PEM is not a Customs Union

*Sigh*

During the Brexit period, I spent hundreds of hours explaining to ministers, MPs, journalists, and anyone who would listen what a customs union is. I even used to run popular [Ed: source plz] Twitter quizzes.

After all that time and effort, I can confidently say that virtually no one in the UK knows what a customs union is.

This lack of understanding is front of mind as I write this week’s newsletter due to EU Trade Chief Maroš Šefčovič suggesting the UK could join the Regional Convention on pan-Euro-Mediterranean preferential rules of origin (shorthand: PEM) and the British press promptly reporting it as an invitation to join a pan-European customs union.

Sigh.

Let’s start from the beginning: what is a customs union?

With the slight caveat that you can get some very messy trade agreements labelled customs union (I’m looking at you, Mercosur), a customs union requires that its members:

• Remove tariffs on goods (or a subset of goods, I’m looking at you, EU-Turkey) traded between them.

• Apply the same external tariff to goods (or a subset of goods) imported from non-members.

In infographic form:

Why choose a customs union over a free trade agreement?

Well, while a free trade agreement removes tariffs between Country A and Country B, the tariff removal is conditional on firms demonstrating that the product they are exporting from Country A to Country B is actually from Country A or Country B.

Every free trade agreement includes both general and product-specific rules, called preferential rules of origin, that set out criteria for whether a product can be deemed “originating” or not.

These rules of origin are necessary because Country A and Country B do not have a common external tariff. The lack of a common external tariff means that Country A could apply a lower tariff to imports from Country C than Country B. In such a scenario, if firms were not required to demonstrate origin, there is a risk that exporters from Country C could circumvent Country B’s higher tariff by shipping their products via Country A (which applies a lower tariff to imports from Country C) and then taking advantage of the free trade agreement to send the product into Country B tariff-free.

The downside, of course, is that rules of origin compliance can be expensive, reducing the benefits of the free trade agreement’s tariff removal. In practice, it also means that tariffs remain the default — your export only benefits from the tariff removal if you can demonstrate it meets the rules of origin criteria.

A customs union’s common external tariff removes the need for rules of origin on trade between Country A and Country B. Due to both Country A and Country B applying the same tariff to imports from Country C (and other non-members) , the risk of circumvention disappears. This means that tariff-free trade between Country A and Country B is the default (unconditional), removing the rules of origin compliance burden and ambiguity around whether a product qualifies for tariff-free trade or not.

(Note: all of the above is massively oversimplified — in practice, everything is usually slightly more complicated.)

Things a customs union doesn’t do [unless you add other things to the agreement]: remove border checks, remove regulatory barriers to trade, require regulatory harmonisation, etc.

Anyway, now you know what a customs union is.

But if PEM is not a customs union, what is it?

Here, I’m going to lazily copy and paste an explainer I wrote back in 2017 (!):

Originating *ahem* in 1997, the pan-Euro-Mediterranean cumulation system of origin fully materialised in 2005.

There are currently 23 Contracting Parties to the PEM Convention:

• the EU,

• the EFTA States (Switzerland, Norway, Iceland and Liechtenstein),

• the Faroe Islands,

• the participants in the Barcelona Process (Algeria, Egypt, Israel, Jordan, Lebanon, Morocco, Palestine, Syria, Tunisia and Turkey),

• the participants in the EU’s Stabilisation and Association Process (Albania, Bosnia and Herzegovina, the former Yugoslav Republic of Macedonia, Montenegro, Serbia and Kosovo),

• the Republic of Moldova.

All signatories to the PEM Convention have agreed to replace protocols of rules of origin in the FTAs between each other with the rules of origin laid down in the PEM Convention, streamlining procedures across the zone.

What are the benefits of signing up to PEM?

I’m afraid I’m going to have to talk about rules of origin again, and something called diagonal cumulation.

What is diagonal cumulation?

Well …

If a free trade agreement includes provisions allowing for Country A to treat inputs imported from Country B as being from Country A (and vice versa) for originating purposes, it is known as bilateral cumulation. This is fairly common.

But let’s say that as well as an FTA with Country B, Country A has another one with Country C, and Country B also has a free trade agreement with Country C.

http://www.wcoomd.org/en/topics/origin/instrument-and-tools/comparative-study-on-preferential-rules-of-origin/specific-topics/study-annex/cum-dia.aspx

If the rules of origin requirements in the trade agreement between Country A and B allow for diagonal cumulation explicitly with Country C, a producer based in Country A could import a good from Country C (that originates in Country C), incorporate it into something else, alter it, do nothing with it, whatever, and then sell it to a customer in Country B and it would be treated as if it was of Country A origin no matter how much value was added, or not, in Country A.

Simple.

The PEM Convention allows for diagonal cumulation between all signatories to the agreement (so long as free trade agreements are in place between all the Contracting Parties concerned). This facilitates the dispersion of supply chains across the zone, making it easier for exported goods to qualify for the respective preferential free trade agreements between the various parties. (It also allows for full cumulation between some countries.)

Not. A. Customs. Union.

So should the UK join PEM?

I mean, probably. Anna Jerzewska has written an excellent piece (free to read, but you need to provide an email address) looking at the pros and cons.

They essentially boil down to:

Pros:

• It would help EU and UK exporters with regional supply chains (e.g. running through Turkey, Morocco, Norway, Switzerland, etc) qualify for tariff-free trade under the EU-UK Trade and Cooperation Agreement (TCA).

Cons:

• While the EU-UK TCA largely incorporates PEM-style rules of origin, there are some differences. Electric Vehicles are the obvious one, where the TCA rules of origin are more liberal than PEMs, at least until 2027. This means that EV exporters can more readily qualify for tariff-free trade under the current TCA rules of origin than the PEM alternatives.

In my view, the obvious solution is to run both the PEM and TCA rules in parallel. This probably requires some legal wizardry, but in practice, it would mean that exporters have the choice of either using the PEM rules of origin and benefiting from the cumulation provisions or using the TCA rules of origin, presumably because the product-specific rule is more appropriate for them.

In gif form:

While this sounds complicated, it is actually quite common for exporters to choose between rules of origin. For example, a UK exporter to Japan can choose to use the rules of origin listed in the UK-Japan free trade agreement or the rules of origin listed in CPTPP.

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Chart of the week

DG Trade’s Lucian Cernat has written a new ECIPE paper looking at the future of trade, jobs and technological change. It includes this very good chart:

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Best,

Sam