News and Analysis • Volume 12 • Number 3 • May 2008

The Local Content Paradox at the WTO: A Minor Lapse or Lapse or Organised Hypocrisy?

Do More

See also

Contradictory provisions on the use of local content requirements under WTO rules on investment measures on the one hand, and preferential trade arrangements on the other, raise legitimate questions about developed country adherence to the principle of comparative advantage.

The multilateral trading system is largely founded on the concept of economic efficiency. One example of this is the preference of the drafters of the General Agreement on Tariffs and Trade for tariffs rather than quotas as a means of protection against imports. Even trade measures imposed for health or safety reasons must pass the test of being both ‘necessary’ and the ‘least trade-restrictive’ possible. Among the dozens of WTO treaties, the Agreement on Trade-related Investment Measures (TRIMs) is the most sanguine about economic efficiency as the guiding principle of rules-based international trade.

Local Content Requirements Prohibited under TRIMs

The TRIMs Agreement, introduced during the Uruguay Round, banned the imposition of ‘performance requirements’ – a hallmark of industrial policy between the 1960s and early 1980s, and one extensively used by East Asian countries. Among the prohibited measures on the ‘illustrative list’ annexed to the TRIMs Agreement are so-called ‘local content’ requirements.

The prohibition of local content requirements – despite their potential contribution to industrial development – is based on the notion that they are an ‘economically inefficient’ mechanism to protect or promote domestic industry. This theory holds that investors in any country should be free to source the components of their manufacturing processes abroad if foreign inputs are cheaper and arguably better in terms of quality than local ones. The underlying assumption, of course, is that local inputs are necessarily less cost-effective.

Developing countries reluctantly agreed to this clause (and many other unfavourable conditions, see box on page 15) because they considered such concessions as part of a bigger deal, namely the promise of significant gains in agriculture, as well as in textiles and clothing.

TRIMs and some other WTO agreements, such as that on subsidies and countervailing measures, restrict the ‘policy space’ of developing country governments to use industrial policy as a tool for economic development. This shows that the demandeurs of these agreements are opposed to the very idea of an ‘active’ industrial policy – never mind that it played an essential part in their own industrialisation strategies.

Rules of Origin in Preferential Trade Require Local Content

Preferential trading arrangements were incorporated into the GATT through the 1979 Enabling Clause, which allows developed countries to grant ‘more favourable treatment’ to developing countries than to other participants in the multilateral trading system. To put this principle into practice, developed countries set up Generalised Systems of Preferences (GSPs).

While these schemes provide considerable market access advantages to the recipients, they are grounded in the donors’ own priorities and granted on a unilateral and non-reciprocal basis. To ensure that no other countries would take advantage of these opportunities, GSP providers introduced ‘rules of origin’, which, according to the donors, were meant to serve two main purposes. First, they were designed to prevent trade deflection. Second, couched in more altruistic terms, the rules were intended to help developing countries create an industrial base by making use of only ‘local inputs’ in the manufacturing process.

This, it was argued, would allow countries with low levels of industrialisation to develop vertically integrated production structures by building up domestic manufacturers’ supply capacity. There is, however, no evidence to suggest that these rules have helped beneficiary countries achieve this objective.1

What the rules of origin have done instead is to restrict the utilisation of preferences so that competition from these relatively weaker countries does not displace import-competing sectors in the donor countries. According to studies commissioned by the UN Development Programme, the preference utilisation rates of four Asian least-developed countries (LDCs) under the EU’s Everything but Arms initiative is 60 percent for Bangladesh, 68 percent for Cambodia, 70 percent for Laos and 67 percent for Nepal.2

The cost of complying with the preferential rules of origin is not trivial. Although there is relatively little hard empirical evidence on the issue, Jan Herin has estimated that for firms wishing to take advantage of preferences under the EFTA-EC FTA, the administrative and technical work needed to achieve compliance with the rules of origin added around 5 percent to the cost of production.

Similarly, according to the World Bank, the administrative cost of providing the documentary evidence to support the certificate of origin under the North American Free Trade Area (NAFTA) is in the range of 1.8 percent of the value of exports. The distorting impact of the rules – resulting from the need to use higher cost local (or donor) inputs to qualify – may be equivalent to an average duty of around 4.3 percent. While separate statistics are not available for developing and least-developed countries, it is fair to assume that such figures are much higher for LDCs since their administrative and bureaucratic requirements for trading across the border are notoriously burdensome.

Protectionist interests in developed countries are well-known for their ingenuity in turning such mechanisms to their benefit. For instance, donor country manufacturers of inputs (yarn, textiles or fabrics) entering into the production of apparel in recipient countries successfully lobbied their governments to incorporate a ‘cumulation’ provision in their GSP schemes. This provision allows apparel to be exported under preferential rates to GSP-granting destinations even if the finished products contain elements manufactured in the donor countries (instead of just local inputs as originally foreseen).

The local content requirement combined with the cumulation exception serves two purposes. First, it prevents exporters to GSP markets from using raw materials from the lowestcost suppliers, such as China, which directly compete with donor country products. Second, it provides a captive market for GSP provider inputs in the recipient countries’ manufacturing processes.

The famous ‘yarn forward’ requirement – contained in a majority of US preferential arrangements and a similar clause in the EU arrangement – helps protectionist interests achieve both of these objectives.

With regard to limiting third-country input, the US National Council of Textile Organisations warned the government against extending full duty- and quota-free market access to LDCs just prior to the WTO’s 2005 ministerial conference in Hong Kong. The organisation’s president Cass Johnson was quoted as saying: “With duty-free status, Chinese penetration of the US market would increase dramatically as US apparel imports would shift away from Western Hemispheric producers that use US-made components to producers in Bangladesh and Cambodia that would be using Chinese-made components.” 3

As to the second objective of safeguarding captive markets, Munir Ahmed pointed out in December 2005 that as of 2004, 77 percent of US fabric and textiles exports went to Mexico and Caribbean/Central American countries, which had preferential trading arrangements with the US. In the same period, 37 percent of European textiles were exported to Bulgaria, Romania, Tunisia, Morocco and Turkey – all which benefited from preferential market access to the EU.4

The issue of preferential rules of origin has never been resolved at the WTO, despite a clearcut end-1999 deadline for its settlement. It has once again gained prominence in the aftermath of WTO Members’ Hong Kong promise to grant duty- and quota-free market access (in principle at least) to least-developed countries. Nevertheless, the ministerial declaration’s call to ensure that preferential rules of origin applied to LDC imports are ‘transparent and simple’ and contribute to ‘facilitating market access’ remains a tall order in view of developed countries’ reluctance to antagonise their protectionist lobbies, which thrive on the complicated rules of origin that clearly favour local or donor inputs.

However, when we look at the TRIMs Agreement, which prohibits governments from requiring firms to use local inputs, we can legitimately question developed countries’ motivations. Under a benign interpretation, we can call the TRIMs restrictions a ‘minor lapse’. Seen from a less benevolent angle, they are nothing more than ‘organised hypocrisy’.

Ratnakar Adhikari is President of South Asia Watch on Trade, Economics & Environment (SAWTEE) in Kathmandu.

ENDNOTES

1 WTO. 2005. Options for Least-developed Countries to Improve Their Competitiveness in the Textiles and Clothing Business. WT/COMTD/LDC/W/37 2 Raihan, Selim; Adhikari, Ratnakar and Adhikari, Kamalesh. 2007. Export Diversification for Human Development in the Post-ATC Era: Perspectives from Asian LDCs. UNDP. Colombo 3 NCTO Press Release, 12 December 2005 4 Ahmed, Munir. 2005. Development in Textiles and Clothing Trade, Post ATC: Modelers Off Mark; EU/US Trade Policy Remains Predominant Influence. UNDP. Colombo