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# **Piffalls: Hub-and-Spoke Pattern and Rules of Origin**

The 'hub-and-spoke' pattern is potentially harmful as it may produce significant distortions in allocation of resources. There are two sources of distortions: differences in market access and rules of origin. Distortions due to market access are mainly at the expense of 'spoke' countries, as the 'hub-and-spoke' situation puts "spoke" firms in disadvantage vis-a-vis "hub" firms simply because the latter have better market access than 'spoke' firms to other spokes. Firms, especially those operating in increasing returns-to-scale industries, may seek to exploit advantages offered by differences in trade barriers and relocate or expand their activities at hub at the expense of spokes. Although preferential access to hub markets and low wages in spoke economies may offset significant relocation of industrial activity to hub and generate dynamic growth effects in spokes,<sup>6</sup> the 'hub-and-spoke' pattern reduces benefits of integration to a "Southern" partner.

The choice of rules of origin impacts the spatial distribution of production activities within FTA and may frustrate the objectives of economic development. The distinction should be made between preferential (as stipulated in FTA) and World Customs Organization nonpreferential rules of origin. The latter tend to be more restrictive than the former, simply because they go beyond the usual "change-of-heading" approach typical for nonpreferential rules of -origin (see, for instance, Krueger 1999, Panagariya 1999). Their impact on distribution of production activities within FTA depends on the kind of a cumulative system that is used.7 Flexible rules of origin encourage sourcing of inputs outside FTA countries, whereas "... strict rules of origin (...) may affect upstream, side-stream or downstream third-country producers of inputs" (UNCTAD 1998, paragraph 47).

The preferential rules of origin,<sup>8</sup> an indispensable component of any FTA to avoid trade deflection as well as often to take into account interests of domestic industries,<sup>9</sup> tend to offer extra advantages to "hub" firms for three reasons. First, "spoke" firms operate within much smaller economies and, therefore, tend to rely more on "externally" imported inputs including other spokes. This often puts a hub firm in a better position that a similar spoke firm in meeting the conditions for preferential access.1<sup>0</sup> Since the industrial base of the EU or EFTA is dramatically

**6** Empirical evidence corroborates this possibility. In large part thanks to FDI, relocation of higher valueadded industries from CEECs to the EU has not occurred. To the contrary, most FDI in Hungary, for instance, have gone to sectors at a higher end of the technology spectrum (Hamar 1998, Kaminski and Riboud 2000). This phenomenon was also observed in Ireland albeit after accession to the EU (Barry 1996).

7 Cumulation, i.e., the requirement that sufficient processing of the product occurs in any of<sup>theFTA</sup> countries, can be bilateral (i.e., between two signatories of FTA), diagonal or partial, and full. Full cumulation reduces the potential for trade diversion implicit in FTA. For an extensive discussion, see UNCTAD 1998. Needless to add that non-cumulation is more restrictive than cumulation.

8 Rules of origin spell out the conditions that a product must satisfy in order to be eligible for preferential access to markets as determined in a regional agreement. The rules of origin defined in the SAAs and Europe Association Agreements are identical. While the agreements use change of tariff heading at the four-digit level of the Harmonized System to define origin, they also use technical requirements especially for such products as footwear, textiles and clothing.

9 'Trade deflection' describes a situation when an importer in a high-duty country imports<sup>aproduct</sup> through a low-duty country and then re-export it to the importer's duty-free. Rules of origin are<sup>used to</sup> prevent it. However, preferential rules are often specified in ways minimizing competition from imports and/or enhancing export prospects to the FTA partner.

**10** Note also that meeting the requirements of the rules of origin increases the costs. These are huge amounting-according to an estimate for EFTA-European Community trade (Herin 1986)-to between