Trade & Supply Chain

The trouble with preferential treatment

Published: Jul 2015

While free trade agreements continue to proliferate at a remarkable pace in Asia, the utilisation rates are on the whole negligible. Is this because governments have not effectively communicated the benefits? Or are FTAs simply not all they are cracked up to be?

A well-known economic priority for many governments in Asia of late – and indeed in much of the Western world – has been to encourage companies to pursue a global strategy. Globalisation and technology have made the world a much smaller place and the companies today that don’t explore growth opportunities beyond their own shores are likely to drown in a sea of competition.

That makes sense. Ever since the economist David Ricardo observed that countries do well when they focus on what they are relatively good at producing, the benefits of free trade have never really been in doubt. However, governments should bear in mind that, counterintuitive as it sounds, the benefits of Free Trade Agreements (FTAs), which in Asia have been the dominant channel through which governments have sought to foster greater cross-border business, are not quite so evident.

Just look at the figures. While Asia has seen an enormous proliferation of FTAs across Asia in recent years – both bilateral and regional – utilisation rates of Asian FTAs are notably low. Usually uptake by businesses ranges between a mere 10% and 20%, according to Asia Development Bank (ADB) figures. Often the fact that few businesses seem to be taking advantage of FTAs open to them is blamed on poor communication. There is a common line of argument that says FTAs would see much greater uptake if only governments did more to publicise their existence to treasurers, Chief Procurement Officers (CPOs) and other key corporate decision makers.

Last year a HSBC sponsored study by the Economist Intelligence Unit argued this exact point. The survey revealed that of the 800 businesses – large and small – that were surveyed across a total of eight different jurisdictions, only 26% are using the FTAs that have been established. If you dig down a little further into the data, only 19% were taking advantage of bilateral FTAs, the agreements that have been most common across the continent. Does this apparent lack of enthusiasm for FTAs from the region’s exporters reflect the fact that exporters see no value in the agreements? Other findings suggest that this is not the case. Of the 26% who use FTAs, 86% reported that their exports had seen an increase as a consequence of trading under the terms of the agreement. An additional 24% told the researchers that they their exports had increased significantly as a result of their participation.

Not everybody is convinced this is always the reason, however. One alternative explanation is that companies are by and large aware of FTAs negotiated between countries where they do business; but they simply do not have the time, expertise and resources to make sense of what they need to do to take advantage of them. Usually certain complex criteria must be met in order for goods to be exempted from import duty or qualify for lower rates. And when you think about the number of FTAs in place across the Asia region, each containing perhaps hundreds of pages of dense legal text it is not difficult to imagine some companies reasoning that utilisation is not worth the hassle.

“Currently, the Rules of Origin differ in each FTA negotiated and it is not easy for laymen to comprehend the legal text of the concluded FTA,” says Angelia Chew, Partner, Trade & Customs, Indirect Tax at KPMG in Singapore. “Although the benefits of FTAs are clear, the cost of not meeting these criteria is hefty. Customs authorities in the region are aggressively conducting FTA audits. Any non-compliance will result in penalties and interest payable on top of the duty shortfall. Many companies – including multinationals and small-medium enterprises – give up on applying for FTAs as they do not have sufficient resources to fully understand the rules in the agreements and are unable to manage compliance concerns.”

Can anything be done to resolve this issue? Well, as often is the case when complexity is the challenge, technology is one possible solution (for those that the initial outlay is not prohibitively expensive, of course). There are on the market a whole range of automation models that can integrate FTA functionality with company Enterprise Resource Management (ERP) systems and leverage the capability of similarly integrated Global Trade Management (GTM) systems.

Chart 1: Why FTAs remain on the shelf

Chart 1: Why FTAs remain on the shelf

Source: Economist Intelligence Unit

Solutions like these work by allowing companies to solicit and store origin data from suppliers, and calculate the origin for manufactured products. In addition, they can also make it easier to generate and track origin requests. All in all such tools such as these can provide companies with a structured, controlled process through which to calculate preferential origin and, importantly, eliminating the fear of non-compliance by ensuring everything is in place ahead of customs audits.

There is also another, third perspective on the issue. “I don’t think it is about information,” says Jayant Menon, Lead Economist, Economic Research and Regional Cooperation Department, ADB. Analyse the detail of the vast majority of FTAs and the rationale of those companies choosing not to utilise an FTA soon becomes apparent. “In a lot of these agreements, the difference between the preferential rate provided by the FTA and the normal Most Favoured Nation (MFN) rate, the difference is quite small or even zero. For some tariff lines, where there are much larger preference margins, utilisation might be higher and could be increased by more information. But by and large the problem is that the margins are simply not there to worry about using them.”

The fourth explanation relates to Asia’s distinctive trade relationships. As a recent ADB Working Paper on the matter points out, about two-thirds of intra-regional exports consists of intermediate goods (eg parts and components) and much, if not all, of this trade already travels duty-free, or at very low rates. There are several reasons. First, a significant proportion of the parts and components being traded are electronics exempt from tariffs under World Trade Organisation’s Information Technology Agreement. Second, many of these intermediate goods may also be subject to duty-drawback schemes under which tariffs can be waived. Then the last point to make, which is applicable to final as well as intermediate goods, is that tariffs have been in any case been declining in the region in recent years irrespective of any FTAs.

Too many FTAs

Governments in Asia should take note. There are currently more than 100 FTAs in place over the region, and many more still being negotiated. With the negotiation of each of these agreements using up considerable time and administrative resources, one would think it sensible to at least consider whether there might be more effective means by which greater intra-regional trade can be facilitated. FTAs, remember, are but one way to encourage trade and, in fact, can sometimes encourage the wrong kind of trade ie trade diversion.

That quickly becomes a vicious circle. Non-signatory countries, not wishing to lose market position, will endeavour to negotiate their own agreements. “They feel forced to come into the game and sign FTAs with others,” says Carlos Kuriyama, Senior Analyst at the APEC Policy Support Unit, Asia Pacific Economic Cooperation (APEC). “Everyone then wants to have preferential treatment over others and it creates distortions.” No wonder we’ve seen such a proliferation in bilateral and regional agreements in Asia-Pacific over the past ten years. FTAs, it seems, beget more FTAs.

My view is that we’ve got to the point where there are so many FTAs, that they are becoming a burden rather than a benefit.

Jayant Menon, Lead Economist, Economic Research and Regional Cooperation Department, ADB

“My view is that we’ve got to the point where there are so many FTAs, that they are becoming a burden rather than a benefit,” says Menon. Radical though it may sound, instead of wasting yet more time and energy negotiating yet more agreements with one another why don’t policy-makers, Menon asks, focus on harmonising what is already in place and offer the accords to everyone on a non-discriminatory basis? This would be advantageous in two respects. “If you offer it to everyone, you would have lowered your barriers to trade and you’ve reduced your cost of administering multiple FTAs and multiple rules of origin. It would encourage greater trade and, ultimately, isn’t that the real objective of an FTA?”

That would appear to be the kind of thinking that has informed the Beijing-backed plans to establish a vast, Free Trade Area of Asia Pacific (FTAAP). At the APEC summit held in late 2014, the Chinese President Xi Jinping announced that the bloc had “approved the roadmap for APEC to promote and realise the FTAAP.” It was a ‘historic’ step, he added, and one which reflected the “confidence and commitment of the APEC members to promote the integration of the regional economy.”

Companies should start seriously considering how they can best use FTAs to reap the benefits of duty savings as soon as possible.

Angelia Chew, Partner, Trade & Customs, Indirect Tax, KPMG, Singapore

Despite China’s apparent optimism there is no doubting that the diversity of markets in Asia will pose a big obstacle that will need to be overcome if this objective is to be realised. After all, one of the reasons that FTAs are so popular is that in most cases they involve fewer countries and so differences are easier to iron out. “It is possible for the Asia Pacific free trade area to become a reality in the next ten years but the biggest challenge lies in harmonising the rules of all the various FTAs signed,” says KPMG’s Chew. “While this will take some time, companies should start seriously considering how they can best use FTAs to reap the benefits of duty savings as soon as possible.”

If negotiations over the so-called ‘mega-regionals’ – the Trans-Pacific Partnership (TPP) and the Regional Comprehensive Economic Partnership (R-CEP) have become protracted, how long will it take to reach consensus between every economy in the region? If those can be concluded though it might just pave the way for something bigger. “Right now there are some big regional agreements being negotiated and if these don’t see the light of day it’s going to be hard for a free trade area across the Asia-Pacific to become a reality,” cautions APEC’s Kuriyama. “But I think those regional agreements, if they can be established, could serve as a stepping stone to something like the FTAAP.”

What now then? As negotiations over the so-called ‘mega-regionals’ – the contentious TPP and R-CEP – roll on, Menon’s observations raise the question of whether such agreements are worth pursuing at all. What precisely would be gained by those deals, even in the best-case-scenario? “We will end up with a fragmented world trade system carved up into different trading blocks,” he says. “This will not be good for members, or for non-members.”

Indeed, neither, perhaps, is that the type of distortion-free trading paradigm that David Ricardo had in mind when he articulated his theory of comparative advantage. To rework an old saying of the great Chinese philosopher Confucius, one might say that trade is actually really simple – it’s just that the governments of countries sometimes insist on making it complex.

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