The use of local content requirements (LCRs) has been growing for a long time. Used by developed as well as developing countries, they aim to promote the use of local inputs and serve the purpose of fostering domestic industries. Argentina, Brazil, China, India, Indonesia, Russia, Saudi Arabia and the USA are very frequent users of LCRs. India is by far the most prominent user, followed by Brazil. While LCRs might have perceived benefits related to specific policy goals in the short term, the damaging impacts of LCRs evolve over time and outweigh short term benefits. This study estimates the economic impact of LCRs in a selected sub-sector of motor vehicles, where they are frequently used, i.e. the heavy duty vehicles subsector.
ECIPE collected LCRs which affect the selected subsector in a database, classifying them by three different dimensions: their different types, their scope, and their level of impact. This database is used as a basis for the assessment of the economic costs of these LCRs for BRICS countries. Overall, 72 different LCRs have been identified. Most LCRs were found in Brazil and Russia, which each apply 20 measures, followed by India with 15 and China with 13 measures. Finally, in South Africa there are only 4 measures in place which affect the heavy vehicles sector. The analysis finds that most LCRs are related to government procurement, financial support and business operations, as well as to export measures. In addition, we find that the LCRs that are related to financial support and business operations have generally a high impact. For the purposes of this study, the cost of the collected LCRs has been estimated by translating their negative effects into ad valorem equivalents (AVEs). Brazil and Russia apply the most distortive LCRs for heavy vehicles with an estimated increase of their import price of 15.6 and 11.1 percent in both countries respectively. China and South Africa both show low AVEs of 4.5 and 3.3 percent respectively, and India’s LCRs are least distortive with an estimate of 2.2 percent.
Estimating the impacts of the collected LCRs on the economy in the BRICS countries shows that their impact is at least threefold. First, the LCRs have a negative impact on trade in heavy vehicles in the BRICS countries. The identified LCRs are estimated to restrict imports of heavy vehicles by -21% and -12% in Brazil and Russia, while for the other BRICS countries imports of heavy vehicles are reduced between -9.3% and -3.7%. Although to a much lesser extent, the identified LCRs also reduce BRICS countries’ exports of heavy vehicles. Second, LCRs significantly increase the prices for imported heavy vehicles leading to higher prices for firms as well as consumers. The prices firms have to pay for intermediate goods in the heavy vehicles sector are estimated to increase up to 2.9% and 4.8% in Russia and Brazil. Consumer prices for heavy vehicles are estimated to rise between 0.2% and 5.4%. Third, our estimations show that LCRs increase industry output in the targeted sector, but only at the expense of other closely related industries which decrease their industry production.
For example, while industry output in the heavy vehicles sector increases between 0.2% in China and 10.37% in Russia, the domestic production of other transport equipment and other machinery in Russia and Brazil decreases by -0.16% to -0.37%. While it is only natural that industry output that is subject to protection by LCRs increases, the analysis shows that this effect is outweighed by the detrimental side effects. LCRs raise the price of the product it protects and of the product which requires protected inputs, in this case heavy vehicles. As a result, this raises expenditures for every buyer in the economy, which has a depressing effect on sales and output also in other industries. Final consumers as well as firms have to reallocate resources from other areas in order to pay for more expensive vehicles and vehicle parts. Over time LCRs can therefore lead to lower competition, less innovation, and less product variety in the domestic market, which reinforces the negative effects of LCRs.
The analysis illustrates the detrimental impact of LCRs, highlighting again the need for policymakers to address the growth of LCRs and their significance in modern protectionism more thoroughly. A first multilateral option is an increased use of complaints through the WTOs Dispute Settlement Body (DSB) in order to eliminate them and to have specific LCRs declared incompliant with WTO rules. This would also establish necessary additional jurisprudence covering a wider set of LCRs. A second multilateral option is the start of negotiations in the WTO. The topic of LCRs should indeed be high on the new working agenda in order to clarify current rules on LCRs and to obtain stronger negative rules against their use. If negotiations among the entire WTO membership do not progress, a “coalition of the willing” of member countries could engage in negotiations with the aim of clarifying rules and making them stronger. These negotiations should be supported by a larger body of economic analysis on the full range of existing LCRs. In addition, negotiations on bilateral free trade agreements (FTAs) should lay a stronger focus on LCRs. Current EU negotiations on FTAs offer a good ground for such efforts and LCRs should be front and centre in EU FTA negotiations planned in the future.
The authors gratefully acknowledge the research assistance by Nicolas Botton, Julie Richert and Sebastian Schuhmann.
The Use of Local Content Requirements in the World Economy
Local content requirements (LCRs) have a long history. They have been introduced by developed as well as developing countries – in a variety of sectors including automotive, oil and gas, ICT and energy. Especially after the 2008 financial crisis the world has experienced a rapid increase in the use of LCRs. Many countries have introduced discriminatory trade measures with the purpose of benefiting domestic firms at the expense of foreign competitors. Such measures have been a common feature of public procurement policies.
As an effect of increased liberalization and global trade integration, especially after the Uruguay Round, governments cannot use tariffs as much as before for protectionist purposes. However, governments have increasingly turned to non-tariff barriers (NTBs) and are using them with greater ease and flexibility. Local content requirements (LCRs) is a case in point. Such measures are often obscure and, in the first place, difficult to observe. Unlike tariffs, they are neither numerical nor upfront. Some countries have given LCRs a central role in their recent trade policy and consequently introduced more discrimination and restriction in how exporters can access markets. Their growth and consequences have now become a major concern for global trade policy and should warrant far more attention, both in economic analysis of trade and in the articulation of trade policy.
This paper aims to support both these ambitions. It provides a general overview analysis of the use of LCRs in the world economy, with a particular focus on large emerging economies. Furthermore, it estimates the economic impact of LCRs in a selected sector, motor vehicles, where they are frequently used. The analysis also includes a more specific analysis of the heavy duty vehicles subsector. Finally, the paper outlines ideas for how policymakers can address the growth of LCRs and their significance in modern protectionism.
Many national economies have been struck by the effects of the world financial crisis in 2008. All countries have tried to find ways to rehabilitate. Some have reacted with ambitious policy reforms with the ambitions to boost the local economy, foster domestic growth and mitigate the negative impact of troubled world economy climate.
Some of those reforms (re-)introduced aspects of protectionist policy. One type that has experienced increased attention in this context are LCRs. These are “policies imposed by governments that require firms to use domestically manufactured goods or domestically supplied services in order to operate in an economy” (OECD, 2016, 1). There are ongoing discussions about the clear definition and limitation of the category LCR proposing the inclusion of distinct types of NTBs or other types of localization requirements like rules of origin. Examples for such policies are India’s LCR on foreign enterprises in the solar panel industry and ICT equipment to include a certain share of domestically produced inputs or LCRs for digital service providers that require local data storage in Russia, South Korea and Venezuela (Ezell et al., 2013, 8). LCRs can generally include measures on condition tax and price concession on local procurement, condition bailouts, government contracts and export financing on local sourcing, tailor import licensing procedures to encourage domestic purchase, reservation of certain lines of business for domestic firms, requirements on local data storage and analysis and local product tests (Evenett, Fritz, 2016, 21).
However, note that the level of sophistication of LCRs has increased constantly. LCRs can also include requirements related to local assembly, and benefits such as tax cuts, tax refunds or complete tax exemptions are often implemented for domestically manufactured goods that comply with a certain amount of local content. These practices can also come in the form of discriminatory tax measures or provisions that favor local businesses, locally assembled products or the requirement of local content in goods (European Commission, 2016, 7). In certain cases, foreign producers can make use of duty-free imports of components, under the condition that the local content of their importing products is of a certain amount. Some countries implement preferential procurement regulations which grant preferences for local products and, in certain cases, markets are even completely reserved for locally produced goods (Ramdoo, 2015, 11 & 21).
Furthermore, it has to be stressed that the impact of LCRs for affected businesses and the economy where they are implemented goes beyond the mere direct measures described above. Regarding the effects on foreign companies that look to enter a market in another country, the harmful effect of LCRs is also due to a level of uncertainty that they create in the regulatory environment. Due to uncertainty of interpretation of LCRs these companies have to invest significant resources into trying to adapt to LCRs and into gathering information on how they will develop and on what the implementation of a specific LCRs will entail for their business operations. LCRs have evolved in sophistication over time and the more specific LCR requirements are expressed the more detrimental the impact can be for business. This is true, for example, for specific R&D requirements that companies have to comply with. Furthermore, LCRs can affect the business strategy of a company for the market in question.
LCRs can also have overall detrimental spill-over effects for the entire economy in the country in which they are implemented. To comply with LCRs, many companies are applying the strategy of relying on local services providers in the market in question. This entails a strong bias between production and services which is artificially created by LCRs. Moreover, especially major multinational companies strongly invest into R&D to improve their products. Certain advanced parts that have profited from strong investments in R&D are, however, excluded from the target market as LCRs require using locally produced parts. Thus, the implementing country is shielding itself from profiting from international R&D investments made by trading partners. More specifically, this can lead to a deterioration of long-term competitiveness of the companies in the country which implements the LCRs.
Most importantly, LCRs can artificially reduce the market size that a foreign company can cover, reducing the company’s incentives to export to the market in the first place. The economy implementing LCRs is depriving itself from having access to competitive and advanced products, which – in the case of trade in automotive products – can have a harmful effect on transport efficiency and sustainability within the market and create costs for consumers. Furthermore, LCRs increase the cost of production which decreases the incentives to export from the market in question.
The Growing Use of LCRs in the World Economy
Just like other types of NTBs, LCRs have existed for several decades already. The frequency of its application in recent years, however, is striking. Various countries have applied LCRs as a protectionist measure at different times in different contexts in order to address economic turbulences (Semykina, 2015, 4f). Therefore, NTBs have appeared in waves linked to economic cycles, like the Smoot-Hawley tariff escalation following the Great Depression in 1929. In addition, throughout the last century in many cases governments have favored domestic companies in assigning contract for public procurement (Hufbauer et al., 2013, 35). Hufbauer et al. (2015, 2) even claim that LCRs are rather the norm than an exemption in public procurement. Hence, earlier types of LCRs mainly addressed public procurement and mandate allocation for publicly financed projects (Cimino et al., 2014, 1).
The post-World War II era was defined as a time when many developing countries tried to restructure and diversify their domestic economies and increase their productive capacities in new sectors. They invested in certain sectors to improve their international competitiveness. For example, Latin American countries tried to expand their natural resource-based sectors and Asian countries increasingly sought to exploit their comparative advantage in highly skilled labor-intense sectors (Tordo et al., 2013, 18). Support by complex protectionist policies imposed by the governments became an incrementally common feature at that time, for example in 1953 when the Brazilian president Vargas urged the national oil company Petrobas to just use workers, capital and technology with Brazilian origin. Developed countries also strategically used LCRs to promote the growth of selected industries. In the 1970s, Norway imposed LCRs in its oil and gas sector for the first time.
The policy reversal started in the 1980s with new attempts to free up trade and take away various distortions of competition. World trade was gradually liberalized and some industries that had been privatized and deregulated showed greater appetite to take a larger role in trade policy. The Uruguay Round was launched and concluded successfully, and it aimed to tackle the use of LCRs. Even earlier in 1984 after a complaint brought by the USA, the Administration of the Foreign Investment Review Act (FIRA) Panel of the GATT ruled in a dispute settlement process that a LCR imposed by Canada was inconsistent with the national treatment obligation according to Art. III:4 of the GATT. The Uruguay disputes between developing and developed countries led to a compromise about the limitation of the legality of LCRs to certain Articles of the GATT provisions (Article III and Article XI). The agreement on Trade-Related Investment Measures (TRIMs) introduced by the WTO in 1994 again decreased legal opportunities for LCRs. However, in the 1990s many developing countries missed out the expected growth effects and questioned the efficiency of the undertaken trade liberalizations. A reversion to bigger government interventionism was the consequence (Tordo et al., 2013, 19). Many sought to overcome their strong dependency on other economies and aimed at export diversification. Therefore, policy was directed towards the promotion of the development of certain industries.
But despite the deeper integration of world trade and stricter and binding WTO rules, LCRs have quietly returned and been transformed into new types that are always one step ahead the trade regulation framework. This also highlights problems in the accountability of trade rules violations in the current world trade governance (Evenett, Fritz, 2016, 21). Still, LCRs became subject to numerous dispute settlement cases in the WTO which often led to penalties (Ezell et al., 2013, 13). Politicians have simply shifted from more transparent and direct forms of protectionism towards more “opaque” behind-the-border NTBs. D’Costa (2009, 621) argues that “even under globalization, economic nationalism in subtler forms can be practiced.” Despite the long existence of LCRs, the increase of their appearance in recent years as well as an increase in their complexity is remarkable (Ezell et al., 2013, 13). Also, the European Commission addressed recent LCRs as new types of covert protectionism (Von Unger, 2016). Many LCR may even remain unnoticed because of inadequate information and late notification to the WTO (Cinimo et al., 2014, 11). Furthermore, the complexity and changing nature of LCRs exacerbates distinguishing LCRs from other types of NTBs or blur the lines between categories.
Many governments increased their use of LCRs during the global financial crisis. These measures have been applied in a variety of sectors including automobile, information technology, healthcare and agriculture (Hufbauer et al., 2013, 36). Some sectors show an especially frequent use of LCRs, though, namely the energy and information technology sectors (Cimino et al., 2014, 2). The questions of which sectors are affected depends on the specific nature of each LCR. Some even have a very sector-specific design. Furthermore, it is crucial whether the LCR is trade- or rather investment-related. In recent years, large economies with high population have been keener to impose LCRs. One reason could possibly be that they assumed their market size big enough to attract large scale FDI despite occurring protectionist measures (Stone et al., 2015, 14). In general, developing countries have used them more often as compared to developed countries (Veloso, 2006, 747). Countries with higher GDP have implemented LCRs rather in sectors depending on services while countries with lower GDP showed a higher number of LCRs in industrial sectors (Stone et al., 2015, 14). There is another correlation between the level of unemployment in the whole economy, as well as in the specific sectors affected, and the LCR used (Stone et al., 2015, 16).
Note that there are perceived benefits of LCRs and governments might resort to their use for justifiable policy goals. By imposing LCRs governments might try to promote general political goals like maintaining or improving the domestic employment, attracting FDI and companies from high-value added and R&D intense industries, and increasing the access to foreign technology (Stone et al., 2015, 17; Veloso, 2006, 750; Ezell et al., 2013, 4). Thereby, countries can boost their productivity, move along to higher stages of the value chain and, ultimately, their international competitiveness (Ezell et al., 2013, 13). Spillovers triggered by a large level of local content act as drivers of these processes. As a result, countries may be able to diversify the economic portfolio and develop other industries around LCR-protected sectors (Semykina, 2015, 5). LCRs can also serve as a political tool for achieving justifiable environmental goals particularly in the renewable energy sectors. Countries that use LCRs in these sectors include Brazil, Canada, United States, South Africa and others. The narrative of LCRs in this sector suggests that “high financial support for renewable programmes might not be publically supported if there were no local benefits” (Kuntze, Moerenhout, 2013, 34). This sector is very delicate as it has to pay attention to the twofold challenge of achievements in climate change mitigation on the one hand and energy security on the other (IEA, World Bank, 2013). However, despite perceived benefits related to such policy goals, in the long-term damaging impacts of LCRs frequently outweigh short term benefits.
Single measures may have been announced to be just temporary but turn out to be more permanent (Stone et al., 2015, 12). A famous example is the Buy-American Act of 1933 that has been amended several times in the aftermath but never been repealed (Hufbauer et al. 2015, 2). In many cases governments even choose to avoid providing official reasons for the implementation of LCRs. (Stone et al., 2015, 14). LCRs imposed in response to the 2008 financial crisis were designed especially for encountering the rising unemployment. Earlier LCRs rather had a wider array of motivations including the protection of infant industry (Hufbauer et al., 2013, 36). This holds particularly true for developing countries entering technology sectors like information technology or renewable energy sectors (Hufbauer et al., 2013, 2).
The Detrimental Impact of LCRs
Measuring the harm caused to foreign trade and investment by the type of measure, LCRs have been ranked fifth (public procurement localization) and seventh (other localization requirements) (Evenett, Fritz, 2016, 36). The other measures that are on places one to four are state aid, trade defense, import tariffs and export taxes or restrictions, while trade finance measures are on sixth place. (Evenett & Fritz, 2016). LCR measures related to trade can take on various forms but an increase has been observed in the use of LCRs related to data localization requirements. As data flow has become an essential aspect of trade, LCR measures related to this have an impact on a majority of sectors within an economy (OECD, 2016, 3). There is an increasing effort to control the local storage and processing of data as well as the movement of personal data. LCRs are highly common in the form of discriminatory government procurement, which reduces the number of eligible firms to enter a market. This reduces output and employment while increasing market power and procurement costs (OECD, 2016, 3). Some experts already perceive this type of protectionism as “perhaps today’s greatest threat to the further liberalization of the global trading system” (Ezell et al., 2013, 5).
The natural consequence is a growing awareness amongst policy makers and in the business world about the rise of (neo-) protectionism and LCRs particularly. The increasing number of reports published by official and private institutes in recent years are indicators for this development (Stone et al., 2015, 11f). LCRs became a topic on international economic conferences (Hufbauer et al., 2013, 13). Furthermore, the website GlobalTradeAlert.org was established in 2009 collecting all monitored discriminatory trading barriers in world trade as well as the Trade and Investment Barriers Report (TIBR) provided by the European Commission yearly since 2011. The US Trade Representative (USTR) established the Trade Policy Staff Committee Task Force on Localization Barriers to Trade in 2012. Theoretic considerations on LCRs date back to the 1970s starting with Baldwin and Richardson (1972), followed by Grossman (1981), Mussa (1984), Davidson et al. (1985), Krishna and Itoh (1988). Further literature concerning the effects of LCRs in different economic settings has been subsequently published by Richardson (1991), Moran (1992), Belderbos and Sleuwaegen (1997) and Tomsik and Kubicek (2006).
However, the number of LCRs does not necessarily indicate the significance of their trade distortion (Hufbauer et al., 2013, 4). Also, despite the large majority of literature pointing out the distorting (long-run) effects of LCRs, there remain voices that highlight the potential advantages following the implementation of a LCR with reasonable content and under certain conditions (Veloso, 2006, 749). One example is the oil and gas industry in Norway that has been regulated by LCRs and favored national companies even if they were not the most efficient (Tordo et al., 2013, 18). This success story depended on a variety of other factors, though, like the human capital, the high quality of institutions and related industries as well as the right timing (Heum, 2008).
The Current Use of LCRs in the World Economy
According to the GlobalTradeAlert database, the countries with the currently biggest activity in LCRs are Argentina, Brazil, China, India, Indonesia, Russia, Saudi Arabia and the USA (see figure 1.1). India is by far the most prominent user of LCRs, accounting alone for more than a quarter of global LCR use. Also Brazil stands out in terms of prominence of LCR in its recent economic policy (Ezell et al., 2013, 12). It has introduced more LCRs than any other country after 2008 (Hufbauer et al., 2013, 36). Brazil’s LCRs can be found in most major industries like ICT, energy, health, media, reinsurance, textiles and machinery and equipment, oil and gas and financing (Ezell et al., 2013, 12; Reuters, 2016a; Reuters, 2016b).
Figure 1.1: Share of globally implemented LCRs by country (%)
Source: Global Trade Alert
Another revealing case is the policy in China which requires foreign enterprises to establish joint ventures with Chinese firms with a minimum share of 50 percent remaining in Chinese ownership as a precondition of operating in the Chinese market (Ezell et al., 2013, 17). That gains additional weight considering that China has recently become the biggest automobile market in the world, which grew by nearly 14% in 2016 and is expected to reach 29.4 million sales (5% growth in sales) in 2017 (Nakamura & Tabeta, 2017; Tang, 2012, 5). Many foreign companies comply with this rule and reportedly joint-venture products consist up to 80% of foreign components (Tang, 2012, 24). The majority of all leading automotive manufacturers have established joint ventures in China as a means to produce locally and avoid the restrictions imposed on foreign automobile companies in the Chinese market (EU SME Centre, 2015, 13). International automobile manufacturers are most dominant in the passenger vehicle segments. However, these remain foreign manufactures that have formed joint ventures with domestic partners. Overall, the foreign investment possibilities in the automotive sector remain restricted (EU SME Centre, 2015, 17).
Also, the USA introduced massive fiscal programs as a consequence of the 2008 financial crisis. The America Recovery and Reinvestment Act (ARRA) of 2009 included clauses requiring that all iron and steel purchased using ARRA funds has to be produced domestically (Cimino et al., 2014, 2). An overview of the global top 15 countries of currently implemented LCRs is provided in figure 1.2, including information on the main sectors of global LCR use.
Source: Global Trade Alert