Implications for Regional Integration

A detailed look at trade between the PRC and two of its largest trading partners, the US and Japan, shows that only a small share of these trade flows can be characterized as arm's length, one-way trade in final goods. Instead, we find extensive two-way trade, deep vertical specialization, concentration of trade in computer and communication devices, and a prominent role for FIEs. While these characteristics define both bilateral relationships, some important differences between the two pairs do emerge. The PRC's imports from Japan are most likely destined for an FIE within the PRC, and are more likely to be processing than non-processing trade; processing imports from Japan to the PRC are roughly balanced with PRC processing exports to Japan. In comparison, the PRC's imports from the US are somewhat less likely to be destined for an FIE within the PRC, and are most likely to be nonprocessing trade; processing imports from the US to the PRC are outsized by PRC processing exports to the US. Even as both Japan and the US experienced rapid growth in non-processing exports to the PRC after 2001, Japan's processing exports to the PRC increased apace, while US processing exports grew far more slowly. The picture that emerges is one in which the PRC is in the midst of a global production chain, with Japan as a principal source of imported intermediates, and the US as a principal destination for exports embodying imported intermediates. This impression is reinforced by Wakasugi, Ito, and Tomiura (2008), who found a sharp decline in Japan's share of the world manufacturing value added between 1996 and 2004, a sharp increase for the PRC, and no change for the US.

While this evidence is often interpreted as support for the view that Japan is more deeply “integrated” with the PRC, we stress that trade flows provide only a limited window into production fragmentation as they do not trace products through the production cycle. While it may certainly be the case that some Japanese firms are more likely to export components and parts to the PRC for processing than are similar US firms, the evidence is also consistent with a relatively greater reliance by US-based firms on production of components within the PRC, and thus with relatively smaller flows of processing exports from the US to the PRC. In other words, larger trade costs may lead US-based multinational firms to choose direct investment over exporting relatively more often than do Japan-based firms. Such a hypothesis cannot be tested with trade data; direct observation of the production structures chosen by Japanese and American multinational firms is required.

Trade costs may also be an explanation for evidence of a “home-market effect” at work in the Japan-PRC relationship that we do not find in the US-PRC relationship. The PRC's imports from Japan of highly differentiated products are much more likely to be ordinary trade than are less differentiated products, a difference not evident in US-PRC trade flows. Transport costs between the US and the PRC may be large enough to outweigh the benefits of concentrating production within the US and serving the PRC via exporting. For Japan, transportation costs are lower and thus serving the PRC market through domestic production may more often be the profit maximizing strategy.

Although the US and Japan face different trade costs and, thus, appear to pursue somewhat different strategies for integrating with the PRC, each will gain from shifting some fragments of production to a country in which they can be produced at lower cost. Helpman and Rossi- Hansberg (2008) emphasize the productivity effect of offshoring and the possibility that these productivity gains raise wages for unskilled as well as skilled workers in the high-wage country. An important question is how the extent of this shift in response to differential transport costs affects the distribution of gains in the high-wage country. Does it matter for source country unskilled wages if more or less of the value chain is offshored?

Our findings also suggest a new perspective on the costs to the US of an East Asian free trade area that does not include the US. There is an emerging consensus view of East Asia as a highly interdependent producer of final goods for North American consumption. Athukorala and Yamashita (2008) characterize the US-PRC trade imbalance as a structural phenomenon resulting from the emergence of the PRC as a final assembly center for East Asian production networks, largely for North American consumption. Consequently, Athukorala (2005) argues that East Asian growth is increasingly reliant on extra-regional trade, mainly as a destination for its exports, strengthening the case for global, rather than regional, trade and investment policy making. Our findings add a somewhat different shading to these arguments, while retaining the case for global, over regional, liberalization. We have documented the many commonalities between the PRC's bilateral trade with the US and with Japan. While the reliance of these two countries on exports to PRC processors may differ, production fragmentation and input processing are important for American producers as well as for Japanese producers. Thus, dialogue on regional trade liberalization should expand beyond a view of the US mainly as a final goods consumer; it should include discussion of gains for the US through greater production efficiency from production fragmentation and gains to East Asia through increased processing trade with the US.

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