Introduction

The People's Republic of China's (PRC) ongoing transitions, from bureaucratic socialism to market economy and from a rural to an urban society, have transformed the country into a global economic power.¹ This transition has affected virtually every aspect of the world economy—which goods are made, what they cost, and the wages earned by those engaged in their production. The impact of the PRC's economic emergence on its trading partners, however, goes well beyond the textbook treatment of liberalization of trade in final goods. Widely recognized is the PRC's unique mode of entry, characterized by unprecedented foreign direct investment (FDI) inflows and a heavy reliance on processing inputs as the fuel for explosive trade growth.²

These unique features of the PRC's global engagement suggest that rather than simply changing where goods are made, the PRC's opening permitted shifts in how goods are made. Trade theorists have emphasized two aspects of these shifts in the organization of production—the fragmentation of the production process and the internalization decisions of multinational firms. Fragmentation of production, sometimes referred to as “slicing of the value chain,” is viewed as a consequence of trade liberalization in developing countries (Jones and Kierzkowski 2001) as well as a determinant of the welfare effects of that liberalization on all partners (Deardorff 2001, 2005). Similarly, the internalization decisions of multinational firms, specifically the choice to produce inputs abroad through a foreign subsidiary versus purchasing inputs from an unaffiliated foreign subcontractor, not only arise from the liberalization of trade and investment policies, but also themselves shape the overall pattern of economic activity and its rewards.³

For this paper, we used uniquely detailed 1995–2007 PRC customs data to better understand the pattern of trade between the PRC and two of its largest and most advanced trading partners, Japan and the United States (US), emphasizing the distinct nature of these flows. The analysis revealed the extent to which bilateral trade is due to fragmented production and foreign-invested enterprises (FIEs), as well as the organizational form of the PRC's processing trade relationships with Japan and the US. Using recent theoretical models as lenses through which we could explore the bilateral trade flows, we uncovered commonalities and differences in the production sharing strategies of American and Japanese firms, as evidenced in bilateral trade patterns.

Section 2 presents an overview of US-PRC and Japan-PRC bilateral trade. We quantify aspects of these trade flows that do not fit into neoclassical explanations, specifically the importance of processing trade and the significant role of FIEs. In Section 3, we focus on trade in production “fragments,” highlighting transport costs as a factor driving differences in the share of processing trade across the two bilateral relations. We also discuss new evidence on the vertical specialization of the PRC's exports to the US and Japan. We turn then to exploring the role of foreign enterprises in the PRC's bilateral trade flows in Section 4. We ask if the trade data provide insight into how American and Japanese firms serve the local market and whether transport costs and product differentiation illuminate the differences. Finally, in Section 5, we exploit a unique feature of the PRC customs data to explore the organizational form of multinational firms engaged in processing trade, specifically comparing flows to the US with those to Japan. We conclude by summarizing our comparisons of the bilateral relationships and drawing implications for further research on the distributional gains from offshoring and for further dialogue on an East Asian regional trade and investment agreement.

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