Where does your iPhone come from? You bought it online from Amazon UK, as you found there a good deal, and it was delivered to your home address in a couple of days. It was assembled in China, as you can read on its back, but proudly “Designed by Apple in California”. Cupertino, to be precise. But if you zoom into its production process, you will find out that it is not entirely “Made in China”. The battery, together with other components, is Chinese. However, the display, as well as the camera (by Sony), is Japanese. Memory and GPS come from the US, while the baseband from Germany. Icing on the cake, the processor is by Samsung, South Korea. And this is only part of the story. What about the inputs of intermediate goods? They are themselves imported. And what about the money flows behind the import flows? Ownership does not necessarily coincide with the location. Thus, it should not surprise that eventually, it is a Taiwanese company (Foxconn) that assembles iPhones in China. But after all, does it matter where it is from? You are sitting on your sofa, playing around with the phone you have just unpackaged, priced 809 € on the Apple website, and paid out 590 €, not a bad deal. Why should you care about its origin? Well, they do influence the final price.
Rules of origin: a passport for goods
It is not only about reducing production costs. Supply chain fragmentation happens to be crucial when it comes to trade policy. The legal origin of a product is essential to determine, for example, whether it can benefit from preferential tariffs, following a bilateral trade agreement, or whether it is exempted from anti-dumping duties imposed against specific countries. In these cases, rules of origin (ROO) are the answer. Rules of origin are specific provisions applied by a country to determine the origin of goods, which could be different from where they have been shipped. The need to establish an “economic nationality” of traded products stems from the fact that trade policy measures (e.g. tariffs, quotas, anti-dumping duties) depend on the product’s country of origin, which – as the iPhone example shows- cannot be reliably inferred from the point of entry. Under the North American Free Trade Agreement (NAFTA), for instance, Mexico, Canada, and the United States eliminated duties on each other’s exports, while imports from other countries continued to face tariffs. Without rules of origin, goods manufactured in countries different from Mexico and Canada could circumvent US import tariffs simply by being trans-shipped through or repackaged in one NAFTA member country on their way to the States. Free Trade Agreements (FTAs) thus use ROO to distinguish goods originating from member countries, which are eligible for preferential tariffs, from those from third countries.
ROO save the Queen
Preferential tariffs can distort sourcing decisions, as they contribute to lowering import prices by boosting foreign demand. Complying to rules of origin, though, might be costly for exporters. Moreover, the criteria adopted in these rules differ from country to country, from FTA to FTA, making ROO a controversial topic. Not surprisingly, rules of origin have also been one of the most debated issues in Brexit talks. To benefit from the preferential tariff treatment negotiated under the UK’s deal with the EU (i.e. the Trade and Cooperation Agreement, TCA), UK exporters will have to comply with the preferential rules of origin’s requirements. Namely, they will need to prove that the product that they are selling comes from the UK according to the rules agreed in the FTA. The EU membership and, since February 2020, the participation to the European Customs Union removed these obligations, as all countries in the Customs Union faced by law common external tariffs. However, as the UK has not entered in a new Customs Union after Brexit, Rules of origin would lead the game, with expensive consequences.
Typically, for preferential origin, the exporter country must contribute to around 50% of value-added of the product to claim its origin. The tolerance levels set by the TCA depend on the product type. For example, rubber and plastic articles must not exceed 50% of foreign value-added. For cereals, the production should use materials that are wholly obtained. Special ROO apply for a limited trade volume for certain fisheries products and aluminium products.
One of the worst fears of British producers was that, after Brexit, there would have been no more a European value-added for products exported by the UK, but UK and EU value-added will be separated. Consequently, UK products, that significantly rely on imported components, would have struggled to reach the required threshold to qualify as “Made in the UK” and claim preferential treatment. Lucky for the UK exporters, the UK and EU have agreed on full bilateral cumulation. This means that materials originating from the EU, as well as production carried out within the EU on non-originating materials, may be considered as originating in the UK (and vice versa). (1)
Red light for cars
Yet, bilateral cumulation would still not allow imports from third countries. Due to its heavy involvement in the global value chain, the British car industry is probably the most challenged one. In fact, not only the automotive sector is the UK’s largest exporter of goods (about 80% of cars were exported in 2019), but it also heavily relies on imported intermediate inputs. According to the OECD, in 2011 motor vehicles were among the three British industries with the highest foreign value-added shares in UK exports (44.4%), after Coke & petroleum (56.1%) and Basic metals (51.7%).
Imported inputs come from all around the world. Companies like Honda, Nissan and Toyota import car components from Japan to the UK to only assemble them. According to an estimate of the Society of Motor Manufacturers and Traders, 44% of average UK cars’ components originate from UK suppliers and UK value-added is around 20%. For electric vehicles, batteries can represent between 30% and 50% of the value, and they are mostly produced in China, South Korea and Japan. The European Automobile Manufacturers’ Association (ACEA) had asked a 70% threshold for non-EU and non-British parts for electric cars, against the previous requirement of 55% local value-added. The answer was clear, though. No “diagonal cumulation”, meaning that materials originating in third countries do not count to satisfy the origin rules. However, the EU agreed to allow an exemption for electric cars, but only until the end of 2026. Probably foreseeing the EU’s response, Tesla had already decided to build its first major European factory near Berlin in Germany rather than in the UK.
An expensive economic identity
Finally, proving origin is itself costly. Only for administrative costs, the 2013 Trade and Investment Balance of Competence Review estimated that British firms would face costs linked to rules of origin from 4% to 15% of the cost of goods sold. Ultimately, the unintended effect of ROO will be to make UK exporters being less price-competitive in EU markets or choosing to not export at all. Ironically, exporting under the WTO “Most Favoured Nations” clause could turn to be cheaper than preferential tariffs available under the trade agreement.
Nevertheless, the EU has proved to be flexible on the application of rules of origin. One element of flexibility comes with the self-certification of rules of origin, with collecting and maintaining information on the origin of components. Moreover, the UK and EU have agreed a 12-month grace period on rules of origin which should give firms time to adapt to the new regime. During this period, companies will be exempted from administrative obligations, but will still have to comply to ROO. Flexibility around rules of origin was deemed to be key in a highly integrated world. Yet, in a rigid Brexit negotiation process, flexibility appeared to be a challenging but possible achievement.
EU-UK Trade and Cooperation Agreement, 24 December 2020
(1) Bilateral cumulation is not specific to the TCA, but it is already present in other FTAs, like the EU-Japan FTA.