Manufacturing Services on Physical Inputs Owned by Others. Henry Vargas Campos (Banco Central de Costa Rica)

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Manufacturing Services on Physical Inputs Owned by Others Henry Vargas Campos (Banco Central de Costa Rica) Gabriela Saborío Muñoz (Banco Central de Costa Rica) Rigoberto Torres Mora (Banco Central de Costa Rica) Paper Prepared for the IARIW 33 rd General Conference Rotterdam, the Netherlands, August 24-30, 2014 Session 8B Time: Friday, August 29, Afternoon

MANUFACTURING SERVICES ON PHYSICAL INPUTS OWNED BY OTHERS Methodological and Practical Issues Prepared by: Gabriela Saborío Muñoz Rigoberto Torres Mora Reviewed by: Henry Vargas Campos

Content 1. Introduction... 3 2. Methodological Aspects:... 4 3. Results of fieldwork... 6 4. Data Evaluation of Companies... 7 5. Impact on Accounts... 8 5.1National accounts... 8 5.2 International Accounts... 10 5.2.1 Comparison Register BPM6 and BPM5... 10 5.2.2 Balance of current and financial account... 11 6. Conclusions... 13 7. Bibliography... 13 8. Annexes... 14 8.1 Annex1: Questionnaire... 14

1. Introduction The dynamics of trade and financial relationships prevailing on global scale makes necessary the countries provide appropriate and strong statistics regarding the adoption of international methodologies. The most recent methodological guidelines, associated with international accounts come from the Balance of Payments and International Investment Position Manual (BPM6) of International Monetary Fund (IMF), which provides strong cornerstone in the development and disclosure of external sector data such as: quality requirements, integrity guarantees, adherence to the methodology, accuracy and reliability, utility for users and access to statistics. In recent years, globalized production processes have raised their importance, so countries facing multiple challenges regarding mechanisms to obtain, statistics among other demands, a more comprehensive framework and coherent outsourcing of physical processing, sales and the management of manufacture all of which does not involve the physical possession of the goods. In this context, it is usual that some companies submit goods, without crossing economic ownership, to companies located in other economies for transformation purposes. In Costa Rica, such as other countries, the main source of foreign trade statistics is incorporated by the customs declaration of import and export issued by countries customs. Nevertheless, custom declarations recording the gross values of the trade in goods are not useful when establishing the actual cost of manufacturing services. For this reason, in most cases, the measuring process involves to visit each and every one of the companies to establish the cases in which the activity qualifies as processing services by third parties. To determine the appropriate amounts of service transformation a questionnaire was designed (Annex 1) which was applied to companies attached to foreign special trade regimes in the country, namely: Free Zones and Inward Processing Regime. This activity allowed the identification of 15 companies that perform transformation processes on behalf of others.

2. Methodological Aspects: The manufacturing services on physical inputs belonging to third parties include transformation, assembly, among others; perform by companies without assuming ownership of the property. The company that performs the transformation (Company Y in Figure 1) does not adquire economic ownership of assets y, therefore, the transaction or transactions to be posted in the production accounts and international are derived from the service provided to the owner of the goods. The Fifth Edition of the Balance of Payments Manual (BPM5) recognized, as an exception to the change of ownership, the registration of the gross value of goods sent by the owner to a non-resident for the transformation purposes. In practice this registration method derives problems when there are transfer prices between related companies and temporary differences between the time of receipt and the return of the processed goods, which leads to accumulation of inventories and, consequently, the recognition of a liability of the economy where the processing company with the economic owner of the goods (non -resident). In some cases, the amount for inventories was significant, and creates problems of interpretation of results in the current account of the balance of payments that is an important indicator for economic analysis. Figure 1: Transformation Services on behalf of others Country A Company X (Owner of the Goods) Goods to Transform Processed Goods Country B (Compiler) Company Y (Transforms by charge of company X) Source: Self Prepared

According to the sixth edition of the Balance of Payments and International Investment Position (BPM6) International Monetary Fund (IMF), in paragraph 10.64, transformation services include transaction between the owner and transformer; specifically, the fee charged by the processor; which may include the cost of materials purchased by the processor. The registration service of transformation in the balance of payments proceeds if a resident of a certain economy works on property belonging to a non-resident, and when the activity implies some degree of transformation of good. BPM6 indicates that in practice value transformation services are not equal to the difference between the amount of goods sent for processing and the value of goods and processed. Among the causes of this situation include: earnings/holding losses, including overheads and measurement errors associated with the transfer of property valuation. In addition, Manual recommends that for those economies compilers where the gross value of goods related transformation services are considerable, is useful to incorporate additional items: Table 1 Goods for processing: Supplementary items Importing country Transformation Service (own goods processed abroad): Goods supplied for processing (goods sent). Goods received after processing (returned goods). Exporter Transformation Service (Real transformed belonging to third parties) Goods received for processing (goods received). Goods dispatched after processing (goods sent). Source: Department of Macroeconomic Statistics (DEM) The adoption of the recommended treatment in BPM6 of the registration for the processing of goods on behalf of others has an impact on the level of trade flows which are ultimately recorded in the balance of payments. The value of goods channeled under this figure, must be deducted from the amount of imports and exports of goods reported by customs and, registered of the value corresponding to the service in the service category for the current account of the balance of payments.

3. Results of fieldwork The fieldwork conducted involves visits to various companies attached to special trade regimes: Free Zones and Inward Processing Regime. External sales of these companies account for 85% of exports of special foreign trade regimes, which identified 15 organizations whose main business is processing services for third parties. These companies have annual financial statements for then Foreign Trade Promoter (PROCOMER) to which the BCCR has access. The statistical basis 1 groups the processing activities carried out in the country from Uniform from all economic activities International Standard Industrial Classification (ISIC): Chart 1 Companies that perform processing services for third parties by economic activity Economic Activity Number of Companies Manufacture of Electronic equipment and Machinery Manufacture of Electronic and Optical products Manufacture of Electronic components and boards, Computers and Peripheral equipment 5 2 1 Manufacture of Basic Metals 1 Manufacture of glass and glass products 1 Manufacture of Clothing 3 Other Manufactured Industries 2 Total 15 Source: Department of Macroeconomic Statistics (DEM)

4. Data Evaluation of Companies The review of financial reports and data on foreign trade enterprises identified as producers transformation services show the following aspects to note, regarding the advantages and disadvantages of the practical implementation of the recommendation BPM6. 1. Inconsistencies between the value of imports and exports of goods, mainly due to transfer pricing. Exports as part of their cost are considered prices of raw materials imported lower used to assess the import of raw materials. Thus, for several years in some companies imports exceed exports. 2. In the accounting period the local processor does not use the entire raw material received on consignment. 3. The financial statements report directly revenue transformation services. 4. Some companies reported higher net profits. This result would not be expected to cost centers and affects the level of operating surplus. 5. The value of exports of goods of this group of companies for the period 2006-2012 accounted for between 3% and 5% of the national production and about 24% of total exports of goods. Figure 2: Costa Rica: Gross National Production 90000 80000 70000 60000 50000 40000 30000 20000 10000 0 2006 2007 2008 2009 2010 2011 2012 6,00% 5,00% 4,00% 3,00% 2,00% 1,00% 0,00% National Production Proportion of Processing firms exports Source: Department of Macroeconomic Statistics (DEM)

5. Impact on Accounts The adoption of the recommendation of the 2008 SNA and BPM6 2009, related to treatment of goods for processing on behalf others which leads to a significant effort in terms of fieldwork in order to identify which institutional units processing services performed on real property that do not change; that is, that non-residents maintain economic and legal ownership of the property. As for the impact on national and international accounts main referral the recommendation which affects trade flows of goods and services. Meanwhile, the value of production and the result in the current account of the balance of payments does not undergo significant changes. 5.1National accounts The accounting practice for companies is to report the income from the fee charged for processing of goods. Having to incorporate the amounts exported goods of some companies that are sometimes lower than the amounts imported, as mentioned in the previous section, if BPM5 guidelines are followed, compilers of national accounts and balance of payments are compelled to charge transactions change in inventories, payment of dividends abroad and financial, among others, in order not to distort the value added processors, the current account balance, and national disposable income. Specifically, the log of the gross value of exports and imports of goods involves adjustments in the production account in order to be consistent with the aggregate value reported by the company, as detailed in the following arrangement:

Chart 2 Production Account of the Company. Based on the financial statement. With adjustments to reflect the value of exported and imported goods Value of Production Processing Fee 800 Exports of goods 0 2200 Intermediate Consumption 700 2100 Raw materials imported 0 1400 Imports of raw materials 0 2300 Inventory accumulation 0 900 Other Supplies 700 700 Added Value 100 100 Wages and salaries 20 20 Net operating surplus 80 80 Source: Department of Macroeconomic Statistics (DEM) The recommendation of the 2008 SNA - BPM6 solves the problem of allocating production associated with the export of goods and the corresponding consumption of raw materials, changes in inventories and the resulting financial transactions; however no change in the value added and the GDP impact is not correct and volatility that prints on these variables the presence of high operating surplus in companies that operate as cost centers. Finally, once estimated the aggregate value of the companies related to the transforming activity shows that as a share of GDP is not representative; which is shown in the following statistical basis.

Chart 3 Gross Domestic Product at Current prices Millions of colones Source: Department of Macroeconomic Statistics (DEM) 2006 2007 2008 2009 2010 2011 2012 Total 10,365,563.7 12,149,371.0 14,042,803.8 15,338,355.5 17,414,037.8 18,952,079.8 20,787,412.6 Enterprises Linked with Manufacturing 134,273.9 126,070.8 137,076.0 103,905.9 92,356.7 118,233.0 116,381.5 Services Percentage share 1.30% 1.04% 0.98% 0.68% 0.53% 0.62% 0.56% 5.2 International Accounts 5.2.1 Comparison Register BPM6 and BPM5 According to the data associated with external trade in goods for the 15 companies that perform processing of goods on behalf of third parties; based on the recommendations of the Fifth Edition of the Balance of Payments Manual (BPM5) check in the balance of payments should be as follows: Chart 4 Accounting of processing services in Balance of Payments Millions of dollars 2011 2012 2013 Credit Debit Credit Debit Credit Debit Current account Goods 2130 2284 2485 2576 2670 2458 Financial account Other investment Commercial credits 640 683 418 Currency and deposits 486 592 630 Source: Macroeconomic Statistics Department (DEM). According with BPM5 methodological guidelines inventory accumulation was a liability to the resident entity to maintain real property that is owned by nonresidents. However, based on the provisions corresponding BPM6 is derived accounting for transactions processing service in the services account. This involves including the gross amounts relating to the export and import of goods provided by the office. The accounting in balance of payments would be:

Chart 5 Accounting of processing services in the Balance of Payments Millions of dollars 2011 2012 2013 Credit Debit Credit Debit red Crédito Debit Current account Services Manufacturing Services on Physical Inputs Owned by Others 502 599 655 Financial account Other invesment Currency and deposits 502 599 655 Source: Department of Macroeconomic Statistics (DEM) It is assumed that the amount for transformation is paid in cash by the non-resident property owners. 5.2.2 Balance of current and financial account In general terms, results in the international accounts from adopting BPM6 recommendations are similar to those obtained under the previous manual. Indeed, the balance of the current and financial account of the country, in terms of GDP, is consistent with a country with a low domestic savings and, therefore net importer (net debit) of capital from the rest of the world. Similarly, the net investment position is consistent with the characteristics described in the transactions of the country with the rest of the world. Chart 6 Current Account, Capital Account and Net Debt in terms of Gross Domestic Product (GDP) 2011 2012 2013 1. Current account balance in terms of GDP BPM6-5.0% -5.1% -4.9% BPM5-5.4% -5.3% -5.1% Source: Macroeconomic Statistics Department (DEM The result of the current account deficit in terms of GDP remains at about 5%, which is consistent with an economy that has diversified its exports though, especially exportable services activities; domestic production has a high component of imported raw materials and capital goods.

The main methodological changes referred to in the Sixth Edition BPM6 BPM5 are the amount of goods entering the economy to be changed without a change in ownership of the property. In this context, goods for processing on behalf of others are excluded from the goods account and the value of service is counted as an export of services; specifically on account of manufacturing services on inputs owned by others. BPM6 recommends that if the gross value of the assets involved in the activity of processing services for third parties, are significant is useful to incorporate additional items with details relating to the supply and / or delivery of goods for processing, as appropriate. In order to implement this recommendation companies that perform this productive activity to determine whether the transformation takes place at your own peril he visited or no change in ownership of the property. The results indicate that the total exports of special trade foreign regimes, on average, 40% of the value of exports of goods corresponds to transformation of inputs owned by others. Chart 7 Exports of special trade regimes and Transformation Services 2011 2012 2013 Exports of Special Trade Regimes 5,570 6,263 6,546 Exports of Enterprises Linked with Manufacturing Services 2,130 2,485 2,670 Manufacturing Services on Physical Inputs Owned by Others 502 599 655 Source: Macroeconomic Statistics Department (DEM). The corresponding manufacturing services on inputs owned by others amount, recorded in the services account, in the period 2011-2013 represents an average rate of GDP of 1.3%.

6. Conclusions Exports and imports of goods of companies from related undertakings transformation services represent about 24% of total exports, nevertheless in terms of value added in the period 2006-2012 their share is around 1%. The adoption of the recommendation BPM6 impacts the bill of goods and services in the current account of the balance of payments. Although international trade flows reduce the gap in the current account in terms of gross domestic product maintains the average ratio close to 5%. The recommendation of the 2008 SNA BPM6 and involves a major effort for the countries in order to identify those companies that are dedicated to provide processing services. However, the recommendation has more benefits than drawbacks for the country; it solves some of the problems associated with the estimated level of exports and imports of goods and allocation of inventory and consequent financial transactions. Administrative records available to the country facilitate the implementation of the measure because companies report directly the rate charged by the prosecution. 7. Bibliography 1. International Monetary Fund (IMF) (2009). Manual on Balance of Payments and International Investment Position (BPM6). Washington, D.C. 2. Organization United Nations. Manual of National Accounts (SCN2008). New York.

8. Annexes 8.1 Annex1: Questionnaire Company: Legal identity card: Economic Activity: Month: Harmonized System Code Electronic Report for the Central Bank of Costa Rica EXPORTS ID Product Amount Unit Price Quantity Unit of Ship to Consignee Code Description Amount Currency Amount Currency Quantity measure Value of raw material input for the production of the month $ Domestic Imported On consignment ( % o $ ) Non consignment ( % o $ ) Value of inventories at the end of the month: Of raw materials in transit $ Of raw material $ Of work in process $ Of finished goods $