Tamara Kovziridze, Veronika Movchan, Vadim Gumene and Michael Emerson. 10 August Abstract

Transcription

1 Understanding the EU s Association Agreements and Deep and Comprehensive Free Trade Areas with Ukraine, Moldova and Georgia The Pan-Euro-Mediterranean Convention on Preferential Rules of Origin and its Benefits A Comparative Analysis of its application for Georgia, Moldova and Ukraine Tamara Kovziridze, Veronika Movchan, Vadim Gumene and Michael Emerson 10 August 2017 Abstract The present article explains diagonal cumulation and its benefits under the Pan-Euro- Mediterranean (PEM) Convention on the rules of origin, as will be applied by the three DCFTA states, Georgia, Moldova and Ukraine. The article argues that for countries with comparatively limited domestically available intermediate products and raw materials diagonal cumulation offers increased opportunities for complying with domestic content requirements in order to then benefit from tariff preferences under various FTAs with PEM countries. Overall the PEM Convention marks a technical step in the direction of a multilateral pan-euro-mediterranean free trade area, with a partial integration of the complex network of over 60 bilateral FTAs. This paper compares Georgia, Moldova and Ukraine in terms of their status for joining the PEM Convention, their trade flows in final and intermediate products with PEM countries, as well as their potential benefits from diagonal cumulation. Tamara Kovziridze is Senior Director at Reformatics, Tbilisi, Veronika Movchan is Academic Director at the Institute for Economic Research and Policy Consulting, Kyiv, Vadim Gumene is Research Director at Expert-Grup, Chisinau, Michael Emerson is Associate Senior Research Fellow at CEPS, Brussels. The authors would like to thank their colleagues from Reformatics, for their useful comments to the draft of this paper, as well as Lela Nozadze, junior analyst at Reformatics for her support in producing the present work. Available for free downloading at Research and policy advice project supported by the Swedish International Development Cooperation Agency (Sida).

2 Contents 1. Introduction Relevant Definitions of Rules Origin and Cumulation Pan-Euro-Mediterranean Convention (PEM) Key Features Free Trade Agreements and the PEM The three DCFTA States and the PEM Convention... 8 Georgia... 8 Moldova... 9 Ukraine CIS rules of origin Perspectives of Utilization of Diagonal Cumulation in Georgia, Moldova and Ukraine Georgia Moldova Ukraine Conclusions References List of Tables and Figures Table 1. Key Facts of the PEM Convention... 5 Table 2. Participants in the PEM Convention... 7 Table 3. Georgia's Imports of Intermediate Goods Table 4. Georgia's Export of Final Goods Table 5. Export of Final Apparel to PEM and Import of Intermediate Apparel Products from PEM, Table 6. Moldova's Imports of Intermediate Goods (BEC Classification) Table 7. Moldova's Exports of Consumption Goods (BEC Classification) Table 8. Trade in apparel and footwear in 2016 within the selected PEM countries Table 9. Trade in vehicle components in 2016 within the selected PEM countries Table 10. Ukraine s Imports of Intermediate Goods Table 11. Ukraine s Exports of Final Goods Table 12. Trade in Apparel in 2016 among the Selected PEM Countries Table 13. Trade in Footwear in 2016 among the Selected PEM Countries Table 14. Trade in Electronics in 2016 among the Selected PEM Countries Figure 1. Export of textile products from Georgia in (USD million) Figure 2. Export from Georgia of textile products, Figure 3. Import to Georgia of fabrics, Figure 4. Sectors with High Share of Intermediate Imports and Oriented on Exports,

3 The Pan-Euro-Mediterranean Convention on Preferential Rules of Origin and its Benefits A Comparative Analysis of its application for Georgia, Moldova and Ukraine Tamara Kovziridze, Veronika Movchan, Vadim Gumene and Michael Emerson 10 August Introduction The present paper analyses the opportunities offered by the Pan-Euro-Mediterranean Convention on preferential rules of origin (PEM) 1 for the three Eastern Partnership countries that have DCFTAs with the EU - Georgia, Moldova and Ukraine - and are at the same time members or prospective members of the Convention. This opportunity is allowed for by the three DCFTAs, which means that the comprehensive trade agreements between the EU on the one hand and respectively Georgia, Moldova and Ukraine on the other, will provide for not only bilateral, but also diagonal cumulation of origin. Such a cumulation opens up potential opportunities for trade and investment as it widens the possibilities for originating products to be composed of goods and materials from two or more countries. It is particularly relevant for economies with comparatively limited resources and raw materials as they have the possibility to cumulate origin with at least one third country and thus diversify production and export opportunities. This in turn makes production and then export more attractive for investment as investors and producers are less limited by the usual domestic content requirements needed for the made in country A mark to be placed on their products. In what follows, we first explain the relevant definitions of rules of origin and cumulation, then briefly analyse the benefits of the PEM Convention and its interrelationship with DCFTA, as well as the status quo of utilization of PEM rules of origin by the three DCFTA states. Some indications will also be given about potential areas of export diversification and growth using the PEM rules of origin. 2. Relevant Definitions of Rules Origin and Cumulation Rules of origin is a backbone feature of international trade. Preferential trade regimes, including free trade arrangements, only apply in practice provided that the origin of goods to which preferential treatment is extended can be verified. The benefits of tariff preferences, 1 Regional Convention on pan-euro-mediterranean preferential rules of origin, Official Journal of the European Union, L54, Vol 56, 26 February

4 2 KOVZIRIDZE, MOVCHAN, GUMENE & EMERSON such as under free trade agreements or unilateral trade preferences (including the Generalised System of Preferences - GSP), are extended to traders in practice only if the state s authorities ascertain that that goods destined for import comply with the rules of origin stipulated in the relevant trade agreement. Most commonly this is done by rules of origin certificates. Broadly speaking, rules of origin specify the conditions under which a product is considered as originating from a country in question. The rules of origin define the so-called domestic content for goods, i.e. the share of product value that has to be originated domestically so that the product is considered as made in the country in question. There are different rules of origin that can be regulated bilaterally, or on a multilateral basis. For example, EU member states use EU rules of origin in trade with each other, and mostly with EU trade partners as well. The EU and its DCFTA partners, Georgia, Moldova and Ukraine, also use the EU rules of origin in their bilateral free trade. CIS countries apply the CIS rules of origin agreed through a CIS-wide multilateral agreement. An important concept related to rules of origin is cumulation. This allows products that have obtained originating status in one country to be further processed in another country as if they had originated in that latter country, without the finished product losing the benefit of tariff preferences when exported to a third country with which they have a preferential trade agreement. Cumulation can only be applied between countries operating with identical rules of origin. Cumulation facilitates economic integration and allows countries to combine materials without losing the originating status of the good. In other words, the cumulative system permits contracting parties to use originating products from each other. This opportunity is especially relevant for smaller economies that face the challenge of qualifying for a sufficient domestic content requirement in order to benefit from trade preferences. There are different types of cumulation - bilateral, diagonal and full cumulation. Bilateral cumulation allows two countries, which have a preferential trade agreement (e.g. a free trade agreement) to cumulate origin of goods between each other. This means that if raw materials are exported from country A to country B, and processed there into a final product, the imported raw materials can be considered as if originating in country B, and exported to country A tariff-free, provided that the rules of origin are satisfied. Diagonal cumulation is similar to bilateral cumulation but it applies to production processes involving at least two countries. Diagonal cumulation can be used if three or more countries have free trade agreements with each other. The domestic content of goods is composed of not only the exporting country but also third country(ies), which provides more opportunities for cumulating origin. More specifically, a producer in country A may process a product using materials imported from country B and export this product in country C under the label made in country A, provided that the rules of origin are complied with. When domestic content requirement for a product value is, for example, 40%, in case of diagonal cumulation this 40% may be composed of value content from country A as well as from country B and C.

5 THE PAN-EURO-MEDITERRANEAN CONVENTION ON PREFERENTIAL RULES OF ORIGIN AND ITS BENEFITS 3 Full cumulation allows cumulation of origin within the entire preferential trade zone, allowing for maximum flexibility. In particular each step in trade of intermediate products does not have to meet the critical domestic content (e.g. 40%) requirement, but this can be cumulated in any number of smaller steps. For example, the European Union (EU) and Commonwealth of Independent States (CIS) allow for full cumulation among their respective member states. The introduction of the cumulation is generally considered to be beneficial for the economy, overcoming limitations imposed by the rules of origin (without cumulation). Augier et al (2005) estimated that diagonal cumulation can increases trade by 7 to 22%. 2 According to Innwon and Soonchan (2009), diagonal cumulation can boost trade by 16%, and 36% in the case of full cumulation. 3 Hayakawa (2012) studied the impact of diagonal cumulation on FTA utilization between Japan and Thailand and found a more modest 4% trade creation effect Pan-Euro-Mediterranean Convention (PEM) Key Features The cumulation system that we analyse in this article is that of the PEM Convention, created in 1997 on the basis of the European Economic Area agreement of 1994 between the EU, the EFTA countries, the CEEC (Central and Eastern European Countries) and the Baltic States. It was then enlarged in 1999 by adding Slovenia, Turkey and the Faroe Islands. In the case of Turkey cumulation applies to industrial goods only, as the EU-Turkey Customs Union covers just the industrial goods. In 2005, the Pan-European cumulation system was widened to the participants in the Barcelona Process and as a result the Pan-Euro-Mediterranean cumulation system was created on the basis of a multilateral convention among all members, the so-called Pan-Euro- Mediterranean Convention (hereafter referred to as the PEM Convention). The PEM Convention is an international agreement, which specifies a single set of rules of origin for goods. The PEM Convention thus aims to eliminate difficulties in the management of different rules of origin in the countries of the PEM zone. This means that goods or products which have originating status in one of the PEM countries may be added to products originating in other PEM countries having mutual FTAs, without losing originating status within the Pan-Euro-Med zone. The purpose of the Convention is to simplify the rules of origin in all free trade agreements (FTAs) between all contracting parties by adopting common rules of origin through a single legal document. Currently the PEM cumulation zone includes the European Union, the EFTA states (Iceland, Norway, Switzerland, Liechtenstein), the Barcelona Process participants (Algeria, Egypt, Israel, Jordan, Lebanon, Morocco, Syria, Tunisia, Turkey, Palestine), the Faroe 2 Augier et al (2005) The Impact of Rules of Origin on Trade Flows, Economic Policy, 20(43). 3 Innwon P., Soonchan P. (2009) Consolidation and Harmonization of Regional Trade Agreements (RTAs): A Path towards Global Free Trade, MPRA Paper No Hayakawa K. (2012) Impact of Diagonal Cumulation Rule on FTA Utilization: Evidence from Bilateral and Multilateral FTAs between Japan and Thailand. IDE Discussion Paper #372, November 2012.

6 4 KOVZIRIDZE, MOVCHAN, GUMENE & EMERSON Islands, countries included in the EU's Stabilization and Association Process (Albania, Bosnia and Herzegovina, the former Yugoslav Republic of Macedonia, Montenegro, Serbia, Kosovo), Georgia and Moldova. Notably, the PEM rules of origin are almost identical to the EU rules of origin, with only minor differences. In 2011 the Convention was revised, and has been entering into force since then as the participating states conclude its ratification. All have in fact now ratified with the exceptions of Morocco, Kosovo and Syria, meaning that the Convention goes ahead, except that these three members have no vote in ongoing decisions of the system. The Convention includes a 200-page Annex II, which defines the conditions under which nonoriginating products can obtain the status of originating products, line by line for the entire harmonized tariff nomenclature. In other words, these are the conditions under which the value added in a production chain starting in country A may be added to the value added in country B before the processed product is exported to country C benefiting from tariff preferences. Thus the product becomes recognized as made in country B (i.e. as originating in country B) for the purpose of benefiting from the free trade preferences extended by country C. The 2011 Convention is in substance very close, beyond detailed technical amendments and simplifications, to the former Convention. However, the main point of the new Convention is that it establishes a single legal text that is attached to all of the FTAs in the PEM system, as long as they contain a reference to the PEM (which requires amendment to various bilateral FTAs). Once this is completed any further amendment to the Convention itself, agreed unanimously by all parties, is automatically passed on into all the network of bilateral FTAs. This will greatly facilitate future revisions of the rules of origin, avoiding the need for complex ratification procedures at the bilateral level. In this way the PEM system takes a further step towards multilateralisation of this wider European area of free trade agreements. If a country wants to become a member of the PEM Convention, as a precondition it should have a free trade agreement, providing for preferential rules of origin, with at least one contracting party of the PEM Convention. A candidate country is required to submit a written request for accession to the depositary, which then submits the request to the Joint Committee for consideration (Part III, Article 5 of the PEM Convention). Table 1 below summarises the main points and key facts of the PEM Convention.

7 THE PAN-EURO-MEDITERRANEAN CONVENTION ON PREFERENTIAL RULES OF ORIGIN AND ITS BENEFITS 5 Table 1. Key Facts of the PEM Convention What is the PEM Convention? Contacting Parties of the Pan-Euro- Mediterranean cumulation zone The main objectives of the 2011 PEM Convention Benefits of the PEM Convention Who can join the zone of PEM Convention On the basis of the Deep and Comprehensive Free Trade Agreement (DCFTA) accession to PEM Convention offered to: The 2011 PEM Convention The PEM Convention is a single regional convention on Pan-Euro-Mediterranean preferential rules of origin, which sets out free trade provisions based on identical rules of origin allowing for diagonal cumulation among Contracting Parties (Article 1 (2), PEM Convention European Union EFTA states Participants in the Barcelona Process Kingdom of Denmark in respect of the Faroe Islands Participants in the EU's Stabilization and Association Process Moldova Georgia (Article I (3), PEM Convention) Replace more than 50 bilateral protocols on rules of origin previously in force in PEM zone with a unified legal instrument Apply identical rules of origin for the purpose of cumulation of origin for goods traded between all contracting parties, Create a single zone for diagonal cumulation Allow more effective and simplified system of management of rules of origin within Pan-Euro- Med countries (Preamble, PEM Convention) Create extended opportunities for cumulation Increase opportunities for trade and investment Permit accession of neighboring countries into the Pan-Euro-Mediterranean cumulation zone Can be easily be amended in order to better respond to the economic realities (Preamble, PEM Convention) Candidate country should have a free trade agreement in force, providing for preferential rules of origin, with at least one country of the PEM Convention (Article 5(1), PEM Convention) Georgia (already a member) Ukraine (accession in progress) Moldova (already a member)

8 6 KOVZIRIDZE, MOVCHAN, GUMENE & EMERSON 4. Free Trade Agreements and the PEM The DCFTAs between the EU and Georgia, Moldova and Ukraine provides for the opportunity to use not only bilateral cumulation between the signatories, but also diagonal cumulation among other countries sharing FTAs in the PEM zone. To benefit from diagonal cumulation, a country has to satisfy the following preconditions: a) Be party to the PEM Convention b) Have a free trade agreement with at least two members of the PEM Convention c) Use the same PEM rules of origin with relevant FTA partners. The PEM Convention should be explicitly referred to in bilateral FTAs Table 2 below shows the dates of application of the protocols on rules of origin providing for diagonal cumulation between the European Union, EFTA states, Participants in the Barcelona Process and the Stabilization and Association Process. It indicates which countries apply diagonal cumulation with each other, and the date since when these cumulation rules apply. The table shows that the EU, the EFTA states and Turkey have the most comprehensive sets of agreements permitting diagonal cumulation. The participants in the Barcelona process have limited agreements with each other, but none with the Balkan states of the Stabilisation and Association Process. Similarly the latter have extensive agreements among themselves.

9 THE PAN-EURO-MEDITERRANEAN CONVENTION ON PREFERENTIAL RULES OF ORIGIN AND ITS BENEFITS 7 Table 2. Participants in the PEM Convention 5 EFTA States Faroe Islands Participants in the Barcelona Process Turkey Stabilization and Association Process EU CH(+LI) IS NO FO DZ EG IL JO LB MA PS SY TN TR AL BA KO ME MK RS EU CH(+LI) IS NO FO DZ EG IL JO LB MA PS SY TN TR AL BA KO ME MK RS Abbreviations: EU European Union, CH (+LI) Switzerland and Liechtenstein, IS Island, NO Norway, FO Faroe Islands, DZ Algeria, EG Egypt, IL Israel, JO Jordan, BA Bosnia and Herzegovina, KO Kosovo, ME Montenegro, MK Macedonia, RS Serbia, LB Lebanon, MA Morocco, PS Palestinian Territory, SY Syria, TN Tunisia, TR Turkey, AL Albania 5 This table contains information as of April, 2016.

10 8 KOVZIRIDZE, MOVCHAN, GUMENE & EMERSON 5. The three DCFTA States and the PEM Convention This section explains the present state of the process of acceding to the PEM Convention by the three DCFTA States: Georgia, Moldova and Ukraine. This process of joining the PEM Convention was accelerated by conclusion of their respective DCFTAs, as these provided a realistic prospect for the benefits associated with diagonal cumulation. At the time of writing all three states are at different stages of joining the PEM Convention, and of introducing changes in their bilateral FTAs to enable application of the PEM rules of origin and diagonal cumulation in practice. The PEM Convention does not prevent parties from using different rules of origin with non- PEM economies. In general rules of origin have to be complied with, depending on the destination market. The three DCFTA states, which as of now apply CIS rules of origin in trade with each other, may continue to do so, depending on their preferences. However, if they prioritize the use of diagonal cumulation with PEM members, they may wish to amend their bilateral FTAs with these countries in order to make reference to the PEM rules of origin. In this case the PEM rules will apply. However, as all three DCFTA states are part of the multilateral CIS agreement with respective CIS rules of origin, they may continue to use the latter in their bilateral trade without affecting their diagonal cumulation with PEM members. The PEM Convention allows for the use of both, the PEM certificate of origin as well as the certificate of origin, issued based on the EU rules of origin, the EUR-1. The two rules of origin are not identical but very similar, with only minor differences. Currently there is a discussion ongoing among the PEM members to move exclusively towards the use of the EUR-1 certificate of origin issued based on the PEM rules of origin. Georgia Georgia s potential partners for diagonal cumulation are the EU, EFTA, Turkey, Ukraine and Moldova, all of whom are members of the PEM, or an applicant in the case of Ukraine. This group will widen if and when Georgia concludes FTAs with other parties to the Convention. In October 2015 Georgia addressed the General Secretariat of the Council of the European Union - which is the depository of the Convention - with the request to join the PEM convention. In September 2016 the PEM Joint Committee made the decision to invite Georgia to accede. In line with Article 5 of the PEM Convention, Georgia s accession was planned to become effective on the 1 st day of the 2 nd month after depositing of the instrument of accession at the General Secretariat of the Council of the EU. Concretely, Georgia officially became member of the Convention on 1 July However, simply joining the PEM Convention is not sufficient to activate diagonal cumulation in practice. This requires that the relevant bilateral FTAs make reference to the PEM Convention, and its rules of origin and provisions for diagonal cumulation. For example, Georgia s FTA with Turkey was concluded in 2007, well before signing the DCFTA with the EU,

11 THE PAN-EURO-MEDITERRANEAN CONVENTION ON PREFERENTIAL RULES OF ORIGIN AND ITS BENEFITS 9 or initiation of the procedures for joining the PEM Convention. In order to benefit from diagonal cumulation with Turkey, Georgia has recently concluded bilateral negotiations with Turkey for this purpose. The negotiations were conducted in the framework of a Joint Committee established by the Georgia-Turkey FTA. The parties are currently in the process of further internal procedures (parliamentary ratification) for entry into force of these amendments to the bilateral FTA. In order to activate diagonal cumulation between Georgia, Turkey and the EU, Georgia and Turkey have to notify the EU when the amendments to their bilateral FTA enters into force. Also, Georgia and the EU have to replace the EU rules of origin in the DCFTA with the PEM rules of origin. According to the Article 38 of the DCFTA Protocol, the Customs Sub-Committee of the DCFTA may decide to amend the provisions of this Protocol, and shall, within one year following accession of Georgia replace the rules of origin by those annexed to the Convention. Diagonal cumulation will then come into force after publication in the EU s Official Journal. The general situation with regards to CIS rules of origin is discussed below. As far as Georgia in concerned, after leaving the CIS as an organization in the aftermath of the August 2008 Georgian-Russian war, it nonetheless maintained its CIS trade and economic agreements, and thus benefits from duty-free and quota-free trade as well as diagonal cumulation with all CIS members, except Russia. Georgia and Russia do have a free trade agreement that is still in force, and the countries apply the bilateral rules of origin agreed in 2009 through diplomatic notes, which does not however allow for diagonal cumulation with other CIS countries. Moldova Moldova initiated the procedure for accession to the PEM Convention in 2013 and is currently formally party to the Convention. Moldova has free trade agreements with several PEM parties, namely the EU, Turkey and CEFTA. However, the application of the Convention and thus diagonal cumulation in practice still requires amendments to relevant bilateral free trade agreements, and only once the respective bilateral procedures are completed, can diagonal cumulation with these trade partners begin. As far as the status with the EU is concerned, the Council of the EU adopted in March 2016 the decision envisaging application of the PEM Convention to trade between the EU and Moldova. In October of the same year, the EU-Moldova Customs Sub-Committee adopted the decision on replacement of the prior prevailing rules of origin by the PEM rules of origin, entering into force on 1 December However, until other protocols of origin within PEM partners (CEFTA, Turkey and eventually Ukraine and Georgia) are in place, cumulation is limited to the bilateral one with the EU. As far as Turkey is concerned, following the entry into force of the Free Trade Agreement between Moldova and Turkey on the 1 November 2016, the two parties have initiated discussions on amending the protocol on rules of origin, by introducing a linkage to the PEM Convention.

12 10 KOVZIRIDZE, MOVCHAN, GUMENE & EMERSON In December 2016, the Moldova-Turkey Joint Committee decided to initiate the necessary amendments to the corresponding Protocol of their FTA. The new amendments will include references to the PEM Convention. As mentioned above, Georgia and Turkey have undertaken similar changes in their bilateral FTA to enable the use of diagonal cumulation. In conclusion, although the PEM Convention membership entered into force on 1 September 2015, Moldova is not yet able to benefit from diagonal cumulation while the necessary amendments in bilateral FTAs are pending. Ukraine Ukraine was formally invited in May 2017 to join the PEM Convention in response to its application filed in September 2016 with the General Secretariat of the Council of the European Union. It is expected to compete the ratification process by the end of Among PEM members, Ukraine has FTAs with the EU, the EFTA, Montenegro, Macedonia, Moldova and Georgia, and thus will be able to implement diagonal cumulation in trade with them once it has acceded to the Convention and introduced relevant amendments into its bilateral FTAs. Ukraine is currently also negotiating FTAs with two important partners of the PEM convention, namely Turkey and Israel. As already described above, the usage of diagonal cumulation among countries is possible only if the PEM convention is mentioned in each of the respective FTAs. Currently, most of Ukraine s FTAs with the PEM countries do not yet contain such clauses. The current situation is as follows. Ukraine s FTAs with Macedonia and Montenegro as well as with Georgia and Moldova do not envisage diagonal cumulation based on the PEM Convention. Thus, Ukraine will have to negotiate a replacement of the protocols of the rules of origin or amendment of the respective articles of the agreements with the above countries. The EU-Ukraine DCFTA mentions the possibility of cumulation based on PEM but requires additional amendments following Ukraine s accession to the Convention. Thus, to use the PEM Convention, the protocol is to be amended in EU-Ukraine DCFTA. According to Article 39 of Protocol I of EU-Ukraine Association Agreement, the Customs Sub-Committee will decide on the replacement of the original rules of origin embedded in the Protocol by the Convention following Ukraine s PEM accession. Ukraine s FTA with the EFTA is the only one of its FTAs that foresees a cumulation option with the PEM countries explicitly in the text of the current protocol. In 2017 Ukraine and Canada ratified their FTA, while the EU-Canada FTA (CETA) is in the process of ratification. Although Canada does not express any interest to join the PEM, the Ukraine-Canada FTA contains the clause that allows diagonal cumulation in case all relevant parties agree (Article 3.3). It is advisable to base any next FTA signed by Ukraine with PEM member states on the PEM Convention. Turkey is most likely to be the next country with which Ukraine will conclude the FTA. The talks were launched in 2012 but the progress was very moderate. Trade in

13 THE PAN-EURO-MEDITERRANEAN CONVENTION ON PREFERENTIAL RULES OF ORIGIN AND ITS BENEFITS 11 agricultural goods that remained outside the EU-Turkey Customs Union caused most of the difficulties. Recently both countries declared the intension to speed up the process and reach agreement by the end of It is reasonable to expect that the rules of origin defined in the agreement will take into account the PEM convention. Ukraine launched FTA talks with Israel in The fourth round of talks took place in January Again, the PEM Convention is expected to be used to define the rules of origin for this agreement, which will provide additional prospective opportunities for Ukraine. CIS rules of origin Importantly, the PEM Convention does not pose restrictions on using other preferential rules of origin when trading with third countries. In case of agreement, Georgia, Moldova and Ukraine can cumulate with the EU using PEM rules of origin, and can apply CIS rules of origin when trading with CIS countries or among themselves. Relevant initial consultations among the three countries have already started. Maintaining the freedom of choosing the rules of origin depending on the trade partner is important because in most cases CIS rules of origin are more relaxed compared to the EU/PEM rules of origin. As the domestic content requirement in CIS rules of origin is in general lower compared to that of the EU, this provides more flexibility in complying with the rules of origin and benefiting from trade preferences. 6. Perspectives of Utilization of Diagonal Cumulation in Georgia, Moldova and Ukraine This section outlines possible benefits for the three DCFTA states by applying diagonal cumulation of origin. It flags the potential sectors and products that may benefit, taking into account existing trade structures, including the import of intermediate goods and raw material from and export of finished products to PEM countries. The analysis below cannot at this stage capture the possible benefits in full. Some such benefits may emerge as a result of increased FDI in manufacturing of products that are new to the respective countries. Such new opportunities may include investment by countries which have FTAs with the three states but are not parts of the PEM Convention. For example, new investment opportunities may emerge for Chinese investors in Georgia as a result of the recently negotiated bilateral FTA to be signed in May Namely, intermediate materials imported from China may be combined with Georgian and Turkish materials and thereby satisfy the required domestic content of origin for export of the finished product to the EU. Such schemes would open up new opportunities for investors as well as traders. In what follows, the potential of diagonal cumulation opportunities are outlined for the three states, Georgia, Moldova and Ukraine. In each case first the general picture is given by providing data of the import of intermediate goods from the PEM countries for each of the three states, in order to see the current trade structure between the PEM countries in terms of intermediate goods. Subsequently, specific products and sectors are identified where

14 12 KOVZIRIDZE, MOVCHAN, GUMENE & EMERSON additional production and trade opportunities could emerge as a result of diagonal cumulation among the PEM countries. On the preliminary assessment there are a couple of products that may mainly be expected to benefit in the medium-term. Georgia The potential benefits of diagonal cumulation could be interesting for Georgia, given its small market with limited raw materials, importing intermediate as well as final products. The possibility to cumulate origin with local as well as imported intermediate products will increase chances for local products to qualify as made in Georgia. Among parties to the PEM Convention Georgia has free trade agreements with the EU, EFTA and Turkey, as well as Moldova and Ukraine, which will soon start to benefit from PEM conditions as well. Table 3 gives data on trade for , since the signature of the DCFTA, including the volume of import of intermediate products, their share in total as well as growth/reduction between Currently there are no specific plans to sign free trade agreements with other PEM signatories in the foreseeable future. Therefore, no other PEM signatories are included in the Table 3 below. As we can see from the table, Georgia imports roughly half of its intermediate products from its current PEM partners, whereby Turkey has the largest share (23% in 2016), followed by the EU (21% in 2016) and Ukraine (6% in 2016). This existing picture of export structure indicates that there are opportunities of diagonal cumulation within PEM countries given substantial import of intermediate products from the latter. Table 3. Georgia's Imports of Intermediate Goods 2014, USD 2014, % 2015, USD 2015, % 2016, USD 2016, % , % change World 3,362, % 3,137, % 2,989, % -11% RoW 1,611,499 48% 1,641,642 52% 1,476,511 49% -9% PEM 1,751,413 52% 1,496,000 47% 1,512,538 51% -14% Including EU 549,501 16% 575,747 18% 621,350 21% 13% EFTA 23,732 1% 37,358 1% 20,155 1% -16% Ukraine 256,872 8% 217,516 7% 173,999 6% -33% Moldova 7,266 0% 4,072 0% 6,766 0% -7% Turkey 914,041 27% 661,307 21% 690,269 23% -25% Source: WITS, authors own calculations.

15 THE PAN-EURO-MEDITERRANEAN CONVENTION ON PREFERENTIAL RULES OF ORIGIN AND ITS BENEFITS 13 The following Table 4 provides data on Georgia s export of final goods, with an emphasis on export to its current PEM partners over the past years. As the table shows, in the past three years since the entry into force of the DCFTA, the share of Georgia s exports of final goods to its PEM trade partners has risen from 41% to 44%. Unlike the import of intermediate goods, here Georgia s largest partner is the EU with 28% in 2016, followed by Turkey (8%) and Ukraine (7%). Table 4. Georgia's Export of Final Goods 2014, USD 2014, % 2015, USD 2015, % 2016, USD 2016, % , % change World 1,065, % 909, % 873, % -18% RoW 617,98 58% 516,53 56% 490,54 56% -21% PEM 447,77 41% 393,37 44% 382,98 44% -14% Including EU 252,761 24% 252,725 28% 243,684 28% -4% EFTA 2,810 0% 6,202 1% 5,018 1% 79% Ukraine % 42,191 5% 61,531 7% -45% Moldova % 6,455 1% 2,03 0% -55% Turkey % 85,80 9% 70,712 8% -7% Source: WITS, authors own calculations. Sector-specific effects As regards the potential for diagonal cumulation, for Georgia the EU and Turkey are the most promising partners. Activation of diagonal cumulation between Georgia, EU and Turkey is beneficial in terms of developing local industries as Georgia. The most likely beneficiary of the activation of diagonal cumulation in the short- to medium-term will be the textile industry in Georgia. However, diagonal cumulation will not apply to agricultural products as the EU-Turkey Customs Union does not cover this sector, and Turkey maintains a highly protectionist policies in agriculture. Table 5 below shows the export of final apparel products to PEM countries and import of intermediate apparel products from PEM. Almost 60% of imports of intermediate apparel comes from Turkey, and 70% of final apparel goes to Turkey, thus making the latter Georgia s largest trade partner in this product. The EU is in the second place out of the PEM partners with 16% and 18% respectively, while all other partners have a negligible share.

16 14 KOVZIRIDZE, MOVCHAN, GUMENE & EMERSON Table 5. Export of Final Apparel to PEM and Import of Intermediate Apparel Products from PEM, 2016 Exports of final apparel to PEM Imports of intermediate apparel from PEM USD share USD share EU 14,480,802 18% 6,684,983 16% EFTA 0 0% 14,175 0% Ukraine 316,235 0% 64,053 0% Moldova 0,121 0% 0 0% Turkey 56,085,344 70% 24,245,757 57% Total 80,194,992 42,462,574 Source: WITS, authors own calculations. Currently the textile industry consists of approximately 200 enterprises, with majority of small enterprises. Figure 1 below shows export of textile products from Georgia expressed in million USD for the period of Figure 1. Export of textile products from Georgia in (USD million) Source: GeoStat, National Statistics Office of Georgia. As Figure 1 above demonstrated, textile product export from Georgia has grown substantially in the past ten years. Even though export decreased starting from 2014, between 2007 and 2014 export of textile products still grew by 80%, from USD 16.0 million in 2007 (when Georgia-Turkey FTA was signed) to USD 81.0 million in This is mainly through export of products to Turkey. The textile industry was somewhat developed in Georgia during the Soviet period, but faced a major crisis after 1991, similarly to other sectors of the economy and re-emerged again starting from 2007 after the conclusion of the FTA with Turkey. Attracted by its comparatively skilled and low-cost labour, low taxes and preferential access to the Turkish and EU markets (then under the GSP+ regime, which was a temporary regime of trade preferences unlike the DCFTA), several European brands outsourced their production to Georgia and some Turkish companies established production plants in the Adjara region, at the border with Turkey.

17 THE PAN-EURO-MEDITERRANEAN CONVENTION ON PREFERENTIAL RULES OF ORIGIN AND ITS BENEFITS 15 Georgia does not produce fabrics and imports them mainly from Turkey (with a share of 39%), EU (24%) and China (17%). Consequently textile products produced in Georgia cannot obtain Georgian certificates of origin for tariff-preferential exports as they do not satisfy the comparatively high domestic content requirements that apply to textile products. Such products cannot benefit from the DCFTA tariff preferences except when fabric is imported from a PEM country with which Georgia has an FTA. In that case bilateral diagonal cumulation can work, notably with Turkey. Georgia s primary export market has been, and continued to be in 2016, Turkey, which usually further processes Georgia s exported textile products, and sells them into the EU as a Turkish product. As the Figure 2 indicates the biggest export market for Georgian textile products is Turkey, with a share of 69%, followed by the EU with 26%. Figures 2 and 3 below visualize respectively the structure of export of textile products from Georgia and main export markets, and main sources of import of fabrics, which are mainly used for textile production. Figure 2. Export from Georgia of textile products, 2016 Figure 3. Import to Georgia of fabrics, 2016 Source: GeoStat, National Statistics Office of Georgia. As soon as diagonal cumulation is activated, taking into account the rules of origin that applies to textile products, the latter produced from the imported Turkish fabrics can be directly exported to the EU market under the free trade regime. This can become a good stimulus for further development of the sector and attraction of FDI. To summarize, the analysis of statistical data as well as interviews with private sector representatives reveal that in the short- to medium-term perspective the most realistic prospective beneficiary of diagonal cumulation will be the textile industry, with a prospect to increase textile production in and export from Georgia. In particular export increases may go to the EU and Turkey, which will be a positive consequence of the DCFTA, in combination of the PEM convention.

18 16 KOVZIRIDZE, MOVCHAN, GUMENE & EMERSON Moldova In the context of the stringent need to diversify the export markets, the Moldova needs a quick and feasible solution, that would allow for greater regional integration and cooperation with other countries (EU, EFTA, CEFTA, Turkey, Ukraine, Georgia, etc.), in order to boost foreign trade and economic development. The full implementation of the diagonal cumulation of origin of goods provided for under the PEM Convention could be one way to achieve this goal. This issue has become even more topical after the entry into force of the EU-Moldova Association Agreement and DCFTA, as well as after signing the Free Trade Agreement with Turkey. Although the Convention came into force, currently Moldova cannot benefit from diagonal cumulation, since the technical procedures required for the actual implementation of the document are not yet completed, namely the required changes in bilateral FTAs among PEM countries and Moldova, where the PEM rules of origins should be explicitly mentioned. Currently a range of products on the EU market is produced in Moldova using mainly intermediate goods from PEM countries. As shown in Table 6, currently over 70% of the import of intermediate goods is coming from PEM countries, mainly from the EU. Thus, the share of such import from PEM countries is higher in Moldova than in Georgia even if the diagonal cumulation among the PEM countries does not yet apply. Table 6. Moldova's Imports of Intermediate Goods (BEC Classification) 2014, USD 2014, % 2015, USD 2015, % 2016, USD 2016, % , % change World 2,112, % 2,046, % 1,674, % -21% ROW 583,237 28% 573,236 28% 461,246 28% -21% PEM 1,528,984 72% 1,473,706 72% 1,212,805 72% -21% including EU 1,009,064 48% 1,030,440 50% 859,362 51% -15% EFTA 21,069 1% 18,230 1% 14,143 1% -33% CEFTA 12,595 1% 15,264 1% 10,100 1% -20% Turkey 185,816 9% 148,615 7% 128,853 8% -31% Ukraine 287,537 14% 249,875 12% 191,803 11% -33% Georgia 2,912 0% 30 0% 49 0% -98% Source: WITS, authors own calculations. Table 7 provides data on Moldova s export of consumption goods, with an emphasis of export to its current PEM partners over the past years. In 2016, more than half of Moldova s export

19 THE PAN-EURO-MEDITERRANEAN CONVENTION ON PREFERENTIAL RULES OF ORIGIN AND ITS BENEFITS 17 of consumption goods went to PEM countries and almost all of them to the EU. Georgia and Ukraine hold only minor shares of 2% and 4%, respectively. 6 Table 7. Moldova's Exports of Consumption Goods (BEC Classification) 2014, USD 2014, % 2015, USD 2015, % 2016, USD 2016, % , % change World 765, % 621, % 498, % -35% ROW 347,467 45% 330,068 53% 233,013 47% -33% PEM 418,062 54% 291,212 47% 265,043 53% -37% including EU 334,939 44% 228,633 37% 215,580 43% -36% EFTA 3,214 0% 4,566 1% 3,335 1% 4% CEFTA 1,629 0% 3,070 0% 2,715 1% 67% Turkey 5,971 1% 4,957 1% 8,559 2% 43% Ukraine 56,854 7% 35,718 6% 20,153 4% -65% Georgia 13,314 2% 11,739 2% 11,363 2% -15% Source: WITS, authors own calculations. At present Moldova s regional trade potential is not fully exploited due to the limitations imposed by the rules of origin, despite the existing network of free trade agreements. Evidently, this can be corrected through the possibility of diagonal cumulation provided for by the PEM Convention. The main advantage from accession to the PEM Convention lies in the fact that exporters will not be limited to the use of raw materials from the EU and Moldova, in order to benefit from preferential access to the EU market. Instead, there may be the possibility to use raw materials, possibly cheaper, from other partner countries from the PEM area, as long as Moldova has negotiated a free trade agreement with them, for duty-free exports to the EU. Similarly, the PEM convention can be used for exports from Moldova to CEFTA, Turkey or other countries within the PEM area, using raw materials from the EU. It also increases incentives for producers located in such countries to make use of inputs from Moldova. Sector-specific effects Over the last few years, industrial goods have represented an increasingly important share in the Moldova s export structure, due in part to the modified legal framework and production opportunities in its Free Economic Zones and Industrial Parks. These created the infrastructure and normative framework required for the development of non-food processing industry within the framework of suspensive custom regimes. As a result, a large share of the country's 6 However, the statistical data shown in the above tables partially reflects the real trade flows, as part of the intermediate goods are not meant to produce consumption goods, while a number of products exported by Moldova are not consumption goods but rather intermediate ones.

20 18 KOVZIRIDZE, MOVCHAN, GUMENE & EMERSON industry which is export-oriented operates under the regimes of Free Economic Zones (FEZ) or Inward Processing (IP). Among the industries profiting most from these regimes we can mention the textile industry, footwear industry, production of machinery and mechanical appliances, electrical machinery and electrical equipment industry as well as the furniture industry. In addition to fiscal incentives, the relatively cheap labor force compared to EU countries and the geographical proximity to EU markets have determined the development of these branches of industry in Moldova. At the same time, in the EU member states, these industries are in a continuous process of reorganization, with the movement of the production process to neighboring states including the PEM area. The industries that use intermediate goods in large proportions are textiles and components for the automotive industries. These are therefore sectors which could benefit the most in the short run from the implementation of the PEM cumulation of origin system. Table 8 shows the evolution of the exports of final apparel and footwear in PEM countries, but also of the imports of intermediate goods from the PEM region. As we can see, in 2016 the EU was the main export partner with a share of 91%, followed by Turkey with a share of 9%. Meanwhile, the imports of intermediate goods from the EU amounted to 58% and Turkey to about 41%. However, in the absence of diagonal cumulation, companies from the EU are limited in the possibilities to outsource production processes to Moldova, since the range of technological processes that could confer originating status to goods from third countries is limited to bilateral level only (especially in case of textiles). Hence, once the diagonal cumulation applies, there will be new opportunities under the PEM Convention for trade with Moldova s PEM partners. In particular the possibility to use cheaper raw materials from other partner countries within the PEM area could provide additional incentives for investment in Moldova. Table 8. Trade in apparel and footwear in 2016 within the selected PEM countries Exports of final apparel and footwear to PEM Imports of intermediate apparel and footwear from PEM USD share USD share EU % % EFTA 661 0% % CEFTA 1 0% 46 0% Georgia 0 0% 0 0% Ukraine 12 0% 551 0% Turkey % % Total Source: WITS, authors own calculations.

21 THE PAN-EURO-MEDITERRANEAN CONVENTION ON PREFERENTIAL RULES OF ORIGIN AND ITS BENEFITS 19 In the automotive components industry there were substantial investments in Moldova in the last few years by specialized EU companies, generating clear perspectives for continuous development of this sector. At present exports of vehicle components are directed almost exclusively to the EU market, namely about 99%. At the same time, the import of raw materials is more diversified, 66% being imported from the EU and 31% - from Turkey. Table 9. Trade in vehicle components in 2016 within the selected PEM countries Exports of intermediary parts of vehicles to PEM Imports of intermediary parts of vehicles from PEM USD share USD share EU % % EFTA 91 0% 0 0% CEFTA 0 0% 0 0% Georgia 0 0% 0 0% Ukraine 174 0% 576 2% Turkey 478 1% % Total Source: WITS, authors own calculations. In conclusion, PEM cumulation should attract new forms of expansion for EU companies in Moldova, by virtue of diversification of the initial raw materials base, which could lead to the development of new competitive advantages for the economy. In the long run there should emerge the development of some sectors with substantial technological and human potential, such as the automotive manufacturing industry including the production of components for the automotive products, and the machinery and equipment industry. These would contribute to the development and modernization of other industrial sectors. Also, implementation of the PEM Convention should become a catalyst in terms of the regional economic integration, the liberalization of trade, and attraction of new FDI. Ukraine To understand whether Ukraine could benefit from the PEM, current trade patterns of the country in terms of intermediate and final products are analysed. Table 10 shows Ukraine s imports of intermediate goods. The importance of trade with the PEM countries has been growing recently for intermediate products. In 2016, 51% of intermediate goods were shipped from the PEM countries, with which Ukraine has or negotiates FTAs, mainly the EU, the EFTA and Turkey. This share increased compared to 2014 due to the expansion of the role of the EU and the EFTA, largely because of the reorientation of Ukraine s gas imports. Out of the PEM country pool, 86% of intermediate goods import stems from the EU.