resulting pattern of trade being of the inter-industry rather than intra-industry pattern. As soon as inter-industry trade involves the sourcing of a fraction of intermediates from the outside world and there is potential for regional trade in the final product (e.g. in apparel and other light industry products), the experience of the EU and US becomes relevant.

East Asian trade has grown remarkably rapidly in the last 15 years through the breaking up of the manufacturing process or the ‘slicing up of the value chain’. With tariff cuts on a discriminatory basis in the China-ASEAN FTA and the Japan-ASEAN bilaterals on the table, tensions are likely to appear in the region. One likely element of these tensions will be the negotiation over Rules of Origin (RoO).

So why are RoO in AFTA apparently less stringent than elsewhere? First, until recently Asian regionalism has been more about cooperation than about preferential trade (APEC under the aegis of the US was specifically set up to avoid preferential trade and the formation of an ‘Asian trade bloc’), with much of the Region’s integration in the world economy driven by unilateral tariff reductions. Second, much of the regional trade has been part of the development of the ‘Asian manufacturing matrix’ whereby the labor-intensive stages of production initially carried out in Japan and then Korea have been outsourced to the lower-wage countries in the region for final exporting to the EU and US markets. In this unusual set-up relative to the other global trading patterns, intra-regional trade in politically sensitive final products where protection is highest was insignificant. Hence, the political-economy forces that would usually lead to lobbying activity resulting in the complex RoO observed elsewhere was not observed.

# **3. The Economics of RoO**

RoO are often justified as an instrument to promote industrialization in low-income countries (or value-added-generating activities). In fact, they impose costs on the intended beneficiaries of preferences. In addition, contrary to what is claimed, rather than help countries industrialize, they end up suppressing trade, an effect that could be particularly important in AFTA countries where much fractionalization of production takes place (Erasmus et al. (2006) provide vivid examples based on case studies in SADC where RoO have been claimed to be a development tool for lowincome members).

The suppression effect of RoO can be easily visualized if one considers that the production of a final product involves a continuum of activities, with the range of activities being ordered in decreasing labor-intensity. For example the sowing of buttons on a shirt could take place in low-income Cambodia, the weaving in Indonesia, the production of yarn in Indonesia. Then imposing a minimum regional VC would suppress trade with the outside partner (Bangladesh) and redirect investments to the region. As a result, production costs would increase and efficiency would fall.

Below we present a general decomposition formula of the costs of RoO using a minimum VC. This decomposition motivates the review of evidence that follows and serves a justification for the new estimates presented in section 4.

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