Maximising value-added in African exports: Understanding the role of Rules of Origin
Rules of Origin (RoO) are an integral part of preferential trade arrangements such as the African Continental Free Trade Area (AfCFTA); they prevent goods from third countries from entering into the trade bloc’s market through countries with low tariffs. The level of the optimal RoO to foster value chains of exporting countries is not clear beforehand. A recent IGC study argues that current RoO in the AfCFTA are too strict from the perspective of maximising domestic value-added in preferential exports.
In a world of global supply chains with increasing vertical specialisation, using the value of exports as a metric for how much trade benefits the exporting country can be highly misleading, particularly in small countries with a lower share of domestic value-added embedded in their exports. Policies such as preferential market access regimes that unambiguously boost exports can hurt development if they simultaneously reduce the share of domestic value-added embedded in exports.
Rules of Origin (RoO) are a critical component of preferential trade arrangements, defining what is needed for a product to have been processed sufficiently in the exporting nation to confer ‘originating’ status. In the framework of reciprocal free trade agreements such as the African Continental Free Trade Area (AfCFTA), a common way they do so is by requiring a minimum share of a good’s value to be produced in the exporting country. Our research finds significant differences in estimates of domestic value-added maximising RoO across African countries, supporting expectations related to differences in economic development, and suggests RoO are likely to be too strict.
The non-monotonic relation between RoO and exported domestic value-added
The relationship between RoO levels and exported domestic value-added is non-monotonic. Very strict RoO reduces the use of cheaper, high-quality international inputs. Exports become less competitive on international markets, which reduces total exports and, hence, exported domestic value-added. Very lenient RoO, following the same logic, increases total exports but reduces the share of exported domestic value-added embedded in exports. This implies that there is an intermediate level of RoO that maximises total domestic value-added in preferential exports.
Figure 1 displays one possible relationship between the regional value content requirement, formalised in the RoO, and exported domestic value-added. The optimal level of a country’s RoO will depend on various determinants related to the country’s level of development and industrial organisation. For African countries, which often have less diversified economies and rely heavily on imported inputs for their exports, RoO may be on the downward-sloping part of this curve, i.e. too strict. The key policy issue is finding a balance between RoO that are strict enough to prevent trade deflection and flexible enough to allow countries to participate in global value chains and maximise their exported domestic value-added.
Figure 1: Non-monotonic relationship between regional content requirement and regional value addition
Research methodology
To determine the level of RoO that maximises exported domestic value-added, we use a methodology that formalises the non-monotonic relationship between RoO levels and value-added. This involves two steps:
- We characterise the theoretical optimal RoO using a simple mathematical model to find the value-added maximising RoO as a function of parameters to be estimated.
- We identify these parameters using the gravity equation of international trade to explain the total value of preferential exports and estimate the impact of changing RoO on the value of preferential exports for different countries.
We use data from the International Trade Centre, World Customs Organization, and World Trade Organization on RoO and data on national exports.
Significant differences in estimates of value-added maximising RoO across countries with different levels of development
Our estimates confirm the economic intuition that differences in appropriate RoO can reflect differences in economic size, production diversification, and integration into global value chains. Our estimates point to a need for substantially less strict RoO for African countries. While the value-added maximising RoO for all beneficiaries of the EU’s general system of trade preferences is 57%, it is only 38% on average for African countries. The estimates indicate that enhancing the regional content of African exporters under the EU Generalised System of Preferences calls for less strict RoO.
Policy implications: Adjust RoO to foster domestic value-addition
- Adapt RoO to the needs of less industrialised economies
African countries are diverse and differ in their industrial development and integration into global value chains. This is reflected in substantial variation in our country-specific estimates of domestic value-added maximising RoO. A conclusion from our study is that implementing RoO that are differentiated to better reflect national economic capacities may help states to benefit more from preferential trade arrangements. Attempting to operationalise this in the context of the AfCFTA is likely to be administratively burdensome and undercut trade facilitation objectives. Adopting RoO that reflects prevailing domestic value-added ratios in less industrialised member countries is, in our view, a more appropriate approach from a development perspective.
- Reduce RoO requirements
Current RoO requirements in both the EU and AfCFTA schemes are higher than the estimated for domestic value-added maximising criteria. For instance, Uganda faces a median RoO requirement of 30% in the EU and 40% within AfCFTA, compared to the estimated regional value-added maximising level of 26%. Reducing the RoO requirements could increase exported domestic value-added and enhance export competitiveness while supporting sustainable economic development in beneficiary countries. Particularly important is to lower ‘peak’ RoO that apply to products such as textiles and where preferential tariff margins are higher—and thus more valuable. Policymakers should aim to strike a balance between preventing trade deflection and promoting local value addition without imposing excessive burdens on exporters.
- Use microdata to assess the effects of RoO
A final policy implication of our analysis concerns the importance of evaluating the impacts of RoO given the heterogeneity across countries that benefit from preferential trade arrangements. Most extant analyses of RoO use trade data and assess variables such as the extent to which preferences are utilised. From a developmental perspective it is important that policymakers understand whether preferential trade arrangements foster productive upgrading reflected in a greater share of domestic value embodied in preferential exports. To do this, governments can use firm-level transactions data from the value-added tax system and combine this with transactions-level customs clearance data.