Diversified Supply Chains and Rules of Origin: Between a Rock and a Hard Place
Camille Van der Vorst is a PhD researcher at the Leuven Centre for Global Governance Studies.
The views and opinions expressed in this blog are solely those of the original authors and contributors. These views and opinions do not necessarily represent those of TradeExperettes, the TradeExperettes editorial team and/or any or all contributors to this site.
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In light of the current COVID-19 crisis, businesses are encouraged to be more resilient to external economic shocks by diversifying or reshoring their supply chains. This is easier said than done, as existing supply chains were not picked at random. Business relationships are carefully selected to create a balance between a wide range of selection criteria such as cost minimisation, product quality or delivery speed. In some cases, the supply chains of exporting businesses might even have been catered to specific Rules of Origin (RoO) that allow them to export under lower preferential tariffs to their export destinations. For these businesses, diversifying supply chains could prove to be a real challenge, where they have to navigate complicated provisions such as cumulation and product specific rules in search of new viable suppliers. This post explores one of the reasons why reorienting supply chains is such a difficult task, and suggests that businesses will face difficult choices as they assess their vulnerabilities.
COVID-19 has exposed the vulnerability of businesses that are too reliant on intermediate inputs from just one or a few suppliers. If the home countries of these suppliers are hit by a severe and unexpected shock, such as when China went into lockdown in early 2020, the downstream businesses are equally impacted by this shock. As Patrick Kirby from the World Bank illustrates, countries that are more heavily embedded in Global Value Chains (GVCs), such as Vietnam, stand to lose more from the COVID-19-induced economic crisis than others. Notably, Vietnam is one of the countries that has acquired a great stake in global supply chains through a strategy of trade agreements and lowering investment barriers. As a result, some commentators have suggested that businesses need to adapt their supply chains to be better prepared for similar shocks in the future.
Kirby argues that more geographical diversity in GVCs could be one solution to the current crisis. Inspired by similar concerns, Lucian Cernat and Oscar Guinea examine the vulnerability of EU supply chains and find that around 50% of imported products to the EU are sourced from more than 25 suppliers. Still, we can derive from this detailed analysis that there is an imminent need for many businesses to expand their supply chains if they want their own company to be able to weather the next storm. At the same time, we have to keep in mind that the circumstances of each business are unique, and that while businesses might want to expand their supply chains, this might not always be a possibility.
This is where we need to draw attention to the challenge that many exporting firms will face when they try to diversify their supply chains. Leaving aside questions such as cost minimisation or transport time, businesses that currently make use of one or more Preferential Trade Agreements (PTAs) have to be careful that they won’t lose preferential tariff treatment by sourcing from additional foreign suppliers. RoO in PTAs require that businesses keep track of the exact source of all intermediate inputs during production. This becomes more complicated and costly as the number of suppliers goes up. More importantly, suppliers might have been specifically selected so that a company fulfils the RoO requirements of the PTAs it’s using.
For example, consider a (hypothetical) European firm producing regular bar soap. A recent report by the WTO indicates that although many medical goods are subject to low most-favoured nation (MFN) tariffs, personal protective products such as soap face an average applied tariff of 11.5%. This European firm might export part of its production to Canada, where it would normally have to pay a 6.5% MFN tariff. Luckily, under the EU-Canada Comprehensive Economic and Trade Agreement (CETA) the preferential tariff is zero. The impact of this tariff reduction is reflected in the trade data— exports of bar soap from the EU to Canada (HS 3401.11) totalled 2,035 tonnes in 2018, up from 1,400 tonnes in 2014.
Now, say our hypothetical firm sources some of its intermediate inputs from outside the EU. For the manufacture of bar soap, a company might need soap in other forms, such as granules or powders (HS 3401.20.10). Our bubbly firm might source some of these intermediate inputs from a third country, as well as from a Canadian supplier. Because CETA allows for what is called bilateral cumulation, the intermediate input from Canada is not considered when calculating how much so-called non-originating inputs our SME’s soap contains. This means that the firm could still export its soap under the CETA preferential tariffs if it is able to meet the specific rules of each product.
Let’s say, that in this case it does, but unfortunately, COVID-19 has impacted the firm’s supply chains. It was heavily reliant on Canadian inputs, but shipments from Canada were delayed due to the pandemic. Production of the intermediate input from the third country were likewise stalled for months on end. To avoid similar issues in the future, our soap-exporting firm could decide to diversify its supply chains. Instead of sourcing most of its inputs from Canada, the firm could start importing from suppliers in other countries. But ultimately, each product it imports needs to be taken into account in the origin calculation which will determine where specific inputs can be obtained.
So when our firm swaps its initial inputs from Canada with new ones from other countries it had not previously sourced from, it risks no longer qualifying for preferential tariffs under CETA when exporting its product to Canada as their product may no longer meet the RoO requirements. Canada was specifically chosen as a supplier because Canadian soap granules are counted as originating inputs, which may not be the case when sourcing from different markets. In this scenario, the firm would face a choice between hedging its supply chain risk and paying the 6.5% tariff or risking similar supply shocks in the future while still being able to export tariff-free to Canada.
Based on this hypothetical soap story, some businesses will face a real balancing act. They might want to diversify their supply chains to hedge against the risk of supply shocks such as the ones we’ve seen during the COVID-19 crisis. Simultaneously, if these businesses are exporting under PTAs, they will have to carefully select and keep track of new suppliers to make sure they don’t lose originating status. Weighing these decisions are difficult choices for businesses, and not all of them are equipped to diversify. These choices are further complicated by increasing calls for reshoring production, or limiting trade to certain trusted countries. But as elaborated above, these decisions are complex, and it is vital that policy makers exercise caution in intervening in these choices by encouraging or forcing companies to source from particular locations.
It is also important to keep in mind that despite the current focus by governments and media outlets on globalisation and its supposed shortcomings, the reliance of some regions on global value chains is inflated. For example, Inu Manak and Logan Kolas at the Cato Institute point out that the United States is not nearly as reliant on imports as public discourse might insinuate. In fact, supply chain shortages were but one of many issues during a global pandemic where firms also suffered from falling demand or local lockdowns. Frank Van Tongeren at the OECD reminds us that, "While the argument about GVCs is often posited as one of efficiency versus security, OECD research illustrates that greater localisation fails to achieve either."
Governments may want to encourage local businesses to diversify their supply chains or to become more resilient, but there are limitations to these actions that must be kept in mind. Firms face many constraints, and one of these are complex RoO that they must comply with in order to benefit from preferential tariff rates. These can be a real logistical headache for businesses trading under one or more PTAs. Because of this and many other reasons, businesses are not fickle about designing their supply chains, and resilience is but one issue that they need to take into account.
Before asking businesses to divert a substantial amount of effort into redesigning their supply chains, governments may want to put an equal amount of attention into streamlining and facilitating RoOs across different trade agreements instead. Some efforts are already under way, not least because of an increasing recognition of the challenges to preference utilization in recent years, an issue that is, in part, related to a spaghetti-bowl of RoO. In August 2020, the European Commission adopted a package of proposals to make the RoO for 20 trade partners in the Pan-Euro-Mediterranean (PEM) region more business-friendly. Hopefully, others will follow suit, and work to create a more flexible environment for international business. But at the end of the day, governments must trust that businesses have the best knowledge about their unique situations, and that current supply chains exist in their current form for a reason.
The views and opinions expressed in this blog are solely those of the original authors and contributors. These views and opinions do not necessarily represent those of TradeExperettes, the TradeExperettes editorial team and/or any or all contributors to this site.