M. Ulric Killion: The Korea-EU FTA postponed to September

by M. Ulric Killion

In an earlier blog (Killion, Korea, EU conclude FTA talks), the announcement of the conclusion of the Korea-EU FTA was perhaps premature. As earlier announced, "Korea and the European Union Monday declared the conclusion of more than two years of negotiations for a free trade agreement. The landmark deal to scrap tariffs for an annual US$106 billion (S$155.2 billion) trade within five to seven years is expected to take effect as early as the first half of next year, following a formal signing and ratification. The announcement was made by President Lee Myung-bak and Swedish Prime Minister Fredrik Reinfeldt during their summit in Stockholm. Sweden holds a rotating presidency of the 27-member European Union. The leaders hailed what would be the biggest free trade accord for both sides. . ."

The Korea-EU FTA postponed

According to Business Week (2009), "An agreement between the EU and South Korea worth billions of dollars has been put on hold after politicians balked at trade conditions."

"The EU and South Korea have been negotiating the free trade agreement for approximately two years. The deal is expected to eliminate duties worth €1.6 billion for European exporters of goods and create addition opportunities worth €1.9 billion, according to the European Commission" (Business Week, 2009).

As for now, the proposed free trade agreement between the EU and South Korea, which most analysts expected to boost mutual trade ties currently worth over €70 billion, due to continuing debates on key issues will be put on hold until September.

Key issues causing a postponement are "rules of origin that establish the level of permissible foreign content in products and so-called duty drawbacks that allow for reimbursement of tariffs under certain conditions."

Earlier in March 2009, Europe's carmakers announced that they will "fight until the bitter end" to derail a 100 billion euro ($125.4 billion) free trade agreement between the EU and South Korea unless the bloc's trade chief addresses their concerns (Reuter UK, March 4, 2009).

The auto industry is the one most vocal opponents against finalizing the Korea-EU FTA. Renata Goldirova (Business Week, 2009) writes: "Carmakers have been staunchly opposed to the EU signing up to what they describe as "unacceptable demands" by Seoul. "This is a damaging development for all European manufacturing industries, including the automotive industry, which is a very strategic sector for the EU," Ivan Hodac from the Brussels-based European Automobile Manufacturers Association (ACEA) said.

Under the current proposal, South Korean manufacturers would be able to purchase 45 percent of car components from low-cost countries such as China and claim the duties back when the vehicles are shipped to European markets. "This would significantly distort competition," Mr. Hodac argued. "Chinese radios in Korean cars will through this mechanism enter the EU at zero percent duties, while the EU companies will continue to pay 14 percent when importing the very same radios."

The Duty Drawback

As for defining a duty drawback, it is generally "a key regulatory measure that involves full or partial refund of paid import duties, when the imported merchandise is destroyed, exported, or consumed as a raw material to produce an exported material. Most countries offer duty drawback incentives with the primary goal of assisting domestic manufacturers to compete in foreign markets" (Hong-Choon Oh, 2005). In terms of the WTO rules, as a general rule a duty drawback scheme is non-actionable so long as the payment is not in excess of the levies actually paid on inputs.

In other words, "Duty drawback schemes, which typically involve a combination of duty rebates and exemptions, are a feature of many countries' trade regimes. They are used in highly protected developing economies as a means of providing exporters with imported inputs at world prices, thus increasing their competitiveness, while maintaining the protection on the rest of the economy" (Ianchovichina, 2002).

As concerns the duty drawback in the proposed Korea-EU FTA, the fear of the EU, though the drawbacks are not in violation of the WTO rules, is that the tariff refunds will not only create a precedent for future free trade agreement negotiations, but also invoke similar demands by other countries in the future. Hodac earlier warned that, "This deal could set a precedent for further free trade agreements with India, Japan and China which would hugely damage Europe's economy" (Reuters UK, March 4, 2009). In response, Brussels has proposed a transition period of three to five years to allow the EU's auto sector to adjust, while EU carmakers and/or ACEA want this transition period extended to at least nine years.

Due to the global financial crisis, the EU's auto industry, which employs about 2.3 million people and another 10 million in related sectors, fears that production could fall by at least 15 percent this year. As of July 14, actually, "Car output in Europe is likely to fall by a quarter this year as government handouts to car buyers fail to halt a major slump, EU car makers said Tuesday" (AP, 2009). Their Korean counterpart, South Korea's auto industry, has also been hit by the global economic downturn with leading carmaker Hyundai earlier planning to cut production at domestic plants by 25 to 30 percent in the first quarter, while Kia, another carmaker, is also expecting to cut output.

As for the EU, the proposed lower barriers to trade and investment with South Korea is of critical importance, because it represents the first of such a pact in Asia. Nonetheless, according to Hodac, the proposed FTA that ends the 10 percent EU import duty on Korean-made cars is "totally unbalanced." From Hodac's perspective, "What is being offered to us has no balance whatsoever. Under the deal the European market is completely open and they [Korea] will get the benefit. Even with the measures that will be taken on our side, we don't believe the Korean market will be open to us."

As for the EU auto market, in 2009, the EU actually imported about 600,000 Korean-made cars. However, the ACES projects, as a consequence of the terms of the proposed Korea-EU FTA, a rise from about 150,000 to 200,000 per year. It is especially for this reason that EU carmakers are the loudest opponents against the proposed Korea-EU FTA. EU carmakers perceive the proposed trade agreement as detrimental to the EU auto industry, while at the same time allowing their Korean counterparts to take advantage of "duty drawback."

Under the mechanism of the so-called "duty drawback", Korean carmakers enjoy the benefit of being able to import cheap components from China, while having all import duties paid on these parts reimbursed if, and once, they are exported in cars destined for an EU market. This also presents the issue, at least from the perspective of Mr. Hodac and the ACES, of the problem of the rules of origin that establish the level of permissible foreign content in products.

EU carmakers, more specifically, are grumbling about a duty drawback enjoying an economic value that is worth between 300 and 500 euros per vehicle to a Korean manufacturer (Reuters, UK, March 4, 2009).

Moreover, in the context of South Korea, and the effect of duty drawback on export promotion, there is strong empirical evidence demonstrating a positive effect of export subsidy in terms of duty drawback on export supply. Thus, in the context of Korea, as one study demonstrates, "the efficiently managed duty drawback system may contribute to export promotion significantly" (Mah, 2007). A consequence that may offer small hope for Brussels' suggestion that, "It is a very political question for South Korea and although we would like to see duty drawbacks phasing out, you have to make a political choice at some point" (Business Week, 2009).

Sources:

M. Ulric Killion, Korea, EU conclude FTA talks, July 17, 2009.

Renata Goldirova, Brussels divided over Korean trade deal, Business Week, July 23, 2009.

Hong-Choon Oh, Sourcing-Production-Distribution Planning of Global Multi-Product Chemical Manufacturing Processes with Duty Drawback, Nov. 2005.

Elena Ianchovichina, Trade policy analysis in the presence of duty drawbacks, World Bank Policy Research Working Paper 3312, May 2004.

EU car makers expect 25 pct output drop in 2009, AP, July 14, 2009.

Jai S. Mah, The effect of duty drawback on export promotion: The case of Korea, Journal of Asian Economics, Vol. 18, Iss. 6, Dec. 2007, 967-73.