Production Fragmentation and Vertical Specialization

Jones and Kierzkowski (2001) provide a useful definition of production fragmentation as the decomposition of production into separable component blocks connected by service links. In their discussion of the causes of fragmentation, they emphasize the importance of reductions in the costs of service links between fragments. Advances in telecommunications have reduced the costs of cross-border coordination, thereby encouraging the decomposition and offshoring of production blocks. Deardorff (2001) examines the link between the factor intensity of fragment production and factor prices in possible production locations (fragmentation across cones of diversification). Like Jones and Kierzkowski, Deardorff emphasizes the cost of fragmentation, noting that if coordination costs are large, offshoring of production fragments may not occur.

Given the geographic proximity of Japan to the PRC, we might anticipate that service links and production coordination are less costly for Japanese firms than for American firms. For both countries, however, the PRC's trade liberalization, its encouragement of processing trade, and its incentives for FDI may all be viewed as policies that integrate the PRC into both countries' supply chains.

We consider first the share of two-way trade in both the US-PRC and the Japan-PRC relationships, using the Grubel-Lloyd (1975) index of intra-industry trade (IIT). Two-way trade may be horizontal trade in similar goods, “vertical” trade in similar goods of different qualities, or vertical trade in intermediate goods, exported and imported as part of a sequential supply chain. Since the IIT index is calculated at a highly disaggregated level precisely to capture trade in similar products, it will include the first two types of two-way trade, but is likely to severely understate the third (trade in production fragments).⁹ At the same time, horizontal trade in similar goods is also likely to be a relatively small share of two-way trade between partners of such vastly different income levels. Thus, the IIT index will give us only a crude preliminary look at the extent to which broadly defined industries are “integrated” with PRC production.

Table 3 [ PDF 20.4KB | 2 pages ] shows the PRC's total exports and imports to Japan and the US for the Standard Industrial Trade Classification (SITC) two-digit industries in which the PRC has the largest global trade (exports plus imports). The IIT index is calculated at the SITC five-digit level and aggregated up to the two-digit industry level. Comparing the first two top panels, we see that Japan's trade with the PRC is more heavily composed of IIT (27.6%) than is American trade with the PRC (14.2%). Individual sectors also show large differences. In electrical machinery and equipment (SITC 77), 52% of trade between the PRC and Japan is IIT, compared to 7.5% between the PRC and the US. In office and processing machines (SITC 75), the figures are 42.5% and 10.7%, respectively. Looking down the columns of Table 3, we see that in eight out of ten industries, IIT is a higher share of Japan-PRC trade than US-PRC trade. The only exceptions are professional instruments (SITC 87) and iron and steel (SITC 67). Xing (2007) found similar patterns of high IIT for the PRC's bilateral trade with Japan compared to the US, at both the aggregate and industry levels for the 1980 to 2004 period.

Both the pattern and magnitudes of PRC-Japan IIT across sectors are very similar to those for PRC-ASEAN IIT (bottom left panel of Table 3). For both bilateral pairs, half of the trade in telecommunications, over 40% of trade in office equipment, and one third of trade in electrical machinery and professional instruments is IIT. In contrast, the pattern and magnitudes of PRC-US and PRC-EU15 IIT are highly correlated, and show little similarity to the PRC's bilateral IIT with either Japan or ASEAN. With regard to the US and the EU15, IIT with the PRC is less than 20% in telecommunications and in office equipment, while it exceeds 40% in general industrial machinery and is about 30% or more in professional instruments and electrical machinery. IIT is also larger in iron and steel for the US and EU15 than for Japan and ASEAN. One possible explanation for these differences is that Japanese and ASEAN firms play different roles than American and EU firms in global supply chains. To the extent that the IIT index does reflect any trade in intermediate inputs, these differences could indicate that Japan and ASEAN are large suppliers of intermediates to the PRC, while the US and EU are large buyers of final processed goods from the PRC. Dean, Fung, and Wang (2008) found evidence that the PRC's trade is shaped by such global supply chains. In 2002, the PRC's exports were characterized by significant vertical specialization, with the foreign content of the PRC's aggregate exports estimated to be between 25% and 46%. About 77% of the PRC's imports in 2002 were processing or normal intermediate imports.¹⁰ More than half of these imported intermediates were from Japan and the Asian Tigers, while only about 18% came from the US and the EU.

Several factors may explain the PRC's reliance on other Asian countries as the source of intermediate inputs. An obvious factor is geographic location. Just as Mexico provides a nearby location for processing and assembly for American firms, the PRC provides a nearby location for labor-intensive fragments of products designed and marketed in Japan: Taipei,China: and Korea. In a formal model, Yi (2003) showed that small differences in trade costs matter when production must be done sequentially. He considered a technology with three sequential stages, two of which may be produced offshore but the last of which must be produced close to firm headquarters. Because some trade costs have to be paid on gross value or weight rather than just the value added at an individual stage, small differences in these costs can have large effects on fragmentation and trade volumes. Yi focused on tariffs specifically, but tariffs are unlikely to drive the PRC's processing trade because intermediates imported under the processing regime are tariff exempt. However, transportation costs play a similar role, as weight accumulates during a sequential production process.

Examining the data in detail, we find evidence consistent with an important role for transportation costs in shaping the roles played by Japan and the US in the global supply chains. The PRC sources many intermediates from Asian countries, while exporting final goods and processed intermediates predominantly to the US, EU, and the rest of the world, including Asia. Moreover, as Figure 1 indicates, the PRC's imports from Japan are much larger than those from the US, and show much faster growth. The PRC's exports to the US are much larger than to Japan and have grown more rapidly.

Dean, Fung, and Wang (2008) provide a more detailed analysis of how the PRC's trade is shaped by production fragmentation. They developed a method to identify imported intermediates using the PRC customs regime data and the United Nations Broad Economic Classification, as well as the 1997 and 2002 PRC benchmark input-output tables. They found that in 2002 Japan accounted for 19% of the PRC's imported intermediates and 23% of the PRC's imported processing intermediates. The figures for the US were only 7.6% and 6.3%, respectively. While Japan's share was roughly stable between 1997 and 2002, the US share fell, with respect to both processing and normal intermediate imports during that time.

Dean, Fung, and Wang used these data to determine the vertical specialization in PRC exports for 1997 and 2002, using two methods. The first method combines the newly identified imported intermediates with the official PRC benchmark input-output table. The second method goes one step further, and uses the Koopman, Wang, and Wei (2008) technique to split the official input-output table—allowing processing exports to be importedinput intensive in production relative to normal exports and domestic sales. For 2002, Dean, Fung, and Wang found a lower bound estimate of the foreign content of the PRC's exports to the US and Japan of 28% and 25%, respectively; upper bound estimates are 55%, and 46%, respectively. These results suggest that the PRC's exports to the US have a higher foreign content, on average, than its exports to Japan, though the difference is probably small.

From the PRC's point of view, the US and Japan are sources for very different imports.¹¹ In 2002, the US accounted for more than half of the PRC's imports of special industrial equipment, more than one third of its imported fertilizers, more than one quarter of its agricultural imports, and about 60% of its imported computers. Japan accounted for 45% of the PRC's imported radio, TV, and communications equipment; about 30% of the PRC's imports of special industrial equipment, electric machinery and equipment, parts and accessories for motor vehicles, and metal products; and more than one quarter of the PRC's metal working machinery imports.

Examining the 2002 bilateral trade data more closely, we find that about 74% of the PRC's imports from Japan were intermediate goods, while only 60% of the PRC's imports from the US were intermediates. The bulk of the remaining 40% from the US were final goods. Nearly half of the intermediates imported from Japan came in under the processing regime (which indicates that they were re-exported after processing), while only about one quarter of those from the US did. In contrast, nearly 68% of the PRC's exports to the US came in under the processing regime, while only 58% of exports to Japan were processing exports.

The types of intermediates that the PRC imports from the two countries show some similarities and some contrasts. In value terms, electronic elements and devices, leather, fur and down products, and chemicals dominate processing imports from the US, while agriculture, paper products, and chemical fertilizers dominate normal intermediate imports. From Japan, electronic elements and devices are important processing and normal intermediate imports, while cotton textiles and other electric machinery are key processing imports, and basic chemicals and steel pressing equipment are important normal intermediate imports.

In sum, we find evidence suggestive of global supply chains with Japan as a principal source for the PRC's imported intermediates, and the US as a key destination for the PRC's exports of products embodying imported intermediates. While the largest flows for both pairs occur in the electronics and machinery industries, there are substantive differences that emerge from the detailed data. The PRC's processing trade with Japan is roughly balanced: three quarters of its imports from Japan are intermediate goods, and its exports to Japan show a fairly high degree of vertical specialization. In comparison, the PRC's processing trade with the US shows a large deficit: a smaller share of its imports from the US are intermediate goods, and its exports to the US show a somewhat higher level of vertical specialization.

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