Foreign Direct Investment and China's Bilateral Intra-Industry Trade With Japan and the US

BOFIT Discussion Papers 1 • 2007 Yuqing Xing Foreign direct investment and China's bilateral intra-industry trade with Japan and the US Bank of Finland, BOFIT Institute for Economies in Transition BOFIT Discussion Papers Editor-in-Chief Iikka Korhonen BOFIT Discussion Papers 1/2007 16.1.2007 Yuqing Xing: Foreign direct investment and China's bilateral intra-industry trade with Japan and the US ISBN 952-462-849-5 ISSN 1456-5889 (online) This paper can be downloaded without charge from http://www.bof.fi/bofit or from the Social Science Research Network electronic library at http://ssrn.com/abstract_id=1002290. Suomen Pankki Helsinki 2007 BOFIT- Institute for Economies in Transition Bank of Finland BOFIT Discussion Papers 1/ 2007 3 Contents Abstract.................................................................................................................................. 5 TUTiivistelmäUT ............................................................................................................................. 6 TU1UT TUIntroductionUT .................................................................................................................. 7 TU2UT TUA brief review of China’s trade and FDI with Japan and the USUT ................................. 9 TU2.1UT TUSino-Japanese trade and FDI UT ............................................................................. 9 TU2.2UT TUSino-US trade and FDI UT .................................................................................... 12 TU3UT TUReview of the literatureUT .............................................................................................. 13 TU4UT TUThe development of China's bilateral intra-industry trade with Japan and the USUT .... 15 TU5UT TUFDI and China's intra-industry tradeUT .......................................................................... 19 TU6UT TUConcluding remarks UT.................................................................................................... 24 TUReferencesUT ........................................................................................................................... 25 Yuqing Xing Foreign direct investment and China's bilateral intra-industry trade with Japan and the US 4 All opinions expressed are those of the author and do not necessarily reflect the views of the Bank of Finland. BOFIT- Institute for Economies in Transition Bank of Finland BOFIT Discussion Papers 1/ 2007 5 Yuqing Xing* Foreign direct investment and China's bilateral intra-industry trade with Japan and the US Abstract This paper analyzes dynamic changes of China's intra-industry trade with its major trading partners, Japan and the US, from 1980 to 2004. It also investigates to what extent foreign direct investment promoted intra-industry trade. The empirical results show that, while shares of China's intra-industry trade with both Japan and U.S rose substantially, its intra- industry trade with Japan has reached 35 per cent of the overall trade, considerably larger than 10 per cent with the US. Sino-Japan intra-industry trade concentrated in the electrical and machinery sectors accounted for 52 per cent and 46 per cent of overall trade respec- tively. On the other hand, it is in the chemical and food sectors where intra-industry trade represented a relatively large proportion of Sino-US trade, 50 per cent and 30 per cent ac- cordingly in each sector. In addition, the analysis indicates that Japanese direct investment in China performed a significant role in enhancing intra-industry trade between Japan and China. However, it found no evidence that the US direct investment in China contributed to the growth of the bilateral intra-industry trade between the two countries. JEL:F14, F23 Key Words: Intra-industry trade, FDI, China * The preliminary work and the first draft were finished when the author was a visiting researcher of BOFIT. The comments of the participants at the seminar of BOFIT are highly appreciated. The author is grateful for the research assistance of Ms. Khun Channary. Corresponding address: International Development Program, Graduate School of International Relations, International University of Japan, 777 Kokusai Cho, Minami Uonuma Shi, Niigata-ken, Japan, 949-7277. Fax: 81-25-779-1187, email: xing@iuj.ac.jp. Yuqing Xing Foreign direct investment and China's bilateral intra-industry trade with Japan and the US 6 Yuqing Xing Foreign direct investment and China's bilateral intra-industry trade with Japan and the US Tiivistelmä Tässä tutkimuksessa käsitellään Kiinan sekä Japanin ja Yhdysvaltojen välisen teollisuusa- lojen sisäisen kaupan (intra-industry trade) kehitystä vuosina 1980–2004. Aiheena on myös, miten suorat sijoitukset ovat edistäneet teollisuusalojen sisäistä kauppaa. Kiinan te- ollisuusalojen sisäinen kauppa sekä Japanin että Yhdysvaltojen kanssa on kasvanut, mutta suhteessa Japaniin se on jo 35 % kokonaiskaupasta, kun taas suhteessa Yhdysvaltoihin ai- noastaan 10 %. Kiinan ja Japanin välinen teollisuusalojen sisäinen kauppa on mittavinta elektroniikkateollisuudessa (52 % kokonaiskaupasta) ja koneenrakennusteollisuudessa (46 %). Kiinan ja Yhdysvaltain välillä teollisuusalojen sisäinen kauppa oli suurinta kemiante- ollisuudessa (50 % kokonaiskaupasta) ja elintarviketeollisuudessa (30 %). Tuloksien mu- kaan japanilaiset suorat sijoitukset Kiinaan ovat selvästi lisänneet teollisuusalojen sisäistä kauppaa. Yhdysvaltalaisten yritysten suorilla sijoituksilla Kiinaan ei ole ollut vastaavaa vaikutusta. Asiasanat: teollisuusalojen sisäinen kauppa, suorat sijoitukset, Kiina BOFIT- Institute for Economies in Transition Bank of Finland BOFIT Discussion Papers 1/ 2007 7 1 Introduction The fact that China has emerged as the largest country in making toys and exporting textile products in the world should not surprise its trading partners. The rich labor endowment and seemingly unlimited rural labors released from the agriculture sector grant China both comparative and absolute advantages in manufacturing labor intensive products. As its economy is gradually integrated with the world economy, China has naturally evolved as a major exporter in almost all of the categories of labor-intensive products, such as shoes, travel gears, clothes, toys, etc. This phenomenon is exactly what the conventional Heck- scher-Ohlin theorem predicts. If a country specialized in producing low value-added labor intensive commodities forever, free trade would be a curse rather than a blessing for the country. That is actually one of the major suspicions that developing countries have on free trade. In the case of China, the economic integration with the global economy has not only greatly expanded the utilization of its abundant human resources and augmented its specialization in labor intensive productions, but also facilitated the development of its manufacturing capacity into high value-added products, inducing fundamental changes in its trade structure. According to reports by China's Ministry of Commerce (2005, 2003), China's ex- ports of high-tech goods have experienced rapid growth. In 2002, China exported $67 bil- lion high-tech goods, ranging from computers, mobile phones, biotech products, to aero- space equipments. In 2004, high-tech exports more than doubled that of 2002; jumping to $166 billion (about 28 per cent of China's total exports), representing a significant ac- hievement in high-tech exports. A study released by the OECD (2006) on the global trade of information and communication technology (ICT) products, outlined an even more striking picture. It showed that China has not only been one of the largest ITC importing countries, but also one of the largest ICT exporters. It exported $180 billion ICT products in 2004, exceeding Japan, the European Union and United States; becoming the number one exporter of ICT products in the world. This paper attempts to analyze the changing trade pattern of China. The analysis fo- cuses on the growth of intra-industry trade (IIT) between China and its major trading part- ners Japan and US. IIT characterizes simultaneous imports and exports of goods under same industry classifications. Rising share of IIT indicates an increase in product varieties, Yuqing Xing Foreign direct investment and China's bilateral intra-industry trade with Japan and the US 8 improved economies of scales in production, and shortened technology gaps with competi- tors. Even if most of IIT belongs to vertical IIT (which covers simultaneous exchanges of goods in the same categories but different qualities), increased IIT in overall trade still marks the progresses in manufacturing capacity, expanded export capability, increased in- volvement in global production networks, and the transition in trade pattern. Additionally, the paper examines factors contributing to the growth of IIT. Particu- lar attention is given to foreign direct investment in China. It has been recognized that for- eign invested firms are the major forces driving the fast expansion of China's exports. In 2004, they exported $339 billion, about 60 percent of China's exports (CSB, 2005). In the high-tech products category, foreign invested firms contributed even more, about 87 per- cent (MOF, 2006). FDI not only boosted China's export growth, but also accelerated the transition of its exports from low value-added to high value-added products. Developing countries usually do not posses the necessary technology to produce high-tech goods. It is the multinational enterprises which bring advanced technology and production know-how into developing countries by green-field FDI, consequently improving production capaci- ties and product varieties of FDI host countries. Furthermore, technology spillovers associ- ated with inflows of FDI also facilitate technological progresses of domestic firms, leading to improvements in production efficiency and product quality. Through alliances with MNEs, domestic firms of developing countries could take advantage of well-established global market distribution systems and recognized brands, which are critical for those firms marketing their products in the global market. A few empirical studies explored the relationship between FDI and China’s IIT (e.g., Hu and Ma, 1999; Zhan, Witteloostuijn and Zhou, 2005). Essentially, those studies are based on aggregated FDI and cross-country analysis. Effects of FDI on IIT however, depend largely on country, as well as industry specific factors. For instance, domestic mar- ket oriented FDI usually function as substitutes of exports from FDI source to host coun- tries. Rising inflows of domestic market oriented FDI reduce, rather than raise bilateral tra- de between FDI source and host countries. In other words, such FDI contribute very little to the growth of IIT. As a matter of fact, the estimates show that, while one third of trade between China and Japan belongs to IIT, intra-industry trade accounted for only 10 per cent of Sino-US trade, in spite of the fact that the US is China's largest trading partner and one of the largest FDI investors. Moreover, FDI in labor-intensive sectors such as textiles, where China has already specialized, generally intensify the specialization, thus mitigating BOFIT- Institute for Economies in Transition Bank of Finland BOFIT Discussion Papers 1/ 2007 9 the bilateral intra-industry trade between China and its trading partners, which are the sources of FDI in those sectors. The estimate demonstrates that only 7 percent of the bilat- eral trade between China and Japan in textile consisted of intra-industry trade; less than half of that in 1980, despite the fact that China’s textile sector is one of Japan’s largest host of FDI in the manufacturing sector. This study investigates the development of the bilateral intra-industry trade between China and the US separately. Additionally, it looks into the issue of major manufacturing sectors and applies sectoral FDI data, rather than aggregated ones, to explore the plausible impact of FDI on IIT. The remainder of the paper proceeds as follows. Section 2 provides a brief review on FDI and China’s bilateral trade with Japan and the US, while section 3 re- views the literature on the relationship between FDI and IIT. Section 4 estimates IIT in- dexes for overall trade; trade in manufacturing, as well as six major manufacturing sub- sectors from 1980 to 2004. Section 5 econometrically analyzes the impact of FDI on IIT. The analysis emphasizes the difference between Japanese and US FDI in terms of how it affects their bilateral intra-industry trade with China. The final section summarizes major findings of the paper. 2 A brief review of China’s trade and FDI with Japan and the US 2.1 Sino-Japanese trade and FDI Sino-Japan trade has risen sharply over the last few years. According to the Japan External Trade Organization (JETRO) (2006), the bilateral trade between the two countries grew 12.7 per cent and reached a new record $189 billion in 2005. Of this amount, China’s im- ports from Japan surged by 8.9 percent to $80.4 billion, while its exports rose 15.7 percent and amounted $109 billion, toping the $100 billion mark for the first time, due to strong IT-related demand from Japan. The growth of China's exports to Japan has no longer depended on textile related products. Instead, information technology related products have led this growth. The ex- ports of personal computers, printers and other office equipments rose 19 percent, and digi- tal mobile music players and other audio/visual equipment 28.7 percent. It is noteworthy to emphasize that Japan's exports to China in visual apparatuses including digital cameras and Yuqing Xing Foreign direct investment and China's bilateral intra-industry trade with Japan and the US 10 home video cameras surged 167 percent. The extensive exchanges of visual apparatuses products between China and Japan unequivocally represent a form of intra-industry trade. Similarly, the two way trade in steel product is also evident. While China's import of steel from Japan rose 15.7 percent because of its booming construction sector, its export of steel to Japan grew even higher, and jumped 27.6 percent. Japanese invested firms in China per- formed a critical role in promoting the two way trade. The surge of Japan's imports from China in steel, semiconductor and electronic parts and scientific/optical equipment was partially triggered by the rising "reverse imports" of Japanese affiliated manufacturers in China. China has replaced ASEAN-4 (Indonesia, Malaysia, the Philippines and Thailand) in becoming the largest destination of Japanese FDI in Asia (Xing and Wan, 2006). In 2005, Japanese MNEs invested $6.53 billion directly in China, making Japan the third lar- gest investor in China. Traditionally, Japan’s Asia-bound investment has concentrated in manufacturing and its investment in China is no different. Table one summarizes cumula- tive Japanese direct investment in China by major manufacturing sectors. The data do not include the reinvestment by existing Japanese affiliated manufacturers. The Japanese elec- trical industry has been the leader in engaging on FDI in Asia. It also takes the lead in Chi- na. According to Table 1, among the manufacturing sectors, Electrical ranked number one, with a cumulative investment of 617 billion Yen in China by the end of 2004. Transporta- tion equipment is the second largest sector in terms of direct investment from Japan. Be- fore the early 1990s, the scale of Japanese direct investment in transportations equipment was relative small. The cumulative FDI in the sector was the smallest among all manufac- turing sectors. After China joined the WTO, the lucrative auto-market in China attracted a tide of FDI from Japan. Major Japanese auto makers such as Toyota, Honda, and Nissan have accelerated their expansions in China. They have substantially increased direct in- vestment for the expansion of production capacities catering to the fast growing local mar- ket. Machinery is the third largest section with 314.8 billion Yen of cumulative investment by 2004. BOFIT- Institute for Economies in Transition Bank of Finland BOFIT Discussion Papers 1/ 2007 11 Table 1 Cumulative Japanese FDI in China (Million Dollars) Sectors 1984 1992 2004 Food 9.6 129.8 1,300.4 Textile 1.2 263.6 2,283.0 Chemical 6.5 100.8 1,929.2 Metal 1.4 96.0 2,117.0 Machinery 1.0 213.8 3,023.3 Electrical 1.2 611.3 5,923.5 Transportation Equipment 0.6 51.7 4,609.4 Source: Calculated by the author based on inward FDI from the Japanese Ministry of Finance. The data does not include the re-investment by existing Japanese affiliated firms in China. Using China as an export platform is one of the major motivations Japanese multinational enterprises invest in China. Investing in China, Japanese MNEs are able to strengthen their global competitiveness by combining China's low production costs together with their su- perior technology, brand recognition, and global distribution networks. According to a JETRO survey (2003), 61.6 percent of Japanese firms operating in China exported at least 70 percent of their products. In 2001, Japanese affiliated manufacturers in China as a who- le sold 65 percent of their products in overseas markets (Xing, 2006). Another unique prac- tice of Japanese affiliated manufacturers is their extensive involvement in "reverse im- ports"--exporting their products back to Japan. Figure 1. Export destination of Japanese affiliated manufacturers in China: 0 10 20 30 40 50 60 70 80 90 100 Total Manufacturing Food and tobacco Textiles Chemicals Metals Industrial machinery Electrical machinery Transportation equipment Precision instruments Other %Export to Japan Export to Others Source: Calculated by the author based on the data from quarterly survey of business activities (2004), METI Yuqing Xing Foreign direct investment and China's bilateral intra-industry trade with Japan and the US 12 Figure one breaks down overseas sales of Japanese affiliated manufacturers into the Japanese market, and non-Japanese market. According to the figure, on average, more than 50 percent of exports by Japanese subsidiaries headed for Japan. In the sector of precision instrument, almost 90 percent of the overseas sales were made in the Japanese domestic market; in the chemical sector, more than 70 percent, and in industry machinery, more than 60 percent. The significant ratios of the sales in the Japanese market suggest that serving Japanese markets is one of the major objectives for Japanese MNEs investing in China. As aforementioned, those products exported back to Japan by Japanese affiliates belong to the product categories which comprise China's major imports from Japan. Therefore, "reverse imports" contribute directly to the growth of the bilateral intra-industry trade between the two countries. 2.2 Sino-US trade and FDI Sino-US bilateral trade soared