OUR RESEARCH
THE UK’S PREFERENTIAL TRADE ARRANGEMENTS IN A POST-BREXIT WORLD – CAN TRADE REALLY BE “FREE”?
Trade negotiators will generally use the term “free“ trade agreements to describe their work. In reality, however, when it comes to trade in goods no trade agreement other than a customs union is ever truly free. All fall short in some respects of leaving traders with no costs related to that trade:
- Few agreements remove all tariffs at the date of entry into force. Many only reduce tariffs to a lower preferential level rather than removing them altogether, or only reduce to zero over an extended period, frequently in excess of 10 years. Some exclude certain goods or sectors from any reduction at all. In reality, to pass the most basic of tests of “free”, an FTA only needs to cover “substantially all trade”.
- Even if tariffs are removed entirely, goods need to pass rules of origin in order to qualify for preferential access. Rules of origin are not created in a vacuum; the rules are negotiated by the partners to the agreement and are subject to a range of pressures that result in some restrictive outcomes that producers can struggle to meet. As a result, utilisation rates of preferences often fall well below 100 per cent.
- And even if the tariffs are set at zero and are subject to liberal rules of origin, exporters and importers will still be required to demonstrate compliance with the terms of the agreement – and this will always have a cost, either in terms of the actual cost of obtaining the documents required or in the time required to meet those requirements. Over time, there can also be costs associated with post-import verification of origin claims.
Tariff Removals or Reductions
In many trade negotiations, one or other of the parties will enter with a stated aim of removing all tariffs on imports from their FTA partner(s) at the date of entry into force of the agreement. Frequently, this level of ambition is not matched by their FTA partners, and the path of the negotiations moves towards finding a balance between the parties’ positions – within the tariff outcomes themselves and/or across the agreed outcomes over the full breadth of the agreement (trade in services, investment provisions, etc).
The WTO sets a broad standard for tariff elimination in determining whether a free trade agreement should be considered to be valid and genuinely comprehensive. It refers to agreements needing to cover “substantially all the trade” between the parties, generally taken to mean at least 90 per cent of the trade, and for implementation of the arrangements to be completed within a “reasonable length of time”[1]. The WTO later clarified this by agreeing that the “reasonable length of time” should generally be no longer than 10 years[2], and has generally recognised that “substantially all the trade” should be taken to mean at least 90 per cent of the trade between the parties.
Case Study - EU-Canada Comprehensive Economic and Trade Agreement (CETA)
The EU-Canada Comprehensive Economic and Trade Agreement (CETA) represents one of the more ambitious and comprehensive tariff outcomes in free trade agreements. However, CETA didn’t deliver total elimination of tariffs between the EU and Canada at entry into force. The two parties agreed to remove tariffs between them on the vast majority of goods, with the EU eliminating tariffs on 97.7 per cent of all goods at entry into force of the agreement and Canada eliminating tariffs on 98.2 per cent of goods at the same time. For industrial goods, the EU eliminated tariffs on 99.4 per cent of tariff lines at entry into force of the agreement, while Canada eliminated tariffs on 99.6 per cent of lines. All tariffs on industrial goods will eventually be eliminated by both sides. Tariffs will be gradually eliminated on some sensitive automotive goods and, in the case of Canada, ships, over a period of seven years.
In the case of fisheries and agricultural goods, however, there are a number of restrictions and exclusions. While Canada removed all tariffs on fish at entry into force of the agreement, the EU retained tariffs on 4.5 per cent of fisheries lines. These tariffs will be eliminated over seven years, but some trade in fish will remain subject to tariff rate quotas (TRQs). Both sides retained some tariffs on agricultural goods at entry into force of the agreement – 9.1 per cent of lines in the case of Canada and 7.8 per cent of lines for the EU. This will reduce to 8.3 per cent of lines for Canada over seven years, and 6.2 per cent for the EU. But TRQs will apply for several goods, and both sides excluded chicken and turkey meat and eggs and egg products from the tariff commitments.
Case Study - EU-Japan Economic Partnership Agreement (EUJEPA)
The EU-Japan Economic Partnership Agreement (EUJEPA) came into effect in March 2019, and is significant as a comprehensive trade agreement between two of the world’s major manufacturing and trading powers which have struggled to accommodate domestic sensitivities. While both the EU and Japan are essentially low tariff economies, both have a number of high tariffs, particularly in agricultural goods. The European Union’s MFN applied tariffs average 5.2 per cent, but tariffs on agricultural goods average 12.0 per cent. In the case of Japan, MFN applied tariffs average 4.4 per cent, with tariffs on agricultural goods averaging 15.7 per cent (source: WTO World Tariff Profiles 2019).
The agreement saw Japan eliminate tariffs on 86 per cent of EU tariff lines at entry into force, with tariffs being eliminated on 97 per cent of tariff lines by the end of the 20 year implementation period. However, the agreement included no tariff reductions on Japanese rice imports and tariffs are to be reduced but not eliminated on many goods, including beef and footwear. For its part, EU set a staging period of up to 15 years for elimination or reduction of some tariffs. Import quotas are to be removed on some goods, but will remain in place, albeit with some additional access, for many goods, including cheese[3].
In 2011, a WTO analysis of FTAs[4] noted that the agreements frequently fail to deliver full tariff elimination, and that exclusions are, not surprisingly, most common for more sensitive goods, especially agricultural goods. These same products also tend to have the highest MFN tariffs. The WTO report pointed to an earlier study which found that in 15 bilateral FTAs involving four of the largest economies, the EU, United States, Canada and Japan, around 7 per cent of tariff lines were listed as excluded from either tariff reductions or elimination.
A more recent study conducted for the US Congressional Research Service noted that WTO analysis had found that of the FTAs notified to it in the period 2007-2014, tariffs had been eliminated on an average of 90.6 per cent of tariff lines, but frequently fell below 80 per cent of lines[5]. Tariff elimination averaged 93.4 per cent of non-agricultural tariff lines, but only 72.1 per cent of agricultural tariff lines. The same study found that the implementation period for tariff elimination or reduction frequently extended beyond 20 years.
Rules of Origin
Rules of origin will determine which goods traded between FTA partners will be eligible for preferential tariff treatment. They are a fundamental part of any trade agreement and their terms are uniquely negotiated for each agreement.
There is no such thing as a universally recognised “correct” rule of origin for any good. The rules can be set using a range of criteria – from the source of the materials used in production, to the nature of the processes used to transform those materials into the final good for export, to the total value added in the country of export or the FTA region. Determination of the rules are frequently subject to strong lobbying on behalf of domestic influences, and the resulting rules can lead to only low proportions of goods traded between the parties qualifying for preferential access.
A recent study of Australia’s free trade agreements found utilisation rates varying from close to 100 per cent down to less than 80 per cent[6]. For more sensitive sectors, which often see higher MFN tariffs and more restrictive rules of origin in trade agreements, the utilisation rates can be much lower. For textiles, apparel and footwear, trade under the Australia-US FTA (2004) has seen only 60 per cent of US exports to Australia and 66 per cent of Australian exports to the US qualify, while under the Japan-Australia Economic Partnership Agreement, utilisation has been 49 per cent for Japanese exports and only 24 per cent for Australian exports. For motor vehicles and parts, utilisation under the Australia-US agreement has been 70 per cent for US exports and 51 per cent for Australian exports. And for agriculture and food, the Japan-Australia agreement has seen a utilisation rate of only 35 per cent for Japanese exports.
The outcome is similar for European agreements. A study of the use of trade preferences in European agreements by industry in the Netherlands[7] showed utilisation of preferences for Dutch trade ranging from less than 50 per cent to almost 100 per cent. Rules of origin were identified as a major factor in traders being unable to take advantage of tariff preferences.
Canada’s history with free trade agreements shows interesting outcomes for preference utilisation. A study in 2012 showed utilisation rates of tariff preferences in Canada’s free trade agreements at 90 per cent, surpassed only by the United States with a utilisation rate of 92 per cent for imports under its FTAs[8]. This study was conducted at a time when Canada’s FTA agenda was almost totally dominated by NAFTA and predates the implementation of Canada’s FTAs with Korea and the EU, as well as conclusion of the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP). In many respects, the high preference utilisation rates under NAFTA highlight the potential that FTAs offer for economies with already highly integrated production chains and where the rules of origin are negotiated with a clear aim of enhancing that integration.
Utilisation rates for Canada’s more recent FTAs so far are less impressive. Data from the EU shows that preference utilisation for its exports to Canada under CETA reached only 36.7 per cent of eligible goods in 2018 – although the EU notes that this was the first full year since the implementation of the agreement and the tariff preferences are yet to be fully implemented[9].
Rules of Origin for Textiles and Apparel
The textiles and apparel sector has frequently been subject to very restrictive rules of origin, with both the EU and US insisting on tough rules in their preferred templates for rules of origin regimes. For clothing, the EU generally pushes for a “double transformation” rule, meaning imported materials need to go through two substantial stages of transformation to qualify for preferential access – eg imported yarns need to be formed into fabrics and those fabrics cut and sewn to make the apparel all within the FTA region for the clothing to qualify.
In the case of the US, the preferred rules are even more rigorous, with the prevailing rule being referred to as “yarn forward”. This means that in most cases, the US pushes for yarns to be spun, fabrics woven or knitted and then cut, sewn and assembled into apparel all within the FTA region for the apparel to qualify for preferential access.
These rules are generally the result of strong lobbying to protect long established domestic industries. In the case of the US, yarn forward rules work in the interests of domestic cotton and synthetic fibre producers and weaving mills. However, parts of the US textiles and apparel industry – especially clothing manufacturers – argue that these rules do not reflect changes that have taken place in manufacturing and trade in recent decades. They point to low preference utilisation rates for US apparel exports in a number of its FTAs as proof of this – that increasingly, US clothing manufacturers are making use of imported yarns and fabrics in the face of lack of local materials at competitive prices.
The 2012 WTO study referred to earlier highlights a number of the factors impacting on preference utilisation, including the effect that more stringent rules of origin can have on access. The study found that for imports to the US under its FTA with the Dominican Republic and Central America, textiles represented the sector with some of the highest potential benefits – in terms of tariff reductions and value of trade – but with low utilisation rates, ranging from a low of 9 per cent of eligible imports to a maximum of just 65 per cent. This was despite the overall utilisation rate for this agreement being 82 per cent of eligible imports[10].
Customs Procedures and Trade Facilitation
The impact of administrative requirements and other non-tariff measures in trade is well-recognised. Non-tariff measures frequently add more to trade costs than tariffs, especially in trade between developed countries. The World Bank conducts annual surveys of the cost – in time and money terms – of meeting the shipping, documentary and border compliance requirements of trade. It estimates that these average 15 hours and around US$170 per export shipment for high income OECD countries. For the UK, the average for export is 28 hours and US$305 per shipment[11].
There has been considerable work done on addressing non-tariff issues at the multilateral level by the World Trade Organisation, through the work of the Committee on Technical Barriers to Trade and the implementation of the Trade Facilitation Agreement (TFA). In terms of the role of non-tariff issues in bilateral and regional free trade agreements, there are two elements to be considered – the extent to which FTAs can complement the work of the WTO in further reducing costs beyond the level associated with MFN trade, balanced by any additional costs arising from meeting the requirements for preferential trade access.
The facilitation costs of trade are a factor in all trade relations. A 2011 OECD study considered the impact of trade facilitation costs on its members in 2011 and concluded that these added around 10 per cent to trade costs[12]. In considering the value of implementing all the provisions of the Trade Facilitation Agreement, the WTO confirmed the impact of trade facilitation costs, finding that full implementation of the agreement could reduce trade costs for developed countries by around 11 per cent, between 13 and 15 per cent for developing countries and more the 16 per cent for the least developed countries[13].
However the Trade Facilitation Agreement is not perfect, in that it doesn’t cover all administrative and compliance costs associated with trade. Bilateral and regional free trade agreements can serve to reduce the facilitation costs of trade, and in doing so complement the effect of implementation of the Trade Facilitation Agreement. FTAs can expand on the efforts of the WTO by bringing forward the implementation of the TFA commitments between parties to an FTA, as well as addressing non-tariff issues not covered by the TFA. The problem is that an FTA can include its own facilitation costs and in doing so counteract the efforts to reduce administrative burdens and costs.
Modern FTAs are successful in picking up the slack between the TFA commitments and seamless trading across borders, with almost all FTAs involving developed economies now including provisions on trade facilitation. However, the record is patchy, and FTAs fall far short of offering the sort of facilitative environment that countries would find under a customs union.
The 2015 WTO report found that less than half of all FTAs had commitments requiring importing customs agencies to provide binding rulings on tariff classifications for imported goods and barely a third included commitments to implement a system of electronic submission of import documentation between FTA partners. Fewer still provide commitments to putting in place enquiry points for trade issues or even committing to publishing import regulations on the internet. Less than 20 per cent commit FTA partners to pre-arrival processing of documentation or guaranteed release times for imported goods[14].
All of these measures are fundamental to ensuring certainty in trade and rapid movement of goods across borders. These types of measures are key to keeping down costs of production and trade. For businesses that have previously manufactured and traded under customs union conditions, their absence in future trading arrangements can represent an additional cost burden.
Lack of harmonisation of international standards and other product requirements can limit the capacity of countries to make consistent commitments on such issues across their FTAs. And even where all of a country’s FTAs include mutual recognition of standards and testing regimes, this can still require producers to manufacture according to a range of different standards for their various export markets, adding to production costs.
The integrity of any free trade agreement is dependent upon a credible system of verification. Verification is essential to insure that goods traded under preference genuinely meet the terms of an agreement and help to ensure that the benefits of an FTA accrue mainly to the partners of the agreement. They protect industries from unfair competition. However verification comes at a cost to those involved in the trade, with manufacturers and exporters needing to trace and check their compliance. Whether this requires obtaining an origin certification from a government or industry authority, or simply retaining the necessary records to self-certify goods with confidence, traders will be faced with expenditure of time and money.
Where an FTA requires that exporters obtain a certificate of origin from a government agency or other body, the cost can be significant – several bodies in the UK can issue certificates of origin and mainly charge between £30 and £50 for the service. In addition there is the time involved in applying for certifications – a small survey of UK exporters using certificates of origin for trade with Europe conducted in 2018 by the UK Trade Policy Observatory found that those companies surveyed estimated that they spent 20 to 30 minutes per shipment on tasks associated with obtaining a certificate[15].
While free trade agreements will generally include provisions that improve coordination of trade-related administrative requirements between the partners, in most cases, the costs associated with demonstrating compliance with the requirements for preferential access will be greater than for trading under non-preferential arrangements. In other words, the benefits of gaining preferential access are likely to come with costs associated with demonstrating compliance with the terms of that access. And these costs will certainly be greater than the costs associated with trading across the essentially open borders of a customs union.
Conclusions
The UK’s exit from the European Union will alter the cost of buying from and trading into Europe. Even if the UK and EU negotiate a high quality free trade agreement, there may be additional costs to UK manufacturers and consumers in the form of tariffs on some goods, and prices will be affected by the administrative arrangements put in place to protect the integrity of the agreement and the two parties’ broader trade arrangements. Any remaining tariffs may disappear over time, but there will be direct price impacts until this occurs. The competitiveness of British products seeking to enter European markets will be negatively impacted.
On the plus side, the UK will be free to pursue new FTA arrangements of its own, but these will also come with their own costs and may in any case not deliver totally tariff-free trade, at least for a number of years. And as the UK’s trade policy sees it entering into more preferential trade arrangements, and its manufacturing and trade arrangements increasingly diverge from those of the EU, there will be greater focus placed on shipments crossing between the UK and the EU as both sides seek to ensure the integrity of their broader trade arrangements. This will inevitably put even greater pressure on the cost of trading across the Channel.
All this makes it absolutely crucial that UK business and consumer groups be an active part of the development and implementation of the UK’s new trade policy. Business and consumers are the key stakeholders in the UK’s future trade policy. We cannot expect that the ease of trade and the cost of trade with Europe can ever match that of working as part of a customs union. New trade opportunities with the rest of the world may ultimately compensate for this. The challenge is to ensure that the UK’s planning and negotiating strategy maximises the likelihood of the most positive outcome.
Footnotes
[1] WTO, General Agreement on Tariffs and Trade (GATT 1947), Article XXIV
[2] WTO, Understanding on the Interpretation of Article XXIV of the General Agreement on Tariffs and Trade 1994, para. 3
[3] Breugel, The EU-Japan Economic Partnership Agreement (2018)
[4] WTO, World Trade Report 2011 - The WTO and Preferential Trade Agreements: From Co-existence to Coherence, p 61
[5] Williams, B R, Bilateral and Regional Trade Agreements: Issues for Congress (US Congressional Research Service, 2018), p 43
[6] PWC, Free Trade Agreement Utilisation Study (2018)
[7] ECORYS, Study on the Use of Trade Agreements (2018)
[8] Keck, A. & Lendle, A, New Evidence on Preference Utilization (WTO Economic Research and Statistics Division Staff Working Paper ERSD-2012-12, Sept 2012), p. 22
[9] European Commission, 2019 Annual Report on the Implementation of EU Trade Agreements
[10] Keck, A. & Lendle, A, pp. 27-28
[11] World Bank Group, Doing Business 2020
[12] Moïsé, E., Orliac, T. and Minor, P., Trade Facilitation Indicators: The Impact on Trade Costs, OECD Trade Policy Papers, No. 118
[13] WTO, World Trade Report 2015 - Speeding up trade: benefits and challenges of implementing the WTO Trade Facilitation Agreement, p. 79
[14] WTO, World Trade Report 2015, p. 45
[15] Holmes, P. and Jacob, N., Certificates and Rules of Origin: The Experience of UK Firms, UK Trade Policy Observatory, Briefing Paper 15, January 2018.
References
Breugel, The EU-Japan Economic Partnership Agreement, Policy Department, European Union Directorate General for External Policies, 2018
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ECORYS, Study on the Use of Trade Agreements, 2018
European Commission, 2019 Annual Report on the Implementation of EU Trade Agreements
Holmes, P. and Jacob, N., Certificates and Rules of Origin: The Experience of UK Firms, UK Trade Policy Observatory, Briefing Paper 15, January 2018
Keck, A. & Lendle, A, New Evidence on Preference Utilization, WTO Economic Research and Statistics Division Staff Working Paper ERSD-2012-12, September 2012
Moïsé, E., Orliac, T. and Minor, P., Trade Facilitation Indicators: The Impact on Trade Costs, OECD Trade Policy Papers, No. 118
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OECD, Regional trade agreements and agriculture, OECD Food, Agriculture and Fisheries Papers, No. 79, OECD Publishing, Paris
PWC, Free Trade Agreement Utilisation Study, 2018
Williams, B R, Bilateral and Regional Trade Agreements: Issues for Congress, US Congressional Research Service, 2018
World Bank Group, Doing Business 2020
World Trade Organisation, The Legal Texts: The Results of the Uruguay Round of Multilateral Trade Negotiations, 1999.
World Trade Organisation, World Trade Report 2011 - The WTO and Preferential Trade Agreements: From Co-existence to Coherence
World Trade Organisation, World Trade Report 2015 - Speeding up trade: benefits and challenges of implementing the WTO Trade Facilitation Agreement
