Introduction

The People's Republic of China's (PRC) rapid emergence as an export powerhouse has attracted much attention in both academic and policy circles. In the past 20 years, the PRC's exports have grown at an annualized rate of 19%, more than twice the rate of growth of world exports. As a result, the PRC has surpassed Japan and the United States to become the world's second largest exporter after Germany.

To a large extent, the PRC's dramatic export rise can be attributed to its relatively low labor costs coupled with its aggressive export promotion policies (Lardy 2002; Huang 2003; Branstetter and Lardy 2006; Amiti and Freund 2008). In the mid-1980s, the PRC installed a processing trade regime that grants firms duty exemptions on imported raw materials and other inputs as long as they are used solely for export purposes. Many foreign firms have taken advantage of this regime to slice up their value chain and move their labor-intensive final-assembly plants to the PRC. As a result, the share of processing exports (i.e., exports conducted under the processing regime) in the PRC's total exports has risen from 30% in 1988 to 55% in 2005. Currently, processing exports account for more than half of the PRC's total export value.

An often overlooked feature of the PRC's processing trade regime is its heavy reliance on imported inputs from neighboring East Asian economies for its exports. According to a recent estimate by Koopman, Wang, and Wei (2008), only 20% of the PRC's processing export value is produced in the PRC, while the remaining 80% consists of the value of imported inputs. These inputs are primarily imported from the PRC's more advanced East Asian neighbors such as Japan, Republic of Korea, and Taipei,China (Dean, Lovely, and Mora forthcoming). This import pattern suggests that the PRC's geographic location within the East Asian region may have played an important role in the rapid growth of its processing trade.

In this paper, we use detailed data on processing trade collected by the General Administration of Customs of the People's Republic of China to analyze the role of the PRC's geographic location in its processing trade patterns (see Feenstra et al. [2004] for a description of the data). This PRC Customs Statistics data set is particularly useful because by its nature, the processing trade regime requires all imported inputs to be used for export purposes. As a result, the data provides for each location a unique mapping of the source economy of imported inputs and the destination economy of its processed exports. This feature enabled us to analyze the roles of both import and export distance in the PRC's processing trade patterns.¹

A cursory glance at the processing trade data reveals a distinctive geographical pattern related to the PRC's processing trade. Using a cross-section of 29 PRC provinces² for 2005, we show in Figure 1 [ PDF 94.2KB | 1 page ] that the average distance traveled by processing imports (import distance) is negatively correlated with the average distance traveled by processing exports (export distance).³ A similar association between export and import distance can be found for all years from 1997 to 2005.

In this paper, we set up a three-country industry-equilibrium model with heterogeneous firms to explain this pattern. In our framework, a continuum of heterogeneous firms from two advanced economies, East and West, sell their products in each other's markets. Each firm can use two modes to serve the other market. A firm can produce its variety at home and directly export it to the foreign economy. Alternatively, it can indirectly export its variety to the foreign economy by assembling it in a third low-cost economy, PRC. By assuming that PRC is located in the geographical proximity of East, our model provides an explanation for the negative correlation between export and import distance for the PRC's processing trade: the inputs that PRC imports from the nearby East are processed into final goods and exported to the far-away West. Conversely, the inputs that PRC imports from the far-away West are processed into final goods and exported to the nearby East.

The model allows us to develop two theoretical predictions relating the PRC's geographical location to its processing trade patterns. First, we expect that the PRC's processing exports are negatively affected by both an increase in import distance and an increase in export distance. Second, we predict that the PRC's processing exports to the nearby East Asian economies are more sensitive to export distance and less sensitive to import distance than its processing exports to non-Asian economies that are located further away.

Using the PRC's bilateral processing trade data, we find support for the theoretical predictions of the model. Specifically, our empirical analysis provides some evidence that the PRC's processing exports are negatively affected by both import and export distance. Furthermore, it provides strong evidence that processing exports to East Asian economies are more sensitive to export distance and less sensitive to import distance than processing exports to non-Asian Organisation for Economic Co-operation and Development (OECD) countries.

Our theoretical model builds on an emerging theoretical literature on export platform foreign direct investment (FDI), i.e., on multinational firms that process their final goods in a foreign subsidiary for export to a third-country market.⁴ Yeaple (2003) and Ekholm, Forslid, and Markusen (2007) examined theoretically the determinants of export platform FDI by setting up a model with two similar advanced “Northern” countries and a third Southern country in which the final good can be assembled at lower cost. Both studies analyzed how firms' choices of using the South as an export platform depend on trade costs, factor-cost differentials, and the fixed costs associated with foreign investment. Grossman, Helpman, and Szeidl (2006) introduced intra-industry firm heterogeneity in this type of setting and examined the role of different types of complementarities on export platform activities. Our theoretical framework complements these three studies in two ways. First, we use elements of Helpman, Melitz, and Yeaple's (2004) model structure to derive a closed-form solution of an export platform's bilateral processing exports. Second, we introduce more realistic assumptions about trade costs by exploiting the empirical regularity that export-platform countries are generally located in the geographical proximity of large markets. For example, the PRC lies in the vicinity of developed East Asia; Mexico neighbors the United States. This allows us to develop new theoretical predictions that relate an export platform's bilateral exports to both export and import distance.

Our empirical analysis is related to Hanson, Mataloni, and Slaughter's (2005) study on the determinants of global production networks. Their study used firm-level data on United States multinational firms to examine the determinants of trade in processing inputs between parent firms and their foreign affiliates. Among other findings, they showed that a foreign affiliate's demand for imported processing inputs is affected by trade costs, wages for lessskilled labor, and host-country policies. In line with their findings, we provide empirical evidence that the PRC's processing exports depend on trade costs on both the import and export sides.

This paper is organized as follows. In the following section, we set up the theoretical model and derive our two main hypotheses. In Section 3, we describe the data. We describe the methods of analysis in Section 4. We report and interpret the empirical findings in Sections 5 and 6, respectively, and we provide concluding comments in the closing section.

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