if it had an FTA with tariff preference margins, this burden would be reduced.

The equations reveal to us that total exports are basically the total prices multiplied by the total quantity of Indonesia's exports to Vietnam, for example. The next question shows that output, or revenue, is basically equivalent to total sales to all destination countries, including domestic sales. All expenditures are set at a level equivalent to all income, and this is rewritten as functions of trade cost.

We want to find out the extent to which ROO affect trade within regions. We control for MFN tariffs and whether a country is a member of an FTA. We also estimate whether ROO are equivalent to tariffs. To determine an FTA's margin of preference, the tariff margins that can be enjoyed and how much to pay to comply with the ROO must be calculated. We estimate the value of the cost, which is equivalent to the tariff. If the margin of preferences is higher than the cost of complying with the ROO, then proceeding with it will be considered, otherwise, it would not.

We also carry out tariff ad-valorem equivalent of ROO by using a standard semi-log equation.

### Estimation Strategy

So we estimate trade value as a function of MFN tariffs, regional trade agreements (RTAs), and ROO.

Let $$t_{ijk}^{MFN}$$ be the MFN tariff rate on product $$k$$ applicable to trade between $$i$$ and $$j$$, $$I_{ij}^{RTA}$$ is a dummy variable marking preferential trade (for any RTA), where $$l$$ indexes the various forms of ROOs (Change in Tariff Classification, local content, and others)
$$x_{ij}$$ stands for gravity equation control variables such as distance, common border, common language, and common colonizer.
Where $$\delta_i$$, $$\delta_j$$, and $$\delta_{(s(k))}$$ are respectively exporter, importer, and sector (HS4) fixed effects, $$s(k)$$ being the HS4 sector to which HS6 product $$k$$ belongs.

### Data

The main data source is ROO data in the form of precise requirements for the HS-6 digit products which were provided by the ASEAN Secretariat.

Trade data in thousands of U.S. dollars are from the BACI database which are based on COMTRADE data but reconcile direct export and mirrored import data.

Trade data cover 1,241 HS-4 digit or 5,180 HS-6 digit product lines for 185 exporting countries and 108 importing countries in 2012. HS Chapters 25, 26, and 27, which are commodities and oil products, are excluded. This results in the number of observations at 4.4 million for all products and 3.96 million for manufactured products.

Gravity variables are from the BACI-CEPII's database.

### Empirical results

We work at the HS6 level of data and also use other gravity control variables such as distance, common border, common language, and common colonizer.

Baseline results are presented here. Columns 1 and 2 present estimates for the whole sample, while column 3 presents results for manufactured products only. For readability, the table is split into two parts: the first with standard gravity control variables plus tariff and RTA markers and the second with ROO coefficients only.

Here we see, the parameter estimates on standard gravity control are expected. Trade elasticity of trade to distance is -0.422, implying that a doubling in bilateral distance reduces trade by 25%. A common land border raises trade by 50% (e^0.420−1).

We can see that most coefficients are significant and that 12 out of 14 main rules are negative. Of the positive ones, the only significant ones are regional value content (RVC) and change in tariff headings (CTH). ROO in the form of RVC or CTH can actually increase trade in a region.

The findings show that the ad-valorem equivalent of ASEAN's ROO is 3.4%. If trade weight is used, it is only 2.9%. This finding is a sort of rule of thumb. If a company wants to make a recommendation for an ASEAN FTA and it is found that the margin of preferences is greater than 3.4% of the tariff, it will likely benefit. If the margin of preferences is less than 3.4%, then it is less likely to benefit.

### Conclusions

From what we have learned, ASEAN's ROO have a relatively simple and transparent structure, with 40% of them related to RVC and CTH. The textile rules seem to stand out as more inhibiting than others. The average tariff equivalent is 3.4%, or 2.9% with the trade weight.

The effects of ROO are quite heterogeneous. While the average effect is small in sectors such as electronics or capital equipment, the effect peaks in sectors such as fats, leather products, textiles and apparel, footwear, and automobiles.

We recommend the simplification and streamlining of ROO in light industries such as textiles and apparel, footwear, and prepared foods, especially as these sectors are actually the main sectors in terms of exports as well as employment creation in ASEAN.

I would like to repeat some of the more important findings. The cost of using FTAs is about 3.4%, which is not small considering the size of tariffs. The lower the cost, the higher the FTA usage rate will be. We would like to see the application of ROO that do not give rise to high cost.

The cost of using FTAs varies among products. Using FTAs entails quite high cost for textiles, footwear, and automobiles. It is very important to know how costly or not costly it will be to use FTAs.

Dr. Ing uses a very good empirical framework, that is, a gravity model. With this, she finds that distance is very important in terms of determining the size of bilateral trade. This is very important work, and it requires very detailed work.

### Q&A

Q1. Is your data just for one year, or do you have several years of data? ROO are introduced as a dummy variable. There are many combinations of ROO. What is the reference? In the case of an FTA dummy, for example, there are usually countries without one, so something else is needed to make a comparison.

My second question is related. Some of the findings from your estimation have positive values, but you would expect some negative values, as the higher the cost of ROO is, the lower is the bilateral trade. CTC and RVC, as well as CTH and RVC, have positive correlations, but ROO are supposed to discourage trade. What you are using as the base for your comparison?

Perhaps you can address my next questions in the future rather than responding at this moment. Can you say which FTAs are more restrictive than others? For example, is the AFTA less restrictive than one of Japan's FTAs in terms of the ROO?

ROO are sometimes very difficult to satisfy for small firms as opposed to large firms. So if you could obtain some information on this use, could you say how restrictive ROO on small and medium enterprises (SMEs) are as opposed to large corporations? If you could ascertain restrictiveness by size of firm, it would be very interesting.

Companies learn how to use FTAs over time. I wonder whether you can formulate an estimation for 2010, for example, and then also for 2013 or 2014, as I'm interested in knowing whether the restrictiveness declines over time as companies learn how to use FTAs.

My last query concerns self-certification versus third-party certification. As you know, under the Trans-Pacific Partnership (TPP), there would be a self-certification regime for ROO, while Japan is involved in third-party certification for many FTAs. How is this related to the restrictiveness of ROO?

Do you support the Indonesian president's decision to join the TPP?

Lili Yan ING
We used one-time data for 2012, because most ASEAN+1 FTAs started in 2010, and we thought that if we used 2011 data, the time frame would be too short. Related to your last questions, those are good suggestions. If we conduct further study, comparisons with the periods would be a good idea, but usually there is a two-year lag for trade data. We chose the 2012 data because they were made available in 2014, meaning that they were the latest data.

Regarding the references, they consist of countries that do not have any FTAs. If a country is not a part of any FTA, that becomes a reference. We compared restrictiveness with a country that is not a member of any FTA.

Concerning RVC and CTH, yes, this is quite interesting in the sense that we expect ROO to be able to actually restrict or limit the use of FTAs. In fact, however, it is interesting that the use of RVC or CTH can actually increase trade in the region. For example, think about automobile production. Thailand is the largest exporter of automobiles among the Southeast Asian countries. Thailand uses steel from Japan and compressors from Indonesia. The particular ROO that apply in that case can actually increase trade in the region because they will limit trade with non-member countries and will lead to the creation of trade among FTA members.

Which FTA is less restrictive? We don't want to make comparisons across ASEAN+1 FTAs as we prefer to work on the subsectors so that we can provide more general, neutral recommendations.

By size of firm, we don't have access to data on the restrictiveness of ROO. We would like access to such data, but even the ministers of trade in certain countries only have limited knowledge on the use of FTAs. Japan is very good in terms of recording, so it would be good if we could get such data from Japan. Then we could see the difficulties that SMEs face.

Regarding the learning process, the model can only reflect changes if there actually are changes in the tariff elimination. If there are changes in MFN or tariff preferential rates, they can be reflected in the model.

When it comes to the TPP, there is a huge debate in Indonesia. I am not a big fan of the existing TPP. I think the inclusion of extensive of lifetime plus 70 years of intellectual property rights (IPR) and 20 years of patents and Investor State Dispute Settlement (ISDS) may create unnecessary costs for society. There is still an ongoing debate about how Indonesia should address this issue. My recommendation to the government at the moment would be to find the good points about the TPP and the points that the country should address. Indonesia has about three years to learn about joining the TPP before finally deciding to do so or not.

Regarding self-certification, personally, I prefer to have an independent third-party certification versus self-certification. Multinational companies always perform self-certification well but it does not necessarily mean that society benefits. I believe in independent third-party systems instead of self-certification systems.

Q2. Regarding the 3.4%, is there any other data, for the North American Free Trade Agreement (NAFTA), for example?

Lili Yan ING
Considering that the rule of thumb is that the international cost of compliance with ROO is between 3% and 5%, 3.4% is relatively less restrictive or low. Sometimes the cost goes up to 6.5%. In most countries, including the Organisation for Economic Co-operation and Development (OECD) countries, it is 3%-5%. However, we should compare this with the margin of preference of tariff, and then 3.4% could be something we would have to think about further reducing.

Q3. Compared to what you have mentioned on ASEAN's ROO, what is your evaluation of the new TPP's points on the ROO, as far as you know? Do you have any idea on any differences?

Lili Yan ING
The TPP articles were just released, and there's still an ongoing process to scrub parts of it. So, unfortunately, with the limited information I can hardly compare the existing ROO. Once the formal and official ROO in the TPP are published, then we can see the comparisons. From what I learned, TPP will adopt a full cumulation of ROO.

Q4. You mentioned that full cumulation is theoretically useful but practically difficult because manufacturers do not want to disclose inputs. Partial cumulation has been put in place in the ASEAN Trade in Goods Agreement (ATIGA). Do you think there is a possibility for ATIGA to introduce full cumulation? Also, the TPP has introduced full cumulation. Could you share your observation on that, and let us know whether you think it will work or not?

Lili Yan ING
Theoretically, full cumulation will provide more benefits for businesses. Full cumulation will work, but I think the likelihood of it being used is very low. Not so many businesses are likely to use it. Regarding ATIGA, many companies are operating in developing countries so it is quite difficult for them to comply with full cumulation. I think that is why they choose partial cumulation. So I think the likelihood of full cumulation working is very small.

Q5. Your quantification of the restrictiveness of ROO had a clear impact on us. Do you use the tariff margins in RTAs? What about the difference between the tariff rates of each FTA and MFN rate? Tariff margins and ROO have a very close relationship and have a strong effect on each other. Also, how do you identify the impact of dummy variables in RTAs and ROO?

Lili Yan ING
You highlight a very important point. We include margins of preferences by looking at the interactions between RTAs and tariffs. Based on the General Agreement on Tariffs and Trade (GATT) Article 24, most of the intra-trade block members apply tariffs at 0%. In ASEAN in particular, by 2010, 98% of the HS product lines at the HS6 level were already eliminated, meaning that tariffs already were zero. So only using MFN tariffs makes my life easy. That is basically the point.

Q6. You showed the cost of ROO by product. Have you compared this cost with the actual reduction of tariffs?

Lili Yan ING
We would like to do that. We would like to see how costly tariffs are in terms of how much compliance with of ROO costs. Some ROO are quite strict. They should be simplified in some sectors.

Q7. Have you compared the effects of AFTA with the effects of NAFTA, in terms of increases in the trade amount of trade value?

Lili Yan ING
I have not done any particular studies on that.

Q8. I think that ROO are utilized in terms of facilitating trade in a region, but there are also the political and economic aspects of hindering trade and monopolizing the region. Does a high level of utilization mean that there is a political intention there, or is it only due to inefficiencies? How should we interpret your data?

Lili Yan ING
Compared to other regional blocs, in particular in the South, East Asian and Trans-Pacific regionalism have several distinguishing features. NAFTA and the EU association/partnership agreements were arguably of a hegemonic nature; for instance, the EU Association agreements with some of its Mediterranean partners mandate the harmonization of NTMs on EU standards; similarly, ROO in both NAFTA and the EU's Paneuro system have been largely dictated by the northern partner (the United States and the EU respectively). They were also characterized by strong hub-and-spoke trade structures. By contrast, East Asian/Pacific regionalism brings together a multipolar region with several economic and political heavyweights, including Japan, China, and the United States, and a number of mid-size but politically sophisticated partners such as Korea, Australia, and New Zealand. Second, and perhaps most importantly, a large chunk of the region's trade is in manufactured products (e.g., electronics) characterized by economies of scale and the prevalence of large firms organized in cross-border value chains. Together, these features imply that the political economy of ROOs is likely to be quite different from that in NAFTA or the EU partnerships.

Q9. What do you think about the TPP? It excludes non-member countries.

Lili Yan ING
I am not a major fan of the existing TPP. It is very wrong in the way that the United States tried to exclude China from the group. When it comes to trade of East Asia, it is impossible if we want to put China aside. I hope that the ASEAN+6 trading partners or the so-called RCEP will be concluded to provide mitigation for the TPP.

*This summary was compiled by RIETI Editorial staff.