Implications of Trade Developments for Future Linkages

Countries that engage in production sharing are more likely to experience common shocks, as they specialize in similar industrial sectors. Technological shocks may also be more easily transmitted from one country to another when firms operate transnationally. Moreover, if production sharing tends to be concentrated in sectors that are more affected by cyclical fluctuations such as consumer goods or auto parts and production, the transmission will be amplified. Burstein, Kurz, and Tesar (2008) found that the extent of US-Mexico production sharing and its connection to the business cycle highlights three noticeable effects. First, trade flows associated with production sharing are more correlated with US manufacturing output than are trade flows that are not associated with production sharing. Second, for a large cross section of countries that host US affiliates, those with larger production sharing trade links with the US also have higher manufacturing output correlations with the US. Third, for those countries, the extent of production sharing in trade is at least as important as the total volume of trade in accounting for a positive, bilateral synchronization of manufacturing output between the countries.

In the case of Asia, the importance of production sharing, largely connected with the PRC, suggests higher intra-regional correlations than in other regions. It also points to growing transmission linkages between the PRC and other Asian countries, particularly those in Southeast Asia. Roughly 9.5% of PRC exports in 2000 consisted of imported inputs, up from 2.2% in 1980. The importance of vertical specialization is the greatest for Malaysia; Philippines; Singapore: Taipei,China: and Thailand; whose exports include from 26% to 37% foreign content (Hummels forthcoming 2009).

While production fragmentation related business cycle synchronization between developing Asia and the G3 has strengthened, the relationship between Asia's private domestic demand and Asian imports has weakened, despite rising intra-regional trade. ADB (2007) showed that the correlation between Asia's private demand and its imports has trended downward. Therefore, the value added in production sharing appears to be strengthening linkages through exports to shock-affected markets, while weakening shocks passing through the import transmission mechanism. More recent data, including oil and other commodity price shocks, may help to test this apparent dichotomy.

1. Timing

Depending on its nature, strong regional economic integration could spread shocks rapidly across regional economies or help dampen shock transmission. Some trading linkages have their full effect within the lifetime of a typical business cycle. Others, influenced by fixed costs, irreversible investments, or liberalizing policy reforms, play out over a longer horizon. Changes in the lengths of these impacts and the transmission mechanisms by which they operate may affect the synchronization of business cycles. For example, air shipments arriving within a few days (or even overnight) may transmit shocks (and conversely, transmit mitigating influences) much more quickly than sea shipments averaging several weeks and frequently involving much greater variability in the amount of time the shipment process takes.

As the composition of trade has shifted from commodities to more complex manufactured goods and services, sensitivity to the length of time for delivery increases, as does pressure on manufacturers to adapt production patterns and processes quickly and flexibly. Some factors such as the location of plants and assembly lines do not respond to shocks at business cycle frequencies, maintaining production chain reliance on inputs from a particular source. Other factors prominent in fragmented production, such as the adaptation of production processes and substitutability of local for imported inputs, are more likely to be responsive in the medium-term. When shocks are large and persistent (for example, during trade liberalization reforms or changes in taxation of foreign corporations), footloose multinational corporations may shift their production operations across countries. These relocations are mostly at lower frequencies in time, at which shocks are more easily managed, mitigating (or in some cases, compounding) higher frequency business cycle synchronization between countries.

Rising flexibility in the time involved for these substitution effects (timing in shipping, locating, and adapting production) to operate can imply that an increase in international trade may lead to lower international business cycle correlations. The exact extent of coupling and decoupling will depend on the nature of the shock, the degree of production sharing between the economies involved, the responsiveness of economic agents to market signals and other information, and the flexibility of adjustments.

As fragmented production processes respond to and provoke changes in spatial and temporal relations, business cycle transmission mechanisms both between economies and over time are affected. Similarly, the need to respond to uncertainty in a timely way creates an important force for agglomeration, locating firms producing industrial inputs near the downstream firms that use those inputs. Increased use of air freight to backstop uncertainties in sea shipment and port congestion has been entering the production-location equation, affecting the agglomeration/fragmentation balance. Location and relocation effects are also influencing regional trends. In Asia, the huge market and production platform of the PRC has had an especially strong effect since its openness to external markets and suppliers has increased.

2. PRC Mediation

In the two decades spanning 1985 to 2005, the PRC's exports grew from US$27 billion to US$762 billion and its imports from US$43 billion to US$660 billion. The basic pattern of PRC trade can be characterized as increasing exports to the global economy, while increasing imports of intermediate goods from the rest of Asia. Both before and after the Asian crisis, the average output correlation for countries within Asia, excluding the PRC, was higher than that for Asia including the PRC, reflecting the country's relative independence from the cyclical behavior of the rest of the region. Interestingly, however, the average correlation grew much faster among Asian economies including the PRC than excluding the PRC, indicating that the PRC business cycle is evolving to increasingly move in tandem with the rest of Asia (ADB 2007).

Asian business cycles are much more synchronized with those of the G3 in the postcrisis period than precrisis. To the extent that the PRC functions as an assembly and production center for the rest of Asia, the trade linkages are more direct and stronger between the PRC and members of the rest of Asia than the relationships between themselves. Indeed, for the 5-year period from 2002–2006, the average correlation for Asia including the PRC was higher than that of Asia (excluding the PRC). The correlations of the PRC cycle with both regional and international economies are low, although both correlations have become positive in the postcrisis period, reflecting the increasing integration of the PRC with the regional and global economies.

Hummels (forthcoming 2009) found that most, but far from all, PRC export growth between 1995 and 2005 came from an increase in the number of unique shipments, rather than from an increase in average value per shipment. He contrasted this mixed growth with Thailand and Malaysia, where almost all growth arose from an increase in the number of shipments rather than an increase in the average shipment value. Conversely, almost all growth for Hong Kong, China and Japan came from an increase in average shipment size rather than an increase in the number of unique shipments. Thus, while the average PRC export shipment is rising in value, and even more so in Hong Kong, China and Japan, raising the potential for strengthened international transmission, the same may be less true for Thailand or Malaysia.

The role of the PRC in assembling components imported from other parts of Asia and exporting the final products to G3 markets places it in a unique position to intermediate shocks emanating from the G3 toward developing Asia. Exchange rate policy and use of foreign reserves are commonly discussed channels for such action, but trade and production adjustments to the structural links may have more lasting effects.

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