Forced Localization Policies Threaten Global Trade in Innovative Industries

bridges vol. 38, August 2013 / Innovation Matters

By Stephen Ezell

Photo of Stephen Ezell.Stephen EzellOver the past half century, the international trade community has made great strides in removing tariff-based barriers to global trade. In fact, the median global tariff rate has declined dramatically, from 26 percent in 1980 to less than 9 percent today. Yet, in many cases, countries have surreptitiously complemented the reduction or removal of tariff barriers by erecting a range of new, trade-distorting non-tariff measures (NTMs). Unfortunately, the World Trade Organization's 2012 World Trade Report finds that these non-tariff measures are almost twice as trade-restrictive as tariffs. Within the universe of NTMs, countries are increasingly turning to a particularly pernicious subset of trade barriers called localization barriers to trade, or LBTs.

Localization barriers to trade constitute a distinct and rapidly growing class of trade barriers that seek to impose location-specific conditions on global production, procurement, investment, and data flows. These so-called "forced localization" policies are designed to protect, favor, or stimulate domestic manufacturing industries, service providers, and/or intellectual property (IP) providers at the expense of foreign competitors, particularly those operating in innovative industries.

There are five classes of LBTs – those that are: 1) production- or sales-linked; 2) IP- or technology transfer-linked; 3) investment-linked; 4) standards- or certifications-linked; or 5) pertain to data localization. Production- or sales-linked LBTs impose location-specific conditions on the production, sale, or procurement of goods and services in public and/or private marketplaces. These include "local content requirements" (LCRs) stipulating that a certain percentage of a product or service contains local components; price preferences for domestic producers in public procurement; or requirements of local production to gain market access. IP- or technology transfer-linked LBTs compel intellectual property or technology transfer as a condition of market access, or force the local disclosure of foreign intellectual property, such as through the compulsory licensing of IP. Investment-linked LBTs require that firms enter into joint ventures or invest in local R&D facilities as a condition of market access. Standards- or certifications-linked LBTs require the use of country-specific technology standards or impose unfair certification requirements such as source code disclosure. Data-localization policies require that digital services be provided using local facilities or infrastructure, impose conditions on the storage or transfer of data within or across borders, or restrict the cross-border provision of digital services such as cloud computing. Virtually all these policies contravene either the law or the spirit behind countries' commitments in the World Trade Organization to liberalize global trade.

The use of all types of LBTs is growing globally, but local content requirements are perhaps the LBT most commonly deployed by countries. In fact, the Peterson Institute for International Economics estimates that, since 2009 alone, local content requirements implemented by countries have had a total negative impact of US$2.8 trillion on global trade. One of the most egregious examples has been India's Preferential Market Access (PMA) mandate, which imposes local content requirements on the procurement of electronic products by both government and private sector entities with "security implications for the country." A specified share of each product's market – anywhere from 30 percent upwards, and possibly rising to 100 percent by 2020 – would have to be filled by India-based manufacturers. Though India is currently reviewing the PMA's private-sector LCRs, the country's goal in introducing the PMA was to have 80 percent of the computer and electronics sold in India by 2020 be locally manufactured.

But it's not just India. Argentina, Brazil, China, Indonesia, Malaysia, Nigeria, Russia, Turkey, and Vietnam, among many others, have also introduced LCRs, impacting sectors ranging from information and communications technology (ICT), energy, and pharmaceuticals, to financial services and media. In Brazil, at least 70 percent local content is being required for the country's deployment of 4G wireless networks, while Brazil's Petrobras has been required to source as much as 95 percent local content for equipment used in oil and gas field exploration. Meanwhile, the Buy Brazil Act imposes a 25 percent flat price preference for all local providers in government procurement. Nigeria has gone so far as to implement an act banning the procurement and use of foreign computers and technological products in public institutions in Nigeria [when locally made products are available for use]. Nor is it only developing countries that are complicit. In the United States, the Buy American Provision in the 2008 stimulus package imposed LCRs on the steel and iron industries while multiple European Union countries, including France, impose LCRs in sectors such as audiovisual services. Meanwhile, in Canada, Ontario and Quebec require up to 50 percent and 60 percent, respectively, of renewable energy to be locally sourced in order to be eligible for subsidies and feed-in tariff incentives.

Requirements that firms transfer IP or technology, or invest in local joint ventures or R&D facilities, as a condition of market access are becoming increasingly common. For example, most US companies, including Ford Motor Co., DreamWorks Entertainment, and Fellowes, have been forced to enter into joint ventures and build new production or R&D facilities as a condition of entering China's marketplace. Korean public procurement contracts often include local production or technology-transfer requirements. Portugal announced in 2010 that any wind company wishing to gain access to its market had to partner with a local Portuguese university to conduct clean tech research as a way to more quickly gain technical know-how. And India issued a compulsory license authorizing local production of Bayer's anti-cancer drug Nexavar, in part because the drug wasn't being adequately "worked" (i.e., manufactured) in India.

ICTs increasingly drive global economic growth. In fact, the Internet alone accounted for 21 percent of the aggregate GDP growth from 2006 to 2011 across 13 leading economies. That's why it is particularly disconcerting that a myriad of countries have recently moved to constrain digital trade by introducing local data server requirements or restrictions on cross-border data flows. For example, Brunei, China, Greece, India, and Malaysia have all passed laws requiring that data generated within the country be stored on servers located within the country. Both the Danish and Norwegian Data Protection Authorities have issued rulings to prevent the use of cloud computing services when servers are not located domestically. And Nigeria, Russia, and Venezuela have all passed regulations requiring that IT infrastructure for payment processing be located domestically.

In short, LBTs are a significant and growing threat to global trade and commerce. They are deleterious to the global economy for three principal reasons. First, they contravene the established rules of the international trading system, thus undermining confidence in trade's ability to produce globally shared prosperity. Second, as they are not economically efficient, they undermine the efficiency gains from trade. For example, local data server requirements harm economic productivity and dramatically undercut the efficiencies made possible by cloud computing and networked technologies. Third, and perhaps most importantly, because LBTs are fundamentally more concerned with shifting the location of where innovation and production occurs in the global economy than in adding to the global stock of innovation, they lead to an undersupply of global innovation. Moreover, LBTs raise the overall cost of global innovation. Because most innovative industries are characterized by relatively high fixed costs of initial R&D and design but relatively low marginal costs of incremental production (e.g., software, semiconductors, pharmaceuticals, etc.), LBTs compromise innovators' ability to realize "Schumpeterian profits" that can then be reinvested into the next generation of risky and expensive innovation.

And though LBTs appear as if they would benefit the countries that field them, in reality LBTs do extensive damage to countries that use them. LBTs hurt both consumers and small businesses by raising the cost of products and services. In particular, LBTs that raise prices of (or compel the use of inferior) general purpose technologies such as ICTs only inhibit their diffusion among both manufacturers and domestic-serving sectors of the economy – such as financial services, retail, transportation, education, and government – limiting productivity growth in these sectors. This explains why economists have found that for every US$1 of tariffs India imposed on imported ICT products, it suffered an economic loss of US$1.30.

Moreover, LBTs are misguided policy instruments in that they ignore the fact that the best way for countries to ensure their participation in global supply chains, such as for ICTs, is by acceding to global multilateral agreements that remove barriers to their trade. As the Organization for Economic Cooperation and Development (OCED) writes: "The growing fragmentation of production across borders highlights the need for countries to have an open, predictable, and transparent trade and investment regime as tariffs, non-tariff barriers, and other restrictive measures impact not only foreign suppliers, but also domestic producers." That's why the OECD has found that countries not participating in the Information Technology Agreement (or ITA, which removes tariffs on trade in ICT products and is currently being expanded to include hundreds of new ones) have seen their participation in global ICT value chains decline by over 60 percent since the ITA was chartered in 1996. The message is clear: Countries that don't participate in open cross-border flows of digital information and ICT products only end up excising themselves from global production networks.

Worse still, forced localization policies represent a shortcut to growth through which countries try to attract foreign investment without having to undertake the tough policy reforms required to make their economies genuinely competitive. Instead of investing in the prerequisites of a vibrant economy – infrastructure, education, scientific research, a strong business and regulatory environment, etc. – forced localization policies attempt to compel, rather than attract, foreign direct investment (FDI) into countries. At the same time, countries that implement localization barriers to trade only damage their own reputations as attractive locations for enterprise or FDI. The attitude among businesses becomes: "Why would we want to invest in these countries unless we're forced to?"

At the end of the day, a concerted global effort is needed to push back against the scourge of LBTs. New cutting-edge multilateral trade agreements currently in negotiation – such as the Transatlantic Trade and Investment Partnership (T-TIP) between the European Union and the United States, and the Transpacific Partnership (TPP), a 12-country trade pact among Pacific nations – must include very strong disciplines prohibiting the use of forced localization policies. For their part, developed countries must eschew their own use of LBTs. Multilateral trade, aid, and development organizations including the World Trade Organization, World Bank, and International Monetary Fund must clearly speak out against countries' use of LBTs and curtail support for nations that continue to use them. The global business community must also speak out. But countries' forced localization policies put multinational corporations in a precarious position, for they are forced to either give up their technology or risk losing access to some of the world's fastest growing markets, and in the process lose out to competitors who are willing to make what is essentially Hobson's choice. Therefore, developed nations may need to develop procedures to allow multinational corporations to boycott nations that continue to field egregious forced localization policies. Yet perhaps what's most needed are efforts to educate countries to see that there are better ways than resorting to LBTs for them to achieve the innovation-based economic growth they rightly and legitimately seek.

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The author, Stephen Ezell, is a Senior Analyst with the Information Technology and Innovation Foundation (ITIF), with a focus on international information technology competitiveness and national innovation policies.