east asian economic integration report copy

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Manuel Panagiotopoulos East Asian Economic Integration March 2012

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EAST ASIAN ECONOMIC INTEGRATION

BY

MANUEL PANAGIOTOPOULOS

A REPORT FOR THE AUSTRALIAN TRADE COMMISSION

MARCH 2012

This information is provided on the basis that it carries no warranty of completeness, accuracy orsuitability for any particular purpose. The Australian Trade Commission (Austrade) denies

liability for any loss arising from reliance on such information, such reliance being entirely at theusers discretion. In any business decision, independent professional advice should be sought.


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Key Questions:

Q 1: There is much discussion around East Asian regional integration (notably between and across

China, Japan, Korea, the Association of Southeast Asian Nations -ASEAN and Australia). Is it

regional integration or global integration centred on China?

Q 2: How is regional integration affecting importers and exporters and investors in the region by

priority sector: construction, education, Information & Communication Technology (ICT),

financial services, legal services, manufacturing (Elaborately Transformed Manufactures -ETMs

and Simply Transformed Manufactures - STMs) and Mining Equipment and Technology Services

(METs)?

Hypotheses:

That economic integration has been occurring at the regional level in East Asia, which is evident

in the levels of intraregional trade, the expansion of intermediate goods trade and the coordination

amongst fragmented parts of the production processes in the electronic and automotive sectors.

Further, while accepting the huge changes that have been created by Chinas entry in this process,

it remains a regional integration, one amongst three (European Union - EU and the North

American Free Trade AgreementNAFTA nations being the others).

The huge levels of foreign direct investment (FDI) in the region, coupled with the ability to finely

slice the value-chain, should provide entry points for providers of goods and services to these

producers and to the countries which host them.


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Conclusions and Recommendations

The answer to Question 1 is that there is regional economic integration ongoing in EastAsia largely driven by market forces but assisted by freer trade negotiations. While Chinais playing a key role, however, it is not the centre of globalisation. There are three regionalhubs of globalisation: United States/NAFTA, Germany/EU and China-Japan/East Asia.

The ongoing trend of regional integration will create opportunities for Australiancompanies, primarily in the services and mining sectors and niche manufacturing, as theextensive production networks intersect with numerous demands for services and productsthat are outsourced.

There is a complementarity between demographic factors, macroeconomic policies, tradeand investment policies and positive externalities from extensive FDI. These will most

likely result in a long-term rise in per capita gross domestic product (GDP) in the East Asiaregion such that consumer demand will become self-sustaining. There has been significantunder-investment by Australian firms in the Asian region, although it has the highestgrowth rate of the regions reviewed in this study.

Trade and investment policies continue to matter. There will be a critical role for thegovernments to promote further multilateral trade and investment liberalisation at themacro level and provide on the ground guidance and support to minimise the transactionand information costs of Australian companies that venture into the region.

Regional and bilateral market intelligence and the search for appropriate partners are twokey services.

The mapping of significant regional value-chains in automotive, infrastructure, financialservices, health, food and pharmaceuticals would provide valuable information forAustralian companies. The detailed maps of value-chains allows for the disaggregation of

products and services into more discrete units. A variety of cost competitive models,locations, potential partners and the key Australian value-add will become clearer.

Australian companies could expand their relationships with Japanese companies to enterthe East Asian region. Japanese companies have been major investors in East Asia for fourdecades, with large production networks throughout the region. Japanese companies are

also expanding their non-manufacturing investment into the region. Australian companieshave many years of close collaboration with Japanese companies in Australia and Japanesecompanies have upgraded their perceptions of the capabilities of Australian firms. Therecent example of joint business missions in infrastructure and public private partnerships(PPPs) in India and Indonesia could be repeated in other sectors.


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CONTENTS

Section 1 Literature Review

Chapter 1 Definitions of economic integration 7

Chapter 2 De facto and de jure integration 12

Chapter 3 Trade Patterns 17

Chapter 4 Investment Patterns 20

Chapter 5 Production fragmentation / Intermediate goods trade 24

Chapter 6 Measurement issues (Trade Intensities, Value-added, Input-Output) 30

Chapter 7 Multinational Firm Perspective (Interfirm and intrafirm transactions) 33

Chapter 8 Introduction to the Value-chain approach 36

Chapter 9 Policy (FTAs, rules, regulations) 39

Section 2 Commercial Aspects

Chapter 10 Value-Chain Approach in Detail 43

Chapter 11 Value-Chain Implications 54

- Regional and Local Strategies- Services- Manufacturing- Building on the Japanese Relationship

Chapter 12 Firms responses to policy decisions (FTAs) 58

Chapter 13 Final demand patterns in Asia 61

Chapter 14 Examples Australian and Japanese companies strategies in Asia 73

Section 3 References 78


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Chapter Outlines

Section 1 Literature Review

Chapter 1 Definitions of economic integration: Includes overview of economic integration,

definitions and trends and the question of China-centred globalization.

Chapter 2 De facto and de jure integration: includes distinction between de facto and de jure

integration and their relationship in historical and logical sequence.

Chapter 3 Trade Patterns: includes latest figures on overall intra- and extra-regional exports

and imports in East Asia, plus comparisons with EU and NAFTA and questions of

validity of using trade data.

Chapter 4 Investment Patterns: includes historical flows and stock data for FDI, general

factors which have promoted FDI and the growth of intra-regional FDI.

Chapter 5 Production fragmentation / Intermediate goods trade: includes data on production

fragmentation in East Asia, both history and underlying factors, the growth of

intermediate goods trade and the locational aspects of economies of scale.

Chapter 6 Measurement issues): includes overview of various methods of analyzing

intraregional trade beyond total export and import data, e.g., value-added by

industry, product and country and more generalised input-output data.

Chapter 7 Multinational Firm Perspective (Interfirm and intrafirm transactions): builds on

earlier chapter 4 to provide micro-level data on the history and strategy of MNEs inEast Asia, a comparison of Japanese and US MNEs and the choices made

by MNEs regarding intrafirm and interfirm transactions.

Chapter 8 Value-chain approach: includes an overview of the value-chain approach in

studying intra-regional trade and production fragmentation.


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Chapter 9 Policy (Bilateral and multilateral FTAs, Coverage and gaps, Unilateral reform):

includes development of trade and investment policies in East Asia, both bilateral

and multilateral FTAs and the gaps which persist.

Section 2 Commercial Aspects

Chapter 10 Value-chain approach: a more detailed analysis of the value-chain method as the

most appropriate method to use for uncovering commercial opportunities. Also

includes existing case studies of industries.

Chapter 11 Value-chain implications forfirms strategies: regional and local strategy; services

sector; Australian manufacturing; building on the Japanese commercial

relationship.

Chapter 12 Firms responses to policy decisions (FTAs): includes the impact of FTAs on

firms commercial decisions, the response of firms to different types of FTAs and

the impact of shortcomings such as numerous Rules of Origin.

Chapter 13 Final demand patterns in Asia: includes contrasting perspectives on the level of

dependence of East Asian growth on extra-regional demand, the impact of second

and third-generation suppliers on technology upgrading and per capita income,

long-term forecasts for the East Asian region, with special emphasis on the

development of regional final consumption growth, urbanisation and the

contribution made by the existing production networks of MNEs and local firms.

Chapter 14 Examples Australian and Japanese companies strategies in Asia.


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Chapter 1. Economic Integration

Discussion and analysis of economic integration, whether regional or global, is dominated by trade

and investment. Essentially, though, these two are just different aspects of international

commercial transactions. Trade is usually the first activity to be undertaken by firms, for various

reasons of production and transaction costs, followed by FDI, which, in turn, creates more trade.

This pattern is especially marked when FDI takes the form of the placement of distinct but

connected parts of a production process in diverse geographic locations, which has been

proceeding mainly during the past four decades in East Asia. The defining element is that the

locations are in different countries, i.e., it is part and parcel of the rapid increase in the size, scale

and scope of MNEs. Starting from the textile and clothing industries, this disaggregation process

has moved into footwear, automotive, electrical equipment, electronics, precision goods,

publishing and others. This process has been given several labels, depending on the theoretical

perspective of the analyst: production sharing; international production fragmentation; vertical

specialization; slicing the value chain; and outsourcing. Each of these labels, in turn, influences

the way trends and statistics are interpreted and policies are formulated.

In general, there are three factors that have supported this rapid transformation. First, rapid

advancements in production technology have enabled industries to slice the value chain into finer,

portable components. Second, technological innovations in communication and transportation

have shrunk the distance that once separated the worlds nations, and improved the speed,

efficiency, and economy of coordinating geographically dispersed production processes. This has

facilitated the establishment of services links that combine various fragments of the production

process in a timely and cost-effective manner. Third, liberalization policy reforms in both home

and host countries have removed a considerable amount of barriers to trade and investment

(Athukorala, 2010).

As these processes have moved from single to multiple country locations, the causal and

reinforcing relationship between trade, FDI, technology transfer and capital flow has resulted in

what is called regional economic integration. The regional aspect refers to the geographic

proximity of the various countries, although there remains a subjective element about the extent of

the region. It also does not imply a lack of commerce outside the region.


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Japanese companies have been a driving force of the process since the 1960s, when Japan first

emerged as a major exporter. Then the second generation, the NIEs (Hong Kong, South Korea,

Singapore and Taiwan) followed in the 1970s. In the 1980s the third generation included

Malaysia, Thailand, Indonesia and the Philippines) and finally China and Vietnam, in the 1990s.

While unilateral liberalizations by individual countries helped initiate export-led development in

the region, the increasing economic integration of East Asia has been an important factor in

sustaining the regions growth (Haddad, 2007).

Since 2000, East Asias trade expansion has been due to the processing of inputs goods or

production sharing, with China as the main manufacturing and assembly centre importing

intermediate goods from neighboring countries. The massive movement of Asian firms into China

has integrated China into the regional economy and the region into the global economy. The

production networks that initially linked Japanese industry vertically with Korea and Taiwan

(China) in low-skill assembly activities have gradually been transferred to lower-wage countries

such as Malaysia, the Philippines, and Thailand. (Indonesia, however, has shown little success

despite even lower wage levels.) These networks are also now being transferred to China and

Vietnam (Haddad, 2007).

The mechanism for this transformation has been the multitude of multinational national

corporations (MNCs), which mobilize resources across countries, regions and the world through

vertical and horizontal networks of procurement, production, distribution and sales. As a result,

regional economic integration has been brought forth into existence and the process of

globalization intensified. Thanks to the openness of global trade and foreign investments

advocated by WTO and responded by national authorities, together with the advancement of

transportation and communication technologies, MNCs are able to rapidly expand with much less

obstacles than before (Yang and Huang, 2011).

In general, the determinants of integration amongst different economies are proximity, market

size, growth rate, trade and investment policies and corporations. International firms contribute to

integration because their cross-border investments in affiliates and their joint ventures and

strategic alliances are trade promoting. MNE affiliates are more trade oriented than local firms,

and the relationship between trade and their investments in local affiliates is increasingly

complementary. Historically, the major foreign investors in East Asia have been Japanese and

American firms. Since 1980, however, Taiwanese and Korean firms and, more recently, firms


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from Southeast Asia have become more significant sources of investment flows in China,

Indonesia, Malaysia, Thailand, and the Philippines. (Dobson, 1997).

There has also been investment by European firms, especially in Singapore and Indonesia.

Investment is distributed into natural resources, wholesale trade, services and manufacturing,

which is concentrated in the electronics and electrical, textile and garment, chemical, and auto

industries (Dobson, 1997).

The impact of trade- and investment-friendly policies has been beneficial to East Asia, more so

than other regions. Economic liberalization has provided low income economies with

opportunities to become integrated into the regional production network, enabling the sequential

takeoff of industrialization in these economies (Hamaguchi, 2007).

Definitions of economic integration include both process and structural elements. Lower barriers

to trade and investment allow the more efficient use of economic resources, generate employment

in less developed economies, narrow the gaps in development and sustain long-term regional

economic growth. Economic integration in East Asia has already progressed in a de jure fashion,

withbilateral and multilateral trade agreements. Most of the trade agreements in the region

include elements that go beyond trade and look toward deep economic integration in the sense

that virtually all of them intend to include provisions on trade facilitation, services liberalization,

investment liberalization and facilitation, economic cooperation, and reforms and harmonization

of domestic rules and regulations, in addition to the reduction and elimination of tariffs (Corbett

and Umezaki, 2009).

Another formulation of a definition: Economic integration generally refers to a staged process

through which a group of countries gradually coordinate or merge their economic policies overtime. This coordination may be bilateral or carried out through a multilateral organization such as

ASEAN. The purpose of economic integration is to lower trade barriers and other economic

obstacles between countries, thereby expanding markets and trade, lowering prices, and improving

the competitiveness of trade partners through lower costs and economies of scale. For some

economic integration arrangements, the ultimate goal is a single market in which there is a free

flow of goods, services, capital and labor, and harmonization of economic and monetary policies.

In other cases, member countries design the arrangement to be a free trade area, a customs union,

or a common market, with no intentions to integrate further (USITC, 2010).


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However, the wider aspect of the relationship of the region to the global economy and Chinas

position also has to be addressed. One of the key questions of this project relates to the nature and

extent of the transformation of world production with regard to Chinas impact. The question then

becomes, is it regional integration or globalisation or globalisation centred on China?

China has loomed as the largest topic of interest since the decade beginning 2000. There is a

tendency to see China as the hub of Asia and Asia as the hub of global manufacturing. A typical

quote: The recent advent of free trade agreements (FTAs) will likely have a marked impact on

Asias trade policy and its cherished status as the global factory (Kawai and Wignaraja, 2009).

(Global factory is a loose usage, implying one hub, but see below for the counter argument.)

The analyses of intermediate trade or production fragmentation are more nuanced, but still retain

the focus on China: The progressive integration of world markets has led to the fragmentation of

production across countries and the formation global supply chainsThe evidence arising out of

this literature points to a strong expansion of production sharing and vertical trade in the global

economy, particularly since the 1990s. Nowhere has the expansion of vertical trade networks and

supply chains been more pronounced than in Asia, largely in relation to the Peoples Republic of

Chinas (PRC) ascension as a regional hub of assembly and global trade power. (Ferrarini , 2011).

However, Ferrarini (2011) has carried out some recent careful analysis on the development and

interaction of regional networks and how they connect to the global network using a measure of

the direction and intensity of countries network relations as providers and assemblers of parts and

components within the international production networks. This is achieved through the Network

Trade Index (NTI), which is definedas a supplier countrys share in parts imports by a

processing industry in the hosting country, weighted by that industrys share of total final goods

exports. The index is computed at the level of industries, or sectors, and for each country pair in

both directionse.g., from Japan to the PRC and vice-versaand is then averaged andnormalized to derive a more synthetic indicator for comparison across countries and industries

(Ferrarini, 2011).

Ferrarinis results show that there are three major regional hubs. The US is the centre of one hub,

based on the automotive and electrical/electronic production network in NAFTA, plus its

connections to Asian electronics production. A second hub is Europe centred on Germany,

especially via the automotive production network. The third hub is the Asian network, especially

in relation to trade in parts and components within the electric and electronics industries

surrounding the PRCJapan axis, also involving a number of economies in East and Southeast


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AsiaApart from Mexicomainly because of its maquiladoras network ties to the US industries

and marketsthe analysis suggests that outside East and Southeast Asia, developing countries are

not yet involved in global production networks to any substantial degree (Ferrarini, 2011).

The final point made above is fundamental for this project, hinting at the more sustainable

economic future of the Asian region.

Further analysis elaborated in Chapter 5, below, on value-added statistics, also does not support a

China-centred globalisation.


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Chapter2. De Facto and De Jure Integration

It is useful and instructive to distinguish between economic integration that occurs de facto and de

jure. The former reflects the idea that the private sector reaches across national boundaries to

expand and coordinate trade and investment in ways that create a larger, more integrated market

without the mechanism of trade and investment agreements.

De jure integration is promoted by the use of formal treaties and legal instruments: There is no

doubt that these two instruments of integration are very much related and indeed ultimately they

are complementary. Integration of neighboring markets without formal regional trade agreements

can create uncertainty among businesses since the institutional foundations may not be sufficiently

clear and transparent. Integration by agreements can be vacuous if the underlying economic

factors are not favorable for integration (Aminian et al, 2008).

Monetary union amongst countries within a region is often talked about as an advanced step

in de jure integration. Although there have been some policies aimed at financial

cooperation, there has been little practical progress in this area. Most of the important legal

accords have occurred in the real sector, with a rapid increase of FTAs in East Asia since the

beginning of the 21stcentury. Perhaps this is due to a natural sequencing of economic

integration, i.e., first the real sector and then monetary integration, which is the experience

of, for example, the EU. Or perhaps it results from more coincidental factors, e.g., the global

movement toward FTAs or the fact that, for whatever reason, there is a strong demand for

economic cooperation, and the real sector is the easiest to negotiate in practice and is less

compromising in terms of perceived national sovereignty. Is there a case for monetary union

in East Asia? Is there a case for wider FTAs? (Plummer & Wignaraja, 2007).

In the current and ongoing fiscal crisis in the EU, with the Euro under constant pressure of

becoming obsolete, such questions must loom even larger in Asia than previous periods. It

would be completely surprising if any moves towards currency union in Asia moved past the

stage of rhetoric for the foreseeable future.

ASEANs first major economic integration initiative was the AFTA in 1992, which is effective

in the original members. The transitional members (Vietnam, Laos, Myanmar and Cambodia)

have additional time to fully comply. ASEAN also has formed the ASEAN Investment Area

(AIA). These efforts at industrial cooperation have been designed with essentially the same goal

in mind as AFTA: reduce transactions costs associated with intraregional economic interaction


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(Plummer and Wignaraja, 2007).

The goal of an ASEAN Economic Community (AEC) was proposed at the ASEAN Heads of

Government meeting in Phnom Penh in November 2002. Originally aimed for 2020, it was moved

forward to 2015 in 2007. The AEC would crate a single market for goods and services and allow

freer movement of capital and people. Although very ambitious for ASEAN, it remains a

challenge to be implemented in a context where tariff removal is the dominant instrument. In the

past few years there has been a proliferation of FTA proposals in Asia, including an Asia Pacific

Free Trade Area (APFTA), which would include all APEC members, an East Asian Free Trade

Area, proposed by Japan, and a proposal to create an FTA between the ASEAN+3, New Zealand,

Australia, and India (ASEAN+6).

As the Doha Round of negotiations is currently indefinitely suspended, it is expected that

regional and bilateral trade deals will become even more prevalent. The creation of Preferential

Trade Agreements (PTAs) such as Free Trade Areas (FTAs) is by no means new. But the sheer

number and the speed with which these agreements have been negotiated in the past ten years are

simply astonishing. By 2005, all but one WTO member was trading under one or more PTAs

(Aminian et al, 2008).

The countries in East Asia, until very recently, have achieved market integration via the market

rather than formal agreement. East Asian economic integration is much greater than Latin

America, which has used mainly the de jure process. Integration using the marketplace or via de

facto agreements (together with business-friendly policies by individual countries) leads to more

intense integration than de jure agreements the propersequencingof the two forms of

integration should first be the freeing of the domestic private sectors which allow them to mature

and to use the international markets to integrate, before establishing legal treaties to further deepen

the relationshipsTrade agreements are both economic agreements as well as foreign policyagreements. Regional trade agreements can also be inward-looking or outward oriented. To keep

the primary focus on the open-trade and economic objectives, it is thus important to first develop a

thick market for exporters and traders, who can pressure the government to pay attention to the

signals of the economic forces (Aminian et al, 2008).

A number of factors have contributed to the recent proliferation of FTAs in the East Asian region.

Firstly, the establishment of NAFTA and the EU created the need for a response to the barriers

erected by these FTAs and to the opportunities to expand exports within East Asia. Secondly, the

stalled discussions of the Doha Round focused members attention to smaller, more achievable


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agreements. Thirdly, the Asian financial crisis of 1997, which prompted more regional

cooperation initiatives. Finally, rivalry among East Asian economies over leadership in the

region has activated strategies involving FTAs (Haddad, 2007).

The Asian financial crisis is probably the most important catalyst for the turn to de jure

integration. Before that crisis, the East Asian countries had been convinced that the de facto,

market-based approach they had used was the more successful. But the crisis and its rapid

movement throughout the region, plus the inadequate response by the SU and IMF demonstrated

the weaknesses of informal regional cooperation and gave East Asians a strong impetus to search

for a regional mechanism that could forestall future crisisThe crisis and its subsequent

contagion to a number of economies in Northeast and Southeast Asia painfully demonstrated that

the East Asian economies were closely related and a resolution to the crisis could require a

regional cooperation...The ASEAN+3 Summit in November 1999 released a Joint Statement on

East Asian Cooperation that covers a wide range of possible areas for regional cooperation

(Aminian et al, 2008).

Again it is worth remembering that trade integration within East Asia was high even before the

Asian financial crisis. In 1995, 48.7% of East Asian exports were intra-regional trade

integration among ASEAN countries (25.2% in 2005) is higher than the trade integration among

ANDEAN community (8.2% in 2005) or MERCOSUR countries (12.9% in 2005) (Aminian et al,

2008).

The de facto process of East Asia was more effective than the de jure process used in Latin

America and it maybe a better sequence for de jure to follow de facto because this sequence can

enhance the internal bargaining power of the outward-looking trade interests first, which may tilt

the implementation of the formal regional trade agreement to be more market-friendly (Aminian

et al, 2008).

The outward-looking trade interests should ideally be focused outside the region, too. Trade

policies have been extensively studied because there is a danger that the progress made in

successive multilateral trade negotiations to reduce barriers to trade and investment could be

undone by preferential agreements that turn into trading blocs and a much lower level of economic

welfare.

Historically, preferential trading arrangements have not played much of a role in the integrationof East Asian economiesIndeed, the fastest trade growth within the region has been the growth


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of trade with China since 1979, and this has occurred in the absence of formal trade-liberalization

agreements. Such trends toward spontaneous regional integration result from progressive outward

orientation of individual economies' trade and investment policies and unilateral liberalization of

goods and capital markets (Dobson, 1997).

On the contrary, the long period of economic growth called the East Asian miracle was due to

macroeconomic stability, high investment in human capital, stable and secure financial systems,

limited price distortions and openness to foreign technology (Hamaguchi, 2007).

The general pattern is East Asia has been that wide disparity of income levels amongst different

countries in close proximity has attracted investment from industries in the advanced economy,

e.g., Japan, which are no longer competitive due to higher labour costs. Those host economies in

turn have upgraded their own industries and moved production to even less-developed economies.

The result has been the current situation of fragmented production and high levels of intermediate

goods trade. But this situation is still considered to entail some risk under a system of numerous

bilateral preferential trade deals, which are neither disciplined by the WTO rules nor counts on

the supra-national regional-level management body such as the case of the European Union, hence

countries in the region should strengthen the de jurefeature (Hamaguchi, 2007).

It is noteworthy that ASEAN has been very active in FTAs in response to the rise of China, which

competes for the inflow of resources and investment and there has been no real progress in trade

agreements between the largest economies of Japan, China and South Korea.

East Asian integration has had both de facto and de jure elements, the former based on factor price

differences and the latter being rather haphazard and unorganised but aimed at the large

multinational companies. These provisions have contributed to reduce setup cost of offshore

factories and operational cost of linking various factories in different countries. Thus, trade

integration also has strengthened the role of scale economies to shape the competitiveness of East

Asian industries (Hamaguchi, 2007).

The resulting integration, production networks and supply chains has created the need for more de

jure action, more liberalization in trade and investment policies, harmonization of regulations, rules

and standards. East Asias policymakers are increasingly of the view that FTAs, if given wide scope,

can supportexpanding trade and FDI activities through further elimination of cross-border

impediments, facilitation of trade and FDI, and other such harmonization efforts. Thus, FTAs can be

regarded as part of a supporting policy framework for deepening production networks and supply


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chains formed by global MNCs and emerging Asian firms ((Kawai and Wignaraja, 2009).


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Chapter 3. Trade Patterns

Analysis of East Asian economic integration is first approached through the dramatic rise in trade,

both global and by Asian economies with those outside the region. Since 2000 these measures

have both doubled but the striking feature is that intra-Asian trade has tripled, and regional trade

involving emerging Asia, in particular, has increased even faster. As a result, Asian economies

accounted for 35% of world exports in 2009, compared with 25% 10 years earlier, with the share

of intraregional exports rising to 55% from 45% over the same period(IMF, 2011).

Furthermore, intraregional trade is most often indicated by the use of total merchandise exports.

According to WTO data, the share of intra-Asian merchandise exports in 2005 was 51% and was

53% by 2010 (cf www.wto.org/english/res_e/statis_e/world_region_export_10_e.pdf). These data

include non-East Asia, so would underestimate the East Asian share. Similar figures are found in

the International Monetary Fund statistics, as shown by the following chart. Despite slight

differences in the totals, both WTO and IMF data show a renewed increase in intra-regional trade.

(Shinohara, 2012)


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Starting in the 1970s and 1980s, when Japan accounted for more than half of the regions trade,

there has been strong growth in trade over the past two decades by other Asian countries,

including China, Taiwan, South Korea and ASEAN. These now account for more than 80% of

regional trade.

Chinas rise especially has resulted in the relative decline of Japan, Taiwan and South Korea.

Chinas accession to the WTO in 2001 and the wide disparity of labour costs resulted in the mass

movement of supply chains into China that produced for the US and EU markets, a redistribution

of trade resources within the region. The redistribution of trade among Asian trading partners of

the United States is typical of the surge in international and regional supply chains, with part of

the production initially located in Japan or in other economies transferring to China. Usually, it

has been the last stage of the supply chain, the assembly of the final products, which has relocated

to China, with the production of the core components remaining within the original country

(WTO/IDE-JETRO, 2011).

The share of Asia in world machinery and transport equipment exports increased from 14.5% in

1994/95 to 42.4% in 2006/7, with emerging East Asia accounting for over 80% of the increment.

By 2006/07, over 58% of total world ICT exports originated from Asia, with the PRC alone

accounting for 23%. In electrical goods, the PRCs world market share increased from 3.1% to

20.6% between 1994/95 and 2006/07 (Athukorala, 2010). These statistics show how rapidly the

East Asian region expanded its intermediate goods trade as an aspect of its integration into the

global manufactured goods trade.

Proliferation of disaggregated production networks has resulted in faster growth of intra-regional

trade compared to extra-regional trade and intra-industry trade growing faster than inter-industry

trade. A dominant portion of the intra-industry trade takes the form of vertical intra-industry trade

or production sharing networks. Indeed, the trade in parts within East Asia accounts for a largeshare of the total trade (that is, the trade in parts and finished products), and the share is

increasing: over 50 % of textiles and garments and over 80 percent of electrical machinery

(Haddad, 2007).

However, at this point it is critical to understand the differences between the use of total trade

figures and intermediate goods trade and their effects on measures of integration:

In 2006/7, intra-regional trade accounted for 55.1% of total manufacturing trade in East Asia, upfrom 53.2% in 1992/3. The level of intra-regional trade in East Asia was higher than that of


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NAFTA throughout this period and was rapidly approaching the level of the EU. For developing

East Asia (Asia excluding Japan) and ASEAN+3, the ratios are lower than the aggregate regional

figure, but they have increased at a much faster rate However, the picture changes significantly

when parts and components are netted out: the share of intra-East-Asian final trade (total trade

parts and components) in 2006/7 was 46.4%, down from 50.3% in 1992/3. The estimates based on

unadjusted data and data on final trade are vastly different for East Asia, particularly for DEA and

ASEAN. Both the level of trade in the given years and the change over time in intra-regional trade

shares are significantly lower for estimates based on final trade. Interestingly, we do not observe

such a difference in estimates for NAFTA and the EU (Athukorala, 2010).

These different calculations point to asymmetry in imports and exports in the East Asian region.

Unlike in EU and NAFTA, in East Asia the increase over time in the intraregional trade ratio

(both measured using unadjusted data and data for final trade) has emanated largely from a rapid

increase in intra-regional imports as the expansion in intra-regional exports has been consistently

slower This asymmetry is clearly seen across all sub-regions within East Asia (Athukorala,

2010).

This asymmetry is due to the heavy component bias in Asian intra-regional trade and the multiple

border-crossing of parts and components within regional production networks. On the export side,

the intraregional share of final goods declined continuously from 46% in 1995 to 37% in 2007,

whereas the intra-regional import share increased from 56% to 63% between these two time

points. The observed asymmetry in intra-regional trade in East Asia reflects the unique nature of

the involvement of Japan and the PRC in regional production networks (Athukorala, 2010).

The implications of this asymmetry are that economic has not progressed as much as the total

trade statistics would indicate and that the East Asian region may be unduly dependent on the

economic demand emanating from the US and the EU. While these concerns are valid, recentdevelopments in the East Asian region and the responses to the severe economic downturns of the

US and EU suggest these fears can be discounted (see Chapter 12 below).


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Chapter 4. Investment Patterns

In general, multinational investment and disaggregation of the value chain have expanded due to

the significant reductions in international communications and transport costs. For transport costs,

geographic distance remains a key factor. These general factors complement the East Asian

specific factors that have supported the strong growth in economic integration through the

proliferation of production networks and the expanded trade that accompanies it.

First, the region is well placed to benefit from fragmentation-based specialization countries in

terms of relative wages. Second, relative cost advantages arising from these wage patterns seem to

have been complemented by the quality of trade-related logistics. Third, first comeradvantage

and market thickness and agglomeration benefits evolved over a long period of time seem to have

played a pivotal role. The latter two factors would have jointly brought about significant cost

advantages in maintaining services links in production networks in the region (Athukorala,

2010).

This pattern of production sharing or fragmentation is proceeding globally, but East Asia is the

region that is preeminent in this activity. A fundamental factor is the great diversity of labor

supply and costs, from Japan, to the NIEs and ASEAN members. Over the past two decades

wages in Korea; Taipei, China; and Hong Kong, China have been rapidly approaching developed-

country levels. But, despite rapid growth, manufacturing wages in the PRC and other latecomers

to export-oriented industrialization in East Asia (Malaysia, Thailand, Viet Nam, and the

Philippines) remain lower than or comparable to countries on the European periphery and

MexicoMoreover, there are significant differences in wages among countries in the region,

providing a basis for a shift in activities to lower-wage sources within the region and rapid

expansion of intraregional product sharing systems (Athukorala, 2010).

As a succinct summary, we could say that significant investments in ports and other logistics

services and communications networks have complemented the historic pattern of early entry of

MNEs and the close proximity of relative cost differentials amongst trade-oriented economies.

Factor costs differentials have been supported by policy choices and investments in ports and

communications systems, which reduce the cost of maintaining services links in global

production sharingSingapore, by far the biggest transshipment hub in the region, tops the

worlds logistics quality ranking. The other major transshipment hub in the region, Hong Kong,

China, is eighth in the global ranking (Athukorala, 2010).


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The choice of location by MNEs is determined by the presence of the other market participants in

the specific or neighboring countries. Over a long period of operating in the East Asian region,

MNEs have invested in the capabilities and technology of their subsidiaries and affiliates, often to

the extent of giving them responsibilities for regional or global production. In addition, there has

been the emergence of China as a vast home to the assembly of electrical/electronic and other

products, which has expanded the component industries in other countries in the region. For over

3 decades there has been rapid economic expansion in several countries in the region and this

seems to have brought about market thickness, which refers to the diversification of the

composition of the traded goods of a country as an outcome of rapid growth and structural

transformation, with a positive impact on the location of outsourcing activity (Athukorala, 2010).

A further important factor that promotes the clustering activities in a region is the achievement of

economies of scale. Scale economies create an incentive for firms to cluster spatially. If average

production costs decline as the scale of production rises at the firm, industry, or regional level,

then there are advantages to concentrating production in a particular location... Scale economies

represent an incentive for the formation of regional production networks (Haddad, 2007).

The Japanese MNEs have been major drivers of the growth of intraregional trade and integration

through their development of highly disaggregated, region-wide production and distribution

networks. Of the exports from the head offices of Japanese multinational corporations, 74 percent

are destined to the overseas affiliates, while 56 percent of the imports come from overseas

affiliates (Haddad, 2007).

We can distinguish foreign direct investment (FDI) in three ways. Firstly, horizontal FDI, in

which operations are set up in host countries to supply that hosts domestic market, not exports.

This type of FDI is considered in the literature to be export-substituting. Secondly, vertical FDI, in

which operations are established in a low labor cost host and capital-intensive inputs are importedfrom the home base. Thirdly, there is export-oriented FDI, whose purpose is to serve third

markets. Vertical and export-oriented FDI form the basis for the development of production

networks. In terms of affiliate numbers, in opposition to the theoretical literature in which

horizontal FDI prevails, export-platform FDI holds the largest share for Japanese multi-national

affiliates; in particular, in the textiles and precision machinery industries. Furthermore, complex

vertical-FDI, in which a parent country invests in a particular host country with the intention of

serving third markets with exports of final goods from an affiliate in the host country, and of

procuring from the third country, accounts for a large share in the electronics, information and


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technology, andprecision machinery industries (Hiratsuka, 2011)

Rather than being substitutes, as traditional, constant returns to scale theory would suggest, FDI

and expanded trade go hand in hand. FDI has been instrumental in the shift to international

production networks, and economies that have experienced the largest FDI inflows have also seen

the largest expansion in merchandise exports. The fragmentation of production presents producers

in developing countries with a golden opportunity to widen their export markets. Indeed,

developing economies make up three of the top six destinations for FDI flows, with China moving

up to become the second largest FDI recipient in 2009behind the United States (WTO/IDE-

JETRO, 2011).

One example of the interplay between FDI, factor cost differentials, regional proximity,

economies of scale and production fragmentation is the hard disk drive (HDD) industry, itself a

component of other industries (which is explored in more detail in Chapter 12). Originally, US

HDD manufacturers set up facilities in Singapore and in time shifted various aspects of the

process to other factories in Malaysia, Thailand and China to take advantage of labor cost

differentials. These latter hosts became major producers. Thailand had become the second largest

exporter of HDDs behind the PRC. Thailands trade share of HDDs accounted for 17% in 2007,

compared with the PRCs 35% (Hiratsuka, 2011).

The success of industries like HDDs in emerging economies has led to more confidence from

MNEs in such investments, which in turn support the sustained growth in wealth in the region.

TNCs (Transnational Corporations) FDI plans are increasingly focusing on developing and

transition economies, especially in South, East and South-East Asia, and, to a lesser extent, Latin

America (UNCTAD, 2011).

Asia has been the exemplary region in which a sequential upgrading has occurred in terms of

industrial development. Global competition and freer markets has driven advanced economies to

invest in higher value-added production and services, while relocating the more labor-intensive

activities to less developed countries. This provides the latter with opportunities to engage in the

regional and global economies and benefit from the import of capital and technology that

accompanies MNEs. FDI has played a crucial role in the process, serving as a vehicle for

transferring technologies, recycling comparative advantages and enhancing competitiveness.

For low income countries in the region, participation in TNCs regional production networks has

become an effective way to build productive capacities and promote exports, industrial

development and economic growth (UNCTAD, 2011).


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The success of this process is highlighted by the more recent trends in FDI, with the investing

firms being from inside the region. Intraregional FDI has made an increasing contribution to

industrial upgrading. The relative weight of the regions FDI sources has shifted: while the United

States played a leading role in the 1960s and 1970s, followed by Japan in the 1980s, their share

has been declining since the early 1990s (table II.6 from the UNCTAD World Investment report

2010). Regional economic integration has boosted intraregional investment, which now accounts

for around 40 per cent of the total FDI stock of the regionFollowing in the footsteps of Japanese

TNCs, companies from NIEs have been relocating their production operations within the region to

take advantage of lower costs, thereby enhancing their competitiveness and promoting industrial

restructuring and upgrading in their home countries. Through this process, neighbouring host

countries have gained increased access to capital, technology, productive capability and foreign

markets. 19

(Refer also to the chapter on final demand in Asia, below, for additional analysis on intraregional

investment and its impact on economic growth).


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Chapter 5. Production Fragmentation and Intermediate Goods Trade

The vast networks of production and distribution managed by MNEs in Asia are also based on the

low transport costs due to their proximity and low trade barriers due to policies. As a result,

growth in one East Asian economy tends to favor an expansion in trade with other East Asian

economies rather than with, say, Latin America. Low trade costs may magnify the advantages of

fragmenting production, rendering the impact on trade of incremental reductions in trade barriers

potentially large (Haddad, 2007).

The resulting enormous intra-industry trade is vertical in two senses. Firstly, the trade in goods

and services that is based on the differing levels of economic development. Secondly, as a feature

of the fragmented production network as various components of final products move between

different facilities. Production sharing, by definition, incorporates the back-and-forth nature of

trade: the importation of inputs for assembly or additional processing, as well as the exportation of

intermediate goods for assembly or additional processing by third countries. This is distinguished

from pure intra-industry trade, one-way production sharing, and the trade in intermediate goods

(Haddad, 2007).

There has been a shift, not just from trade in consumer and capital goods but also from

intermediate goods, to trade in parts and components within the same industry. Trade patterns in

todays global competitive climate where economies of scale strongly work are quite different

from the traditional ones that are based on static comparative advantage. The whole production

processes involve sequential production blocks located across countries. Different stages of

production are shared by different suppliers located in different countries (Lim, 2007).

The result of the development of the extensive networks of production in Asia has been that

network trade (intermediate plus component goods) has more than doubled its share of total

exports to about 50% by the end of the 2000s. The shift from mature to developing economies is

also evident. The share of developing countries in total network exports increased from 22.0% in

1992/3 to 45.7% in 2005/6, driven primarily by the growing importance of East Asian countries in

global production sharing. The share of East Asia (including Japan) increased from 32.2 % in

1992/93 to 40.3% in 2006/7, despite a notable decline in Japans share, from 18.4% to 9.5%. The

major driving force has been the PRC, whose share increased from 2.1% to 14.5%. Within East

Asia, world market shares of ASEAN countries, with the exception of Singapore, have grown

faster than the regional average (Athukorala, 2010).


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There is a significant bias in the component trade of China: a much larger share of component

imports compared to exports, which means that other countries in the East Asian region are

providing parts and components for assembly in China. The share of components in the PRCs

total manufacturing imports from East Asia increased from 16% in 1992/3 to 46% in 2006/7

(Athukorala, 2010).

Furthermore, there is no one-way flow towards a single destination. The intermediate good trade

is multi-directionalthe traditional image of the flying geese pattern which depicts international

structure of trade within the framework of vertical division of labour does not fit wellmore than

73% of VCR and DVD players and 80% of personal computers (PC) are made in China. On the

other hand 62% of hard disk drives (HDDs) and 38% of DVD-ROM drives are produced in

ASEAN countries. These products are used for assembling PCs, hence the production linkage

between ASEAN and China is obvious (sic) (Hamaguchi, 2007).

As mentioned previously, while China plays a key role as the final assembler in the region,

Ferrarinis paper also shows that globalization is not centred on China but has at least three

anchors. Furthermore, the changing demand dynamics in the US and EU after the severe

downturns from 2008, will favour a shift of policies towards generating more regional demand.

The economic integration of China has deepened production fragmentation in East Asia to an

unprecedented level. The rapid integration of China into regional production networks has

countered fears that Chinas global integration would crowd out the opportunities of other

countries for international specialization (Haddad, 2007).

Until recently, it could be said that intermediate goods exports have accounted for about 70

percent of the annual export growth in Asia over the last decademore than double the

contribution of capital and consumer goods together. This has been particularly the case for the

ASEAN-5, the NIEs, and Japan. Exports of intermediate goods have been particularly strong toother Asian economies, whereas consumer goods and intermediate goods have contributed

roughly equally to the increase of exports outside AsiaThe average share of intermediate goods

exports between Asian trading partners has increased to nearly 80 percent in 2009 from about 60

percent a decade earlier (IMF, 2011).

If the expectations of shifting demand patterns are realized, these shares should converge

somewhat, as the economies inside the Asian region become the final destination for more

consumer goods. However, to a large degree, it is the previous dynamic trade performance which

will provide the basis for this convergence.


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Evidence of the appearing shifts is the increasing importance of China as a destination for capital

goods. For Japan and Korea, capital goods exports to China now account for 20 percent to 25

percent of their total capital goods exports (a fourfold increase from a decade earlier), making

China by far their single most important capital goods export destination in Asia, and comparable

to the United States or the European Union as export markets (IMF, 2009).

At the same time, as shown by the major disruptions to regional and global supply chains after the

tsunami in March 2011, Japan remains a key driver of economic growth in the East Asian region.

For all major Asian economies, Japan remains the second most important source of intermediate

inputs after China, and it remains the single most important supplier to China, where it accounts

for 36 percent of all imported inputs sourced from Asia (IMF, 2009).

As the Asian region continues to dominate the trade in intermediate goods and components and

expands the trade of consumer goods, the advanced economies will focus more on diversifying

their trade in services. Once again, some of these services can be called intermediate because

they could meet demand at various points of regional and global value-chains.

New theories have been formulated to understand the formation of international production

networks. Firstly, new economic geography (NEG) attempts to explain the agglomeration and

dispersion of economic activities in geographical space. The spatial structure of economic

activities is considered to be the outcome of a process involving the opposing forces of

agglomeration and dispersionOne important factor that subtly affects the balance between

agglomeration and dispersion is the cost of transport, which includes freight costs, tariffs, non-

tariff barriers, and the risk of exchange-rate variations (Hiratsuka, 2011).

An allied approach, also using net cost analysis and comparative advantage, is fragmentation

theory, which focuses on the location of production processes, and it suggests that production

processes should be fragmented into several stages with separate production blocks being located

at different sites, either domestic or international. By dividing the production process into separate

blocks and situating each block in the most appropriate location, the total cost of production can

be reduced (Hiratsuka, 2011).

For example, in the case of capital intensive and labour intensive components of a product,

marginal costs can be reduced by locating one component in a capital endowed country and the

other in a labour endowed country. In addition, though, fragmentation theory also includes thecalculation of the cost of incurring setup cost of establishing extra production plants and


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service link cost for utilizing transportation and communication services in order to link the two

operations. Firms choice whether or not to split up the production depends on the balance of the

marginal cost saving and the additional costs (Hamaguchi, 2007).

The defining characteristic of NEG is its emphasis on the synergies that accumulate from

geographically adjacent economic activities that are also connected in a production process. Scale

economies and the presence of skilled labour attract more capital and raise incomes. Production

processes that are located in neighbouring countries likely face lower transport and transaction

costs and more efficient use of inventories on a just-in-time basis. The positive feedback

mechanism leads to the self-organization of an agglomerationA remarkable feature of the recent

economic development in East Asia is not successive dispersion of industrialization but the

emergence of new agglomerations (Hamaguchi, 2007).

The stress is on the plural. It may have begun as kind of flying geese pattern, starting with Japan,

but the development of intermediate goods production and trade, especially in electronics and

automobiles, has led to a new pattern. The region has multiple technological centres and co-

agglomerations undertaking final-good and intermediate-good production, with intermediate

goods moving bi-directionally between countries (Hamaguchi, 2007).

A good example is the hard disk drive (HDD) industry, which has critical applications in both

electrical/electronic and automobile sectors. The HDD sector has its own intermediate and final

products. Due to the low cost of transportation, the HDD industry has developed a system of

production fragmentation, where the production process is divided into several discrete stages and

the separate production blocks are located in different countries (Hiratsuka, 2011).


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(Hiratsuka, 2011)

We could say that in the East Asian region, from a value-chain perspective, national bordersresemble notional borders. While remaining fully identical with sovereignty, borders are no longer

impediments to trade and investment. The level and location of trade and investment are much

more function of time, costs and scale. Trade and investment policies have achieved much,

although more could be done. There remain real regulatory and related mechanisms that add to the

transaction costs between countries.

In this context, especially from the point of Australian opportunities, the following conclusion has

important implications: Japanese firms investing in East Asia are likely to more flexibly de-

internalize their production processes and conduct outsourcing activities than those going to other

regions such as North America and Europe (Hamaguchi, 2007).

In the East Asian region, there are more opportunities for Australian providers of goods and

services to build on the extensive relationships they already enjoy with Japanese firms in the

Australian and the Japanese markets. There are literally thousands of Japanese firms throughout

the Asian region, deeply embedded in the industrial and consumer base.

As mentioned before, Ferrarinis research shows that there are three global hubs: the United


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States, China-Japan and Germany. Each hub has connections outside its own region with other

hubs and networks. In East Asia, the China-Japan core is connected closely to several other

countries as fragmented production activities scattered across the region typically involve the

provision of high value-added parts and components by leading economies, such as Japan and the

Republic of Korea, further processing in countries such as Malaysia and the Philippines, and final

assembly in countries involving low labor costs and value added, predominantly in the PRC

(Ferrarini, 2011).

The East Asian region dominates the global electrical/electronic sector, with Japan in the core

position. The global automotive industry networks are more evenly distributed, led by Germany

and the US. By comparison, Asias industrial network is relatively less developed [but] Japans

automotive industry positions itself at the centre of Asias networks, as a prime source of auto

parts and components. Japans strongest network partner is Thailand, which sources 67.5% of its

automotive parts from Japan. Other relevant partners within the Southeast Asian region are

Indonesia, and to a lesser extent the PhilippinesThe PRC has not yet reached a status of major

influence in the regional automotive industries. Nevertheless, in 2006/2007 the country

represented the second-largest regional network leg, in connection with Japan, and also integrates

strongly with the Republic of Koreas auto industry. The Republic of Korea itself represents a

more significant element in the Asian networks, and also has significant relations to the Germanand the US hubs (Farrarini, 2011).


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Chapter 6. Measurement Issues

There is a voluminous literature dealing with the growth of intra-regional trade and investment,

typically in the context of economic integration. It is very common to find this type of statement:

Asia is a highly integrated trading bloc, with buoyant intra-regional commerce (58 per cent of its

trade in 2009). Furthermore, it has diversified its extra-regional markets to reach beyond its

traditional partners, the European Union and the United States. The share of extra-regional trade

excluding the European Union and the United States has increased from 12.9 per cent in 2001 to

18 per cent in 2009 (WTO and IDE-JETRO, 2011).

As useful as these statistics can be, they also suffer from serious deficiencies. When they are used

in analysing international production networks, aggregated trade data can actually obscure those

networks.

Global production sharing opens up opportunities for countries to specialize in different slices

(tasks) of the production process depending on their relative cost advantage and other relevant

economic fundamentals. In this context, the decisions of how much to produce and for which

market have to be combined with decisions on where to produce and with what degree of intra-

product specialization. Consequently, trade flow analysis based on data coming from a reporting

system designed at a time when countries were trading only in final goods naturally distorted

values of exports and imports, leading to a falsification of the nature of emerging trade patterns.

The degree of falsification is likely to increase over time as more complex production networks

are created with an ever-increasing number of participants (Athukorala, 2010).

There is a vast literature on what may be termed standard trade data analysis based on the

traditional notion of horizontal specialization in which trade is an exchange of goods that are

produced from start to finish in just one country (Athukorala, 2010). Such analysis does show an

increase in intra-regional trade in Asia since the 1980s and forms the foundation for arguments in

favour of regional trading agreements.

At the same time, there has been a concomitant expansion of international production

fragmentation, both regionally and globally. This phenomenon has been reflected in a growth in

the trade in parts and components at a rate exceeding that of the trade in final goods because a

good crosses multiple borders while it is involved in processing (Haddad, 2007).

The driving force in the growth of production fragmentation and intra-industry trade has been


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foreign direct investment (FDI, i.e., the activities of multinational corporations (MNCs), including

a significant amount of intra-firm trade. With the importance of MNCs in trade, the nature of

MNCs exports has been reconsidered. In the negotiations of US-China trade disputes, the

representatives of China have repeatedly pointed out that a large portion of its exports to the U.S.

was produced and traded by the MNCs of other countries in China and should be treated as the

exports of these FDI source countries. The trade balances based on ownership should be a better

revelation of trade relationship among countries. This point of view was recognized by the United

States. Since 1995, the U.S. Bureau of Economic Analysis has annually published the report of An

Ownership-based framework of the U.S. Current Account (Yang and Huang, 2011).

International trade statistics account for the gross cumulated value embodied in goods crossing

international borders, not just the value added by the segment of the production process hosted by

the exporting country and attributable to its resources (Ferrarini, 2011). Aggregated data do not

adequately reflect the distribution of value-added in the international value-chains and often

include products that have been counted at least more than once as they travel across the same

borders several times.

This characteristic of trade data has led to new methods of calculation, from looking at intra-firm

sales of MNCs to the analysis of specific value-chains such as the iPhone, apparel or hard disk

drives. A more comprehensive, economy wide approach to measuring value-added trade

combines national inputoutput tables to identify the sources and destinations of value added as

intermediate goods pass through global supply chains (Farrarini, 2011).

More detailed disaggregated trade data has also been compiled, to identify the parts of parts of

components of intermediate goods that are traded in production networks. Compared to input

output analysis, this method is less comprehensive a gauge of processing trade and is limited to

the subcategory of intermediates that are clearly recognizable as parts and components, thusdisregarding processing and assembly activities characterizing vertical trade more broadly.

However, it offers the advantage of parsimony, in terms of both data requirements and the

methodological complexities involved (Ferrarini, 2011).

These various methods have arisen in specific policy contexts, such as economic integration or

trade imbalances or development economics, etc. Each method has its uses and limitations, both in

their original and additional contexts. Taken together they do provide a key insight, which is that

vertical trade is but one aspect of economic integration. FDI and other capital flows are also

important.


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The use of value-added or input-output analyses produces important insights for both policy

formulation and corporate strategy. A good example is provided by looking at China, a key

economy that is well integrated into global production networks. China has raw material and

intermediate goods inputs and a large share of GDP as exports, much higher than other large

economies. A detailed analysis of the imported inputs shows a much lower share of value-added

generated in China.

Koopman, Wang and Wei (2008) modified existing methods of analysing value-added. By

applying our methodology to Chinese data, we have found several interesting patterns. First, we

estimate that the level of foreign content in Chinese exports is close to 50%, almost twice as high

as what we calculate by using the HIY formula. Second, we find interesting heterogeneity across

sectors: those sectors that are likely to be labelled as sophisticated or high-skilled, such as

computers, electronic devices, and telecommunication equipment, tend to have especially low

shares of domestic content.

Conversely, many sectors that are relatively intensive in low-skilled labour, such as apparel, are

likely to exhibit a high share of domestic content in Chinas exports. Finally, we find that foreign

invested firms (including both wholly-owned foreign firms and Sino-foreign joint venture firms)

tend to have a relatively low share of domestic content in their exports (Koopman, Wang and

Wei, 2008).

However, one of the consistent messages in this report is that the economic upgrading of the East

Asia region, including of course China, is proceeding quickly, especially in the past few years.

Recently, Koopman et al (2011) updated their analysis of value-added in Chinese exports and

found that domestic value-added had risen to 60.6% in 2007. By 2012 this figure is likely to be

even higher; an indicator that value-added will support the future economic growth of the East

Asian region.


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Chapter 7. Multinational Enterprise (MNE) Perspectives, Inter-firm and Intra-firm

Transactions

Global Value chains, production sharing/networks/fragmentation are all driven by the international

strategies of MNEs and the evolution of their choices between intra-firm and inter-firm

transactions (make or buy). Early on, the strategy might be to locate some parts of production

in a lower cost market andre-import the parts for final assembly. Later in the process, several

countries could be engaged, with multiple export-import movements of parts before being

assembled into an end product. As international networks of parts and comments supply have

become firmly established, producers in advanced countries have begun to move the final

assembly of an increasing range of consumer durables (e.g., computers, cameras, TV sets, and

automobiles) to overseas locations in order to be physically closer to their final users and/or take

advantage of cheap labor (Athukorala, 2010).

Different industries have distinct internal-external transaction strategies. In the case of standard

consumer goods such as clothing and footwear, global production sharing normally takes place

through arms length relationships, with international buyers playing a key role in linking

producers and sellers in developed countries. On the other hand, production sharing within

vertically integrated global industriessuch as electronics, electrical goods, and automotivehas

evolved in a different manner (Athukorala, 2010). Moving from an initial position in which a

subsidiary performs the same operations as the home plant, a fully internal corporate operation,

albeit in an overseas location (offshoring), eventually some activities or components are sourced

from other suppliers. Some technology transfer would also occur.

In the East Asian region, MNEs pursue two different types of strategies. One rests on cost

differentials and economies of scale to use networks for exports to final markets in the US and

EU. The other is the production of goods for the local markets. The division between the twotypes of investment is not clear-cut, and many foreign affiliates operating in East Asia have

progressively adopted the characteristics of both vertical and horizontal multinationals (WTO and

IDE-JETRO, 2011).

The increasing complexity of multi-country production networks forces MNEs to redefine and

concentrate on core activities. This leads to more extensive outsourcing, providing both

technology transfer and opportunities for new firms to enter the network. A reliable and

conducive international trading environment ensures the unhindered and efficient flow of

investment, goods and services among nations. Through successive negotiations under


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GATT/WTO, trade barriers have been significantly reduced or eliminated and a stable, rules-based

trading system has guaranteed and encouraged firms to engage internationally with confidence.

The availability of efficient and affordable logistics, transport and communication services

supports this global production system (WTO and IDE-JETRO, 2011).

The same considerations apply to services activities. Both manufacturing and non-manufacturing

firms can and do outsource or offshore various types of services, from basic and routine to

complex and customized, even R&D. Data processing, call centres, virtual assistance, legal

support (legal transcription, drafting contracts, legal representation, etc), medical support (medical

transcription, interpreting x-rays, etc), finance and accounting, software and applications

development and R&D are all activities that enterprises can assign to foreign firms. All these

activities are designated as business process outsourcing (BPO) or information technology-

enabled services (ITES). Of the Asian developing economies, it is India and the Philippines that

are benefiting increasingly from offshored computer and IT-enabled business services (WTO and

IDE-JETRO, 2011). A general framework for understanding some of the issues related to intra-

firm and inter-firm or make and buy decisions and the variations is provided by Gereffis

governance diagram:

(Gereffi, 2011)


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In brief, these depend on the complexity of transactions, the extent to which codification can occur

and the capabilities of external suppliers in relation to the requirements of the firm (Gereffi, 2011).

The rapid establishment and proliferation of global value chains or production networks has rested

on large intra-MNE transactions, as much of the trade is carried within a firm but between

countries (Lanz and Miroudot, 2010). Over time, however, many activities are outsourced as

communications become cheaper and faster, standards become ubiquitous and technology and

capabilities improve.


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Chapter 8. Introduction to the Value-Chain Approach

In its simplest terms, the value chain describes the full range of activities which are required to

bring a product or service from conception, through the different phases of production (involving a

combination of physical transformation and the input of various producer services), delivery to

final consumers, and final disposal after use. Considered in its general form, it takes the shape as

described in Figure 1. As can be seen from this, production per se is only one of a number of value

added links. Moreover, there are ranges of activities within each link of the chain (Kaplinsky and

Morris, 2001).

(Kaplinsky and Morris, 2001)

In addition to the manifold links in a value chain, typically intermediary producers in a particular

value chain may feed into a number of different value chains (Kaplinsky and Morris, 2001). The

various alternative or additional links to intermediary suppliers provide a glimpse of the extensive

commercial linkages and hence opportunities that can be evaluated and explored.

Porter (1985) made the fundamental definition of a firm in terms of activities, from input to

transformation to output. This allowed a more detailed understanding of the numerous components

of the firm and facilitated the understanding of how value was created and which activities were

critical, depending on the product or service. Five major categories of activity (inbound logistics,

operations, outbound logistics, marketing and sales and service) could be further and further


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subdivided. Over time, as these elements became better understood, decisions could be made

about outsourcing and/or offshoring, both within and across national boundaries.

Value-chain analysis provides insights into the value-added of each link. For example, global

value-chain analysis has found the share of foreign content of the PRCs exports to be particularly

high in certain electronics products for which key components, as well as product design and

brand values, originate outside the country. For example, the PRC was found to add as little as $4

in value to an Apple iPod fetching a factory gate price in the PRC of $144 (Ferrarini, 2011).

Using the end-prices in the US, Hal Varian (2007), made the following calculations, illustrated by

Gereffi (2011) (Note that this is a snapshot of the mid-2000s. It would be a mistake to think that

these values have remained or will remain unchanged).

(Gereffi, 2011)

Over time, value-chains become established and expand their capacity. Agglomeration at each

section of the value-chain provides enough scale for the development of services and niche

products by outside firms (see also the chapter on fragmentation).

Global value chains foster the parallel development of trade and foreign direct investment.

Industrial clusters created by supply chains tend to grow up around specific tasks and business


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functions. The process is cumulative and, in time, modifies the production system of an economy

(WTO and IDE-JETRO, 2011).

Identifying the discrete links in the regional/global value chains will allow Australian companies,

including Small and Medium Sized Enterprises (SMEs), to find economies of scale appropriate for

the costs involved in entering the value chains. Government can play a part in closing the

information gap.


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Chapter 9. Policy (FTAs, rules, regulations)

Although coming late to the practice of bilateral (and then plurilateral) free trade agreements

(FTAs), since the late 1990s the Asian region has seen the highest proliferation of such

instruments. Four main factors underlie the recent spread of FTA initiatives in Asia: (i)

deepening market-driven economic integration in Asia, (ii) European and North American

economic integration, (iii) the 19971998 Asian financial crisis, and (iv) slow progress in the

WTO Doha negotiations (Kawai and Wignaraja, 2009).

Mostly they deal in the trade of goods and services, but also the so-called Singapore issues (i.e.,

trade facilitation, investment, government procurement, and competition policy), which are

currently beyond the scope of the WTO (Kawai and Wignaraja, 2009).

However, whilst aimed at liberalisation, the proliferation of bilateral and sub-regional FTAs has

also created duplication and overlap, especially in regard to rules of origin, dispute settlement and

other non-tariff issues. These constraints tend to increase transaction costs and trade barriers

despite continuing reduction in average tariff rates in developing countries in East Asia. Increased

transaction costs would tend to reduce industrial dispersion effect in less-developed economies in

the region and, thus, the phenomenon of growth gaps in East Asia would tend to persist (Lim,

2011).

Nevertheless the numerous regional trading agreements (RTAs) among Asian economies have

contributed to regional integration (WTO and IDE-Jetro, 2011). The examples given are the

ASEAN Tree Trade Area (AFTA) and the ASEAN FTAs with China, Japan, Korea, India and the

ANZAFTA.

These larger, more encompassing agreements seem to be more appropriate in a context of

production fragmentation, intermediate goods trade and global value chains. Thus, the rising

importance of product fragmentation seems to have strengthened the case for a global approach to

trade and investment policymaking rather than a regional one (Athukorala, 2010).

Policy generally tends to lag behind market evolution and the desirability of a global agreement

aside, its achievement seems a long way off. In its stead, though, it may be realistic to aim for a

wide regional agreement, such an East Asia FTA. There has been some analysis of the economic

effects of such an agreement. Plummer and Wignaraja (2007) looked at general equilibrium

simulations of six policy scenarios:


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1) A fragmentation scenario: a continuation of the current wave of bilateralism, where the region

is fragmented by several bilateral or small regional FTAs;

2) An ASEAN+3 FTA scenario: free trade among ASEAN countries; PRC+Hong Kong, China;

Japan; and Korea;

3) An ASEAN+6 FTA scenario: free trade among ASEAN+3 countries, India, Australia, and New

Zealand;

4) An Asia-wide FTA Scenario: free trade among all Asian countries;

5) An APEC FTA: free trade am

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