# **2 Preliminary Evidence on PECS and Sourcing Decisions**

FTAs have been a major instrument behind reciprocal liberalization. Between 1950 and 2017, 288 Regional Trade Agreements entered into force with FTAs representing the largest part of the category.<sup>2</sup> To prevent trade deflection or simple transshipment— whereby products from non-preferred countries are redirected through a free trade partner to avoid the payment of customs duties— RoOs are used in FTAs. Theoretically, for each FTA, a particular set of RoOs can be established, negotiated according to the trade, industrial, and economic interests of each party.

Historically, EU FTAs have been characterized by bilateral rules of cumulation, which implied that only inputs among the countries belonging to the FTA could have been cumulated to count towards the establishment of the origin of the product. For example, a country belonging to the Baltic Free Trade Area (BAFTA) agreement could cumulate inputs only from the EU or other BAFTA countries to obtain origin status for the related final good, and export it to the EU under preferential tariffs. Meanwhile, when the imported intermediate originated from countries of other FTAs, like the Central European Free Trade Agreement (CEFTA), these inputs would not have counted to fulfilling the EU-RoOs applied to the related final good. The existence of multiple FTAs led to a spaghetti bowl of preferential areas (and thus RoOs) that did not favor the slicing up of the value chain across Europe (Baldwin, 2006). To reduce the heterogeneity of RoOs in the pan-Euro-Mediterranean region, the EU and its partners agreed on a single set of rules of origin. This was achieved in 1997, which saw the creation of the pan-European cumulation system (PECS). While the PECS system was introduced in 1997, countries did not join immediately. Among the BAFTA and CEFTA countries, the system could be considered mainly in place as of 2002.<sup>3</sup> Since this paper focuses on the impact of RoOs and RoCs on sourcing decision, we exploit the introduction of the PECS and investigate changes in imports among a group of the EU FTA’s peripheral partners, BAFTA and CEFTA (also called Spokes), between 1995 and 2002. To provide preliminary evidence of the effect of PECS on trade relationships, in Figure 1 we plot the evolution of imports to Spoke countries before and after the introduction of PECS.<sup>4</sup> The vertical axis measures changes in imports to each Spoke country from RoW (non-participating countries). Notice that we exclude imports from Spokes themselves and from the EU15. The horizontal axis measures changes in imports to each Spoke country from

> 2For further information see http://rtais.wto.org/UI/PublicMaintainRTAHome.aspx.

> 3The system was based on the EEA agreement (1994) between the EU, the EFTA countries, the CEEC (Central Eastern European Countries) and the Baltic States. Table 12 in Appendix A provides further details about the preferential agreements providing for diagonal cumulation of origin between the EU and the Spoke countries. The system was then widened to Slovenia and to industrial products originating in Turkey (1999). The system was also enlarged to the Faroe Islands in 2005 and later to the countries of the Mediterranean and Balkan region.

> 4Our analysis considers imports of BAFTA and CEFTA countries. Notice that Bulgaria, the Slovak Republic, and Slovenia are dropped from our analysis due to absence of tariff data in the period under consideration. Section (3.2) provides additional details about trade and tariff data used.

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