Fragmentation and vertical intra-industry trade in East Asiavenus.unive.it/mvolpe/Articolo 3.pdf ·...

North American Journal of Economics and Finance17 (2006) 257–281

Fragmentation and vertical intra-industrytrade in East Asia

Mitsuyo Ando ∗Faculty of Economics, Hitotsubashi University, 2-1 Naka, Kunitachi, Tokyo 186-8601, Japan

Received 21 April 2005; received in revised form 14 June 2006; accepted 21 June 2006Available online 21 August 2006

Abstract

East Asia experienced an unprecedented change in its international trade patterns in the last 10–15 years.To investigate this development, the paper decomposes machinery trade into one-way trade, vertical intra-industry trade (vertical IIT), and horizontal intra-industry trade (horizontal IIT), using finely disaggregatedinternational trade data. Our empirical analysis confirms that the significance of vertical IIT drasticallyincreased, while the relative importance of one-way trade dropped. In addition, our empirical results showno evidence that most vertical IIT conforms to the vertical product differentiation model. Rather, the explosiveincrease in vertical IIT is largely due to the expansion of back-and-forth transactions in vertically fragmentedcross-border production processes. The findings show that vertical international production sharing didbecome an essential part of each economy in East Asia in the 1990s, particularly with the explosive increasein vertical transactions of machinery parts and components.© 2006 Elsevier Inc. All rights reserved.

JEL classification: F14; F19

Keywords: Vertical intra-industry trade; Fragmentation; Vertical international production sharing

1. Introduction

East Asia experienced an unprecedented change in its international trade patterns in the pastdecade or so. Until the 1980s, East Asian trade was clearly dominated by typical North-Southinter-industry trade patterns. East Asian developing countries exported resource-based and labor-intensive products, while Japan exported a wide range of final manufactured goods. The traditionaltheory of comparative advantage works well to explain such trade patterns; differences in resource

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258 M. Ando / North American Journal of Economics and Finance 17 (2006) 257–281

endowments, capital-labor endowment ratios, and technological capabilities among countrieslargely determine the pattern of production location and international trade.

The current trade patterns of East Asia, however, can no longer be fully explained by thetraditional comparative advantage theory. The last 10–15 years witnessed the rapid developmentof cross-border production networking among East Asian countries that have been aggressivelyreceiving foreign direct investment (FDI).1 In particular, trade in machinery parts and componentsdrastically increased in both exports and imports, pushing up the share of machinery products, andcommodity compositions of exports and imports became similar in many East Asian countries.Such a convergence of commodity compositions of exports and imports as well as the enormousincrease in machinery parts and components trade implies that intra-industry trade has becomemuch more important than before in East Asia.

What sort of intra-industry trade do we currently observe in East Asia? The typical modelof intra-industry trade that appears in textbooks is the horizontal intra-industry trade (horizontalIIT) model, which is usually accompanied by horizontal product differentiation and well explainsintra-industry trade among developed countries such as the members of the European Union (EU).Another popular theoretical model of intra-industry trade is the vertical product differentiationmodel in which high-income countries export high-price, high-quality products while low-incomecountries in exchange export low-price, low-quality products. Intra-industry trade in East Asiadoes not seem to be fully explained by these models, however. Rather, intra-industry trade resultingfrom international fragmentation, the importance of which is addressed by Jones, Kierzkowski,and Leonard (2002), seems to be the key to understanding current trade patterns in East Asia.

Using a method applied in empirical studies of intra-industry trade, we examine developmentsin East Asia’s trade structure in the 1990s, particularly by distinguishing among types of intra-industry trade. The paper focuses on machinery trade and decomposes each country’s machinerytrade at the finely disaggregated level into one-way trade, vertical intra-industry trade (verticalIIT), and horizontal intra-industry trade (horizontal IIT). In our empirical framework, trade ofcommodities with a certain range of overlapping values of exports and imports is regarded asintra-industry trade, while the rest is classified as one-way trade, and intra-industry trade of com-modities with a certain range of unit-price differentials between exports and imports is classifiedas horizontal IIT, while the rest is categorized as vertical IIT. Unlike previous empirical studies,however, our study incorporates trade patterns reflecting international fragmentation.

Our major findings can be summarized as follows. First, the significance of vertical IITincreased sharply in East Asia in the 1990s, while the relative importance of one-way tradedeclined. Second, the share of vertical IIT in machinery parts and components rose more rapidlythan that of vertical IIT in machinery goods as a whole. Vertical IIT in machinery parts andcomponents expanded significantly. Third, horizontal IIT is rare in machinery trade. Fourth, thedrastic increase in vertical IIT was largely due to the expansion of back-and-forth transactions invertically fragmented production processes, rather than trade of quality-differentiated commodi-ties. Fifth, even in the transportation equipment sector, in which one-way trade is still the mainpattern, vertical transactions of parts and components across borders rose significantly between2000 and the beginning of the 1990s. All of these findings confirm that vertical internationalproduction sharing in the machinery sector has become an essential part of each economy in EastAsia in the 1990s.

1 See Kimura and Ando (2003a, 2005) and Ando and Kimura (2005) for the analysis of the formation of internationalproduction/distribution networks in East Asia and their mechanics, using micro data of Japanese corporate firms.

M. Ando / North American Journal of Economics and Finance 17 (2006) 257–281 259

The remaining sections are organized as follows: Section 2 provides an overview of the tradestructure of East Asia and emphasizes the major changes in the 1990s. Section 3 briefly presentsa literature survey of empirical studies of one-way trade and vertical and horizontal IIT anddiscusses the theoretical foundations upon which our empirical work is based. Section 4 providesour empirical methodology and data description. The results for each East Asian economy areprovided in Section 5, and the summary and concluding remarks are in Section 6.

2. Emergence of intra-industry trade in East Asia

Table 1 presents intra-regional trade in East Asia in terms of exports in 1981, 1991, and 2001.2

Between 1981 and 2001, intra-regional trade in East Asia expanded by 6.7 times, while worldtrade increased 3.1 times during the same period. Intra-regional trade reached almost half of totalEast Asian trade in 2001. Countries throughout the region and at various stages of developmentwere drawn into the trading system, rather than concentrating on trade relationships with specificcountries in the region, as Table 1 (the share in East Asia) indicates.

The commodity composition of trade also changed during that period. Fig. 1 provides thecommodity composition of exports and imports of each country in the period 1989–2002 at thetwo-digit level of the Harmonized System (HS) classification.3,4 Importantly, the commoditycomposition of exports and imports converged in many East Asian countries. If trade patternscan be fully explained by traditional comparative advantage applied to inter-industry trade, thenthe commodity composition of exports and imports should be very different. The fact that thecomposition is converging is an indicator of the importance of intra-industry trade.

Drastic changes have occurred, in machinery industries, including general machinery (HS84),electric machinery (HS85), transport equipment (HS86-89), and precision machinery (HS90-92).The share of machinery trade rose significantly in the 1990s (Fig. 2).5 In addition, both exportsand imports of machinery parts and components increased more rapidly, suggesting a patternthat would be typical of back-and-forth transactions in vertical production networks within theregion.6,7 Convergence of the commodity composition of exports and imports, as well as increases

2 “East Asia” includes China, Association of Southeast Asian Nations 4 (ASEAN4: Indonesia, the Philippines, Thailand,and Malaysia), and Newly Industrializing Economies 4 (NIEs4: Taiwan, Korea, Hong Kong, and Singapore), and Japan,except in some cases that are mentioned.

3 Due to the lack of data at the HS six-digit level, data are shown from 1992 for China, from 1993 for Hong Kong, andfrom 1996 for the Philippines. Although the Philippines is omitted in Fig. 1 due to limited space and coverage, it alsoclearly presents converging commodity compositions of exports and imports as other East Asian countries do. See Ando(2004) for the case of the Philippines.

4 Ideally, for Singapore and Hong Kong, one should look at data on domestic exports (total exports minus re-exports),but data may not be available.

5 The Philippines and Taiwan are omitted in Fig. 2 due to limited space. Both economies, particularly the Philippines,have outstandingly high shares of machinery trade and rapidly increasing parts and components trade as Fig. 4 indicates.Note that numbers for Taiwan are based on the SITC classification (SITC 7) available from World Trade Analyzer. See,again, Ando (2004) for the Philippines and Taiwan.

6 See Ando and Kimura (2005, Table A.1) for the definition of machinery parts and components used in this paper,based on HS classification. This is more finely defined than the one used in Francis and Yeats (2003), based on the SITCclassification.

7 Close to 60% of machinery parts and components exports in East Asia was intra-regional in 2003, while the corre-sponding portion was 40% in 1990, and the intra-regional export value of machinery parts and components was 5.5 timesof that in 1990 on a current price basis. See Ando and Kimura (2006) for details on intra-regional and inter-regional tradepatterns in East Asia.


Table 1Intra-regional exports in East Asia (100 million US$, %)

1981 1991 2001

Country/region Value Share Value Share Value Share

Destination Total(world)

EastAsia

Total(world)

EastAsia

Total(world)

EastAsia

East AsiaEast Asia (region) 1045 34.6 – 3331 42.0 – 7028 46.9 –World 3019 100.0 – 7928 100.0 – 14972 100.0 –

ChinaJapan 47 28.5 41.2 103 14.3 20.9 450 16.9 36.1NIEs4 60 36.3 52.6 369 51.4 74.8 698 26.2 55.9- Hong Kong from China 53 32.1 46.5 321 44.7 65.1 465 17.5 37.3- NIEs3 from China 7 4.2 6.1 48 6.7 9.7 233 8.8 18.7ASEAN4 7 4.2 6.1 21 2.9 4.3 100 3.8 8.0East Asia (total) 114 69.0 100.0 493 68.6 100.0 1248 46.9 100.0World 165 100.0 – 718 100.0 – 2661 100.0 –

ASEAN4Japan 162 34.6 59.6 231 22.9 43.7 403 16.7 31.5China 4 0.9 1.5 23 2.3 4.3 110 4.6 8.6NIEs4 89 19.0 32.7 234 23.2 44.2 588 24.3 45.9ASEAN4 (region) 17 3.6 6.3 41 4.1 7.8 180 7.5 14.1East Asia (total) 272 58.2 100.0 529 52.5 100.0 1281 53.0 100.0World 468 100.0 – 1008 100.0 – 2416 100.0 –

NIEs4Japan 91 10.5 31.6 320 10.5 24.6 499 8.5 17.0China 22 2.5 7.6 286 9.4 22.0 984 16.8 33.5- China from Hong Kong 20 2.3 6.9 267 8.7 20.5 701 12.0 23.8- China from NIEs3 2 0.2 0.7 19 0.6 1.5 283 4.8 9.6NIEs4 (region) 83 9.6 28.8 417 13.6 32.1 871 14.9 29.6ASEAN4 92 10.6 31.9 277 9.1 21.3 586 10.0 19.9East Asia (total) 288 33.3 100.0 1300 42.5 100.0 2940 50.2 100.0World 866 100.0 – 3057 100.0 – 5861 100.0 –

JapanChina 51 3.4 13.7 86 2.7 8.5 309 7.7 19.8NIEs4 213 14.0 57.4 669 21.3 66.3 875 21.7 56.1ASEAN4 107 7.0 28.8 254 8.1 25.2 375 9.3 24.1East Asia (total) 371 24.4 100.0 1009 32.1 100.0 1559 38.6 100.0World 1520 100.0 – 3145 100.0 – 4034 100.0 –

Source: Author’s calculation, based on METI (2004), UN Comtrade online, and Council for International EconomicCooperation and Development (2004).

in machinery parts and components trade, underscore the growing importance of intra-industrytrade in East Asia.

To highlight key features of East Asia’s trade, let us examine the shares of machinery goods andmachinery parts and components in total exports and imports at the beginning of the 1990s andin 2003, in comparison with countries in other regions (Figs. 3 and 4). The figures array countriesin terms of the export share of machinery parts and components. The last decade witnessed arapid expansion of machinery trade, particularly machinery parts and components trade in many


Fig. 1. Changes in the commodity composition of trade in East Asia in the 1990s: (a) China, (b) Indonesia, (c) Thailand,(d) Malaysia, (e) Korea, (f) Hong Kong, (g) Singapore, (h) Japan. Source: Author’s calculation, based on UN Comtrade.Notes: “X” expresses exports and “M” imports. Sectoral composition based on the HS classification is as follows—HS1-24: food; HS25-27: mineral products; HS28- 38: chemical products; HS39-40: plastics and rubber; HS41-43: hides andskins; HS44-46: wood and wood products; HS47-49: wood pulp products; HS50-63: textiles and textile articles; HS64-67:footwear; HS68-70: articles of stone, plaster, and cement; HS71: pearls and precious stones; HS72-83: base metals; HS84:general machinery; HS85: electric machinery; HS86-87: vehicles and railway; HS88-89: aircraft and ships; HS90-92:precision machinery, others: others, and not classified elsewhere.


Fig. 1. (Continued ).


countries in the world, suggesting that trade at the intra-product level, rather than at the finalgood or industry level, became more active. Importantly, the share of machinery goods in EastAsian countries increased not only in absolute terms but also in relative terms. At the beginning ofthe 1990s, most countries with higher shares of machinery parts and components were developedcountries such as Japan, the United States, the United Kingdom, and Germany. By 2003, however,

Fig. 2. Trade in machinery goods and machinery parts and components as a share of total exports and imports in East Asiain the 1990s: (a) China, (b) Indonesia, (c) Thailand, (d) Malaysia, (e) Korea, (f) Hong Kong, (g) Singapore, (h) Japan.Source: Author’s calculation, based on UN Comtrade. Note: Machinery goods are HS84-92.


Fig. 2. (Continued ).

Fig. 3. Machinery goods and machinery parts and components: shares in total exports and imports in 1990–1994. Source:Author’s calculation, based on UN Comtrade. Note: Japan90 and U.S.A.91, for instance, imply 1990 for Japan and 1991for U.S.A.


Fig. 4. Machinery goods and machinery parts and components: shares in total exports and imports in 2003. Source: Andoand Kimura (2006).

the East Asian developing countries had moved to the left, with high export and import shares ofmachinery parts and components, implying growing export-oriented operations. Although Chinaand Indonesia are still relatively on the right side, they are rapidly moving towards the left.While Japan has maintained a share of about 80% of its total exports in machinery goods, thecomposition of its machinery exports changed from final goods at the beginning of the 1990s toparts and components in 2003. Moreover, its share of imports in machinery parts and componentsincreased. Trade patterns between the North and South, or developed and developing countries,seem to have changed considerably, particularly in East Asia.

In other regions, some developing countries also rapidly moved to the left and higher sharesof machinery trade and of machinery parts and components trade, including Mexico in LatinAmerica and Hungary, the Czech Republic, Slovakia, and Poland in Central and Eastern Europe(CEE). Combined with relatively high shares of parts and components trade by neighboringdeveloped countries such as the U.S. and Germany/U.K., it suggests the existence of productionnetworks in machinery industries between the U.S. and Mexico and between Germany/U.K. andCEE countries. These networks, however, are less widespread in those regions than in East Asia.8

Moreover, other developing countries, particularly those in Latin America except Mexico, are

8 In the case of these four CEE countries, for instance, exports to and imports from other CEE countries remain small,which is different from East Asia’s active transactions among intra-regional countries: shares of intra-CEE trade in total


found on the right-hand side, with only a few percent of machinery exports, almost zero percentof parts and components exports, and relatively high shares of parts and components imports.This implies import-substituting structures in these countries.

3. Conceptual framework and empirical estimation

Before discussing our empirical approach, this section reviews key empirical methodologiesused in studies of intra-industry trade and summarizes relevant conceptual frameworks.

3.1. Empirical methodologies used in studies on vertical and horizontal IIT

The empirical literature on intra-industry trade has made extensive use of the Grubel–Lloyd(G–L) intra-industry trade index, adjusted in various ways to mitigate its shortcomings.9 Decom-position of intra-industry trade into its various types was not undertaken until recently, due to thedifficulties in distinguishing vertical IIT from horizontal IIT in the data.

Abd-el-Rahman (1991) uses unit-price differentials between exported and imported goods asa criterion for distinguishing vertical IIT from horizontal IIT. We call this criterion the “thresholdmethod”. Unit-price differentials within a certain range are taken to reflect horizontal productdifferentiation, while price differentials outside the range reflect differences in quality in thecontext of vertical product differentiation.10 The threshold method has received more attentionin empirical studies after the work of Greenaway, Hine, and Milner (1994, 1995), who adapt itto the G–L index in measuring the intensity of vertical IIT and horizontal IIT in the U.K. We callthis “the G–L type threshold method”. Most recent work based on the threshold method followsthis G–L type of threshold method.11

An alternative approach, which is proposed by Fontagne and Freudenberg (1997) and Fontagne,Freudenberg, and Peridy (1997), following Abd-el-Rahman (1991), breaks down total trade intothree categories, namely, one-way trade, vertical IIT, and horizontal IIT, in order to measure therelative importance of each type of trade in total trade. In this approach, one-way trade is distin-guished from intra-industry trade by using a certain range of overlapping values of exports andimports for a given commodity category, while vertical and horizontal IIT are identified by usingsome range of unit-price differentials between exported and imported goods for a given commod-ity category.12 We call this “the decomposition-type threshold method.” Compared to the G–Ltype threshold method, the decomposition-type threshold method has received less attention.13

exports and imports of both machinery intermediate goods and final goods are only 6–7% in 2003, while shares of tradewith Western Europe (WE) are 64% for exports and 50% for imports of machinery parts and components. It indicates thatproduction sharing in Europe is based on the relatively simple WE-CEE nexus, rather than involving active transactionsamong CEE countries. See Ando and Kimura (in press) for discussion of production networking in Europe.

9 See Grubel and Lloyd (1975) for G–L intra-industry index.10 His study uses the terms “intra-range trade” for vertical IIT of quality-differentiated commodities and “two-way trade

in similar products” for horizontal IIT.11 Examples of empirical studies using the G–L type threshold method include Aturupane, Djankov, and Hoekman

(1999) for trade between the EU and Central and Eastern European economies, Hu and Ma (1999) for Chinese trade withits 45 major trading partners, Durkin and Krygier (2000) for U.S. trade with OECD countries, and Martin-Montaner andRios (2002) for Spanish trade with several OECD countries.12 See the next section for details.13 Relevant studies include Fontagne and Freudenberg (1997) and Fontagne et al. (1997) for trade in Europe, Fukao,

Ishido, and Ito (2003) for trade in Europe (intra-EU trade) and in East Asia (intra-East Asian trade), and Kimura and Ando(2003a, 2003b, 2005) for trade among Japan, Korea, and China.


3.2. Theoretical foundations for each pattern of trade

As will be discussed in the next section, our study adapts the decomposition-type thresholdmethod by reinterpreting the conceptual framework. Table 2 provides a summary of the theoreticalfoundations for each type of trade in our empirical analysis.

3.2.1. Traditional comparative advantage and one-way tradeTraditional trade theories explain inter-industry trade patterns based on comparative advan-

tage in relative factor endowments or technology. In a standard setting of the Heckscher–Ohlinmodel or the Ricardian model with constant-returns-to-scale technology and perfect compe-tition, a country exports capital (physical/human)-intensive or high-tech products when it iscapital (physical/human)-abundant or technology-superior, and labor-intensive or low-tech prod-ucts when it is labor-abundant or technology-inferior. Such inter-industry trade is classified aspart of one-way trade in our empirical framework.

3.2.2. Horizontal production differentiation and horizontal IITThe most convenient and popular theoretical basis of product differentiation is horizontal

product differentiation. Horizontal product differentiation models have been analyzed undermonopolistic competition derived from the existence of economies of scale in the differenti-ated product industry.14 In these models, products are different because of certain attributes, butthey are fundamentally the same in terms of quality, cost, and technology employed in their pro-duction. Horizontal IIT in our empirical analysis is basically interpreted as intra-industry tradewith horizontal product differentiation.

3.2.3. Vertical production differentiation and vertical IITIn Falvey (1981) and Falvey and Kierzkowski (1987), intra-industry trade with vertical product

differentiation takes place under perfect competition.15 Falvey and Kierzkowski (1987) assumethat the differentiated product sector is of the Heckscher–Ohlin type with constant-returns-to-scale technology identical across countries, but Ricardian in terms of technology, with fixed anddifferent factor intensities at the variety level; higher (lower) quality variety is produced witha higher (lower) capital-labor-ratio technology and has a higher (lower) price. Each individualdemands only one type of differentiated product according to the individual’s income, resulting inan aggregate demand for a variety of quality-differentiated goods. Vertical IIT occurs when twocountries with differences in income distribution have different factor endowments, or differenttechnologies in the homogeneous product sector.

Flam and Helpman (1987) propose a model of North-South trade with vertical product dif-ferentiation, in which the North uses high technology to export high-quality products and theSouth uses low technology to export low-quality products. There exist differences between thetwo countries in technology to produce differentiated goods or in labor input per unit of output of

14 See, for instance, Lancaster (1980) and Helpman (1981) for the “ideal variety” approach that assumes a diversityof “ideal package” of characteristics among consumers, resulting in demand for variety at the aggregate level. See, forexample, Dixit and Stiglitz (1977) and Krugman (1979, 1980, 1981) for the “love of variety” approach that assumesa representative consumer demanding many varieties of the differentiated good or an individual’s demand for variety.Horizontal IIT extends the variety of goods available beyond those supplied by domestic producers. Helpman and Krugman(1985) observe that these two approaches lead to similar results, regardless of specifications on the demand side.15 Other articles of vertical production differentiation include Shaked and Sutton (1984).


Table 2Trade patterns: theory and empirical perspectives


the differentiated goods, and the North (South) has comparative advantage in high-quality (low-quality) products. On the demand side, similar to Falvey and Kierzkowski (1987), each individualdemands a quality level of differentiated product consistent with the individual’s income. As aresult, differences in technology and income distribution (with an overlap in income distribution)explain vertical IIT.

The results of these models can be interpreted as a sort of “quality ladder” story; high-incomecountries export high-price, high-quality products, while low-income countries export low-price,low-quality products. Vertical IIT in our empirical analysis includes intra-industry trade of verti-cally differentiated products with differences in quality.

3.2.4. International fragmentation and one-way trade and vertical IITJones et al. (2002) argue that international fragmentation in vertical production chains, i.e.,

the splitting of an initial vertically integrated production process into two or more productionblocks and locating them beyond national borders, also results in intra-industry trade (and inter-industry trade). A general framework for analyzing fragmentation was first introduced by Jonesand Kierzkowski (1990).16 The physical dispersion of production processes requires costly servicelinks to connect production blocks, including transportation, telecommunication, and variouscoordination tasks, which are often subject to economies of scale. In the case of internationalfragmentation, in particular, trade and regulatory barriers impose additional service link costs.Recent developments in the world trading system, as well as technological advances, have loweredservice link costs and created new opportunities for extending production fragmentation acrossnational frontiers.

Unlike previous studies, our empirical framework based on the threshold method incorpo-rates the possibility of trade patterns reflecting international fragmentation. In this context,unit price differentials outside a certain range can be interpreted as the reflection not only ofdifferences in quality, but also of back-and-forth transactions with value-added embodied in ver-tically fragmented production processes. Thus, the trade pattern categorized as vertical IIT in ourdecomposition-type threshold method could reflect international fragmentation within the samecommodity category.17 Note that exchanges of products in vertically fragmented production pro-cesses are not necessarily conducted in the same commodity category. The simplest exampleis an exchange of intermediate goods and final goods belonging to different commodity cate-gories in the same industry. Another relevant example is back-and-forth transactions in verticallyfragmented production processes, with changes in commodity categories of imports and exportsthrough some production processes. These sorts of intra-industry trade would be classified asone-way trade in our empirical analysis.

4. Methodology and data description

This section presents the empirical methodology used to examine the relative importance ofeach type of trade, namely, one-way trade, vertical IIT, and horizontal IIT. Our study employs

16 See also Jones and Kierzkowski (2001), Arndt and Kierzkowski (2001), Deardorff (2001a, 2001b), and Cheng andKierzkowski (2001) for the fragmentation theory.17 Horizontal IIT through international fragmentation would also occur, for instance, if imported parts and components

are exported with small unit-price differentials embodied in the local market. Such patterns, however, do not seem to bevery important currently in East Asia.


the decomposition-type threshold method, rather than the G–L type, with reinterpretation of theconceptual framework.

4.1. Methodology

Three steps are required to obtain the share of each type of trade for the sector concerned. Thefirst step is to identify whether trade of commodity j is one-way trade or intra-industry in natureby using a certain range of overlapping values of exports and imports. Trade of commodity j isregarded as one-way trade when the following Eq. (1) holds and as intra-industry trade otherwise:

Min(Xkj, Mkj)

Max(Xkj, Mkj)≤ 0.1 (1)

where Xkj represents country k’s exports of commodity j to the world, and Mkj country k’s importsof commodity j from the world. While a large portion of one-way trade would be inter-industrytrade that can be explained by traditional comparative advantage considerations, one-way tradewould also include trade with changes in commodity categories in the process of transactions invertically fragmented production chains.

The second step is to identify whether intra-industry trade of commodity j is horizontal IITor vertical IIT by using a certain range of relative unit prices of exported and imported goods.Intra-industry trade of commodity j is regarded as horizontal IIT when the following Eq. (2) holdsand as vertical IIT otherwise:

1

1.25≤ PX

kj

PMkj

≤ 1.25, (2)

where PXkj expresses the unit value of commodity j exported to the world by country k, and PM

kj

the unit value of commodity j imported from the world by country k.18 The threshold percentageto distinguish between horizontal IIT and vertical IIT is usually 15% or 25%. Although the 15%threshold is more often used, this paper employs a definition of narrower range of vertical IIT,namely, the 25% threshold, to more precisely analyze the development of vertical IIT.

Intra-industry trade of commodities with a small range of price differentials is regarded astrade of similar goods or horizontal IIT in the context of horizontal product differentiation. Onthe other hand, trade of commodities with unit-price gaps outside that range is regarded as ver-tical IIT. Previous empirical studies typically argue that differences in quality are reflected insuch price gaps, as the vertical product differentiation model predicts. We, however, incorporatethe possibility of trade patterns reflecting international fragmentation as briefly explained in theprevious section, so that unit-price differentials outside a certain range may reflect not only dif-ferences in quality, but also back-and-forth transactions with value-added embodied in vertically

18 Most empirical studies using price differentials to distinguish vertical IIT from horizontal IIT define the criteria asfollows: 1 − α ≤ PX

kj/PM

kj≤ 1 + α, where α = 0.15 or 0.25. As Fontagne and Freudenberg (1997) point out, however,

the left-hand side of this condition is incompatible with the right-hand side. For instance, the threshold of 25% meansthat export unit values can be 1.25 times higher than import unit values. The lower boundary, 0.75 in this case, meansthat export unit values can be 75% of the import unit values. That is, export unit values can be 1.33 (1/0.75) times ofimport unit values, which is incompatible with the right side of the condition. To avoid this problem, we use the criteria1/1 + α ≤ PX

kj/PM

kj≤ 1 + α, where α = 0.25.


fragmented production processes. Therefore, the trade pattern categorized as vertical IIT couldpartially reflect international fragmentation in the same commodity category.

If most vertical IIT in lower-income countries is systematically of commodities with exportprices lower than import prices and most vertical IIT in higher-income countries is of commoditieswith export prices higher than import prices, then the hypothesis of “quality ladder” may hold.If that is not the case, on the other hand, then vertical IIT may include not only trade of quality-differentiated commodities, but also back-and-forth transactions with value-added embodied invertically fragmented production processes in the same commodity category.

Finally, the share of the n-type trade pattern, i.e., the threshold-based index (Sn(i)), for the

aggregated commodity category i is calculated as follows:

Sn(i) =

∑j(Xn

kj + Mnkj)

∑j(Xkj + Mkj)

[n = (a), (b), and (c)], (3)

where the n-type of trade patterns are (a) one-way trade, (b) horizontal IIT, and (c) vertical IIT.Note that some commodities unfortunately have discordant units between exports and imports,

and some have no information on quantities. Since relative unit prices are used in distinguishingamong types of intra-industry trade, it is not possible to determine whether intra-industry tradeof such commodities is vertical IIT or horizontal IIT. Unlike previous studies, however, suchcommodities are retained in our data set as “not classified IIT” and are included in calculating theindex. Without this treatment, the relative significance of one-way trade would be overvalued forcountries with relatively large amounts of “not classified IIT”.

The threshold-based index of each East Asian economy is calculated for trade of eachmachinery sector, i.e., general machinery, electric machinery, transport equipment, and preci-sion machinery, as well as for machinery trade as a whole. To shed light on the developmentof back-and-forth transactions in vertically fragmented production chains, we also calculate theindex for trade in machinery parts and components.

4.2. Data description

Values and quantities of exports and imports at the HS six-digit level are obtained from theUnited Nations (UN) Comtrade and the UN Personal Computer Trade Analysis System (PC-TAS),published by the UN Statistical Division.19 Unit values of exports and imports at the HS six-digitlevel are calculated by dividing values by the corresponding quantities.

Most previous studies use differences in f.o.b. and c.i.f. values as a part of price differentialsbetween exports and imports. To consider price differentials purely as ones due to differencesin quality or ones caused in the process of back-and-forth transactions in vertically fragmentedproduction chains across borders, however, we conduct the f.o.b.–c.i.f. adjustment in calculatingunit-price differentials as well as in using trade values in the first and third steps described above;export values on an f.o.b. basis are multiplied by 1.05, a proxy, to adjust import values on a c.i.f.basis.

Countries in the sample include China, ASEAN4 (Indonesia; the Philippines, Thailand,and Malaysia), NIEs3 (Korea, Hong Kong, and Singapore), and Japan. Data for 3 years,

19 Data for 1996 and 2000 are obtained from the UN PC-TAS. Note that commodities covered by the PC-TAS are thosewith trade values of no less than US$ 50,000.


Fig. 5. Vertical IIT in machinery goods and machinery parts and components in East Asia. Source: Author’s calculation,based on Table 3. Note: The Philippines is not included for 1990. Data for 1990 for China and Hong Kong are for 1992and 1993, respectively.

1990, 1996, and 2000, are used to examine the development of East Asian trade in the1990s.20

5. The development of East Asia’s trade structure

We first present the development of machinery trade patterns in East Asia as a whole, includingChina, ASEAN4, NIEs3, and Japan. As Fig. 5 clearly shows, vertical IIT, particularly vertical IITin machinery parts and components, grew in the 1990s. There is also a stable amount of one-waymachinery trade.

Table 3 presents threshold-based indices of each East Asian economy for machinery trade inthe 1990s: (a) indices for overall trade in machinery (including parts and components); (b) indicesfor trade in machinery parts and components; and (c) shares of machinery parts and componentsin total machinery trade by type of trade. In Table 3, countries are listed from those with the lowestper capita GDP at the top to those with the highest per capita GDP at the bottom.

Our main findings may be summarized as follows. First, the importance of vertical IIT rosesharply, while that of one-way trade declined for overall machinery trade. The share of one-way trade at the beginning of the 1990s was around 40–50%, except for Indonesia with a veryhigh share and Hong Kong and Singapore with considerably lower shares. They decreased by

20 Due to the lack of data available from UN Comtrade/PC-TAS, we calculate indices for China in 1992, 1996, and 2000,those of Hong Kong in 1993, 1996, and those of the Philippines in 1996 and 2000. Moreover, Taiwan is not included inEast Asia due to the lack of data available from these UN databases.

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Table 3Development of machinery trade in East Asia in the 1990s (100 million US$, %)

(a) Machinery goods(total)

(b) Machinery partsand components

(c) Share of parts andcomponents

1990 1996 2000 1990 1996 2000 1990 1996 2000

China(i) Total value (millions US$) 50381 101442 194948 20303 42483 103421 40 42 53(ii) Trade pattern (%)One-way 52 43 27 26 12 9 20 12 17

- One-way: exports > imports 14 16 16 2 3 3 7 9 9Intra-industry trade 48 57 73 74 88 91 62 65 66

Horizontal IIT 3 11 8 4 20 8 47 78 55Vertical IIT 20 44 64 18 65 81 36 62 68- Vertical IIT: export prices > import prices 5 8 6 9 9 10 70 47 86Not classified IIT 25 2 1 53 3 2 84 53 69

Indonesia(i) Total value (millions US$) 10224 23379 21436 3988 11588 11239 39 50 52(ii) Trade pattern (%)One-way 93 73 66 89 66 58 37 45 46


Horizontal IIT 2 5 4 4 7 6 89 73 67Vertical IIT 5 22 30 7 26 36 53 61 64- Vertical IIT: export prices > import prices 3 11 18 2 13 20 32 56 57Not classified IIT 0 0 0 0 0 0 – – –

Philippines(i) Total value (millions US$) 30373 48651 21991 38827 72 80(ii) Trade pattern (%)One-way 59 51 55 44 68 69

- One-way: exports > imports 20 43 24 39 86 73Intra-industry trade 41 49 45 56 79 91

Horizontal IIT 21 11 28 14 97 99Vertical IIT 20 37 16 42 60 89- Vertical IIT: export prices > import prices 14 18 9 20 48 88Not classified IIT 0 0 1 0 91 93

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Table 3 (Continued) (100 million US$, %)




1990 1996 2000 1990 1996 2000 1990 1996 2000

Thailand(i) Total value (millions US$) 20177 59195 61535 11940 34557 41576 59 58 68(ii) Trade pattern (%)One-way 57 40 21 45 27 8 47 39 26



Malaysia(i) Total value (millions US$) 27110 95839 120228 16358 60730 85864 60 63 71(ii) Trade pattern (%)One-way 32 32 18 18 17 2 35 33 10


Horizontal IIT 6 3 3 2 3 2 21 55 60Vertical IIT 42 63 69 48 78 80 69 79 84- Vertical IIT: export prices>import prices 22 26 21 29 30 26 79 74 86Not classified IIT 20 1 11 31 2 15 94 90 99

Korea(i) Total value (millions US$) 57728 135539 174540 24029 63949 94998 42 47 54(ii) Trade pattern (%)One-way 42 32 27 18 16 5 18 23 10



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1990 1996 2000 1990 1996 2000 1990 1996 2000

Hong Kong(i) Total value (millions US$) 109459 157685 195018 47029 77775 116357 43 49 60(ii) Trade pattern (%)One-way 2 2 2 1 0 1 21 3 56



Singapore(i) Total value (millions US$) 58940 173601 191859 29117 98757 127972 49 57 67(ii) Trade pattern (%)One-way 4 2 1 3 0 0 42 9 10



Japan(i) Total value (millions US$) 271640 399121 462924 97483 192434 240058 36 48 52(ii) Trade pattern (%)One-way 46 33 26 39 30 21 31 45 42



Source: Author’s calculation, based on UN Comtrade and UN PC-TAS. Note: Data of 1990 for China and Hong Kong are of 1992 and 1993, respectively.


half in 2000 in most East Asian countries. This increase in intra-industry trade was due mainlyto the sharp increase in vertical IIT, except for Korea and Singapore; shares of vertical IIT in1990 and 2000 were 20% and 64%, respectively, for China, 5% and 30% for Indonesia, 36%and 73% for Thailand, 42% and 69% for Malaysia, 51% and 34% for Korea, 35% and 43%for Hong Kong, 38% and 35% for Singapore, and 41% and 64% for Japan. Combined with anexplosive increase in the value of vertical IIT, these figures clearly indicate how rapidly vertical IITbecame an essential element of machinery trade among East Asia countries, and in East Asia as awhole.

Second, the share of vertical IIT in machinery parts and components increased more rapidlythan that of vertical IIT in machinery products as a whole in many East Asian countries; the shareof vertical IIT in machinery parts and components went up from 18% in 1990 to 81% in 2000for China; from 7% to 37% for Indonesia; from 16% to 42% for the Philippines; from 47% to86% for Thailand; from 48% to 80% for Malaysia; and from 38% to 69% for Japan. In addition,machinery parts and components trade increased more rapidly than machinery trade as a whole:machinery trade and machinery parts and components trade grew by 3.9 times and 5.1 timesfrom 1990 to 2000 for China, 2.1 times and 2.8 times for Indonesia, 3.1 times and 3.5 times forThailand, 4.4 times and 5.2 times for Malaysia, 1.8 times and 2.5 times for Hong Kong, 3.3 timesand 4.4 times for Singapore, and 1.7 times and 2.5 times for Japan, respectively.21 Given thefact that a large portion of trade in machinery intermediate goods is intra-regional, these numberssuggest how active vertical back-and-forth transactions of machinery parts and components acrossborders became and how rapidly cross-border production networking in East Asia was formed inthe 1990s.

Third, horizontal IIT in machinery parts and components is not very important in East Asia.Although the Philippines and Korea present relatively high shares of horizontal IIT, comparedwith other East Asian countries, machinery parts and components trade accounts for 99% of thetotal horizontal IIT in the machinery sector for the Philippines and 87% for Korea. This confirmsthat the important pattern of intra-industry trade in East Asia is vertical IIT, not horizontal IIT astypically observed among incumbent EU members.22

Fourth, the sharp increase in vertical IIT was largely due to the expansion of back-and-forthtransactions in vertically fragmented production processes, in addition to intra-industry trade ofquality-differentiated commodities. Our results provide no evidence that vertical IIT in lower-income countries is systematically of commodities with export prices lower than import pricesand vertical IIT in higher-income countries is of commodities with export prices higher thanimport prices: 9% of vertical IIT is trade of commodities with export prices higher than importprices in China, 61% in Indonesia, 49% in the Philippines, 36% in Thailand, 31% in Malaysia, 8%in Korea, 53% in Hong Kong, 70% in Singapore, and 40% in Japan (Table 4).23 In other words,vertical IIT cannot be fully explained by the hypothesis of the “quality ladder;” rather vertical IITreflects not only intra-industry trade of quality-differentiated commodities, but also back-and-forthtransactions in vertically fragmented production chains in the same commodity category.

21 Trade values here are the sum of imports and adjusted exports, and growth rates are on a current-price basis.22 For instance, Fontagne and Freudenberg (1997) and Fontagne et al. (1997), who use a definition of narrower range of

horizontal IIT (15% threshold), show that close to 20% of intra-EU trade is horizontal IIT from the middle of the 1980sto the middle of the 1990s. Fukao et al. (2003), who use a broader definition of horizontal IIT, find that around 26–29%of intra-EU trade is horizontal IIT during the latter half of the 1990s.23 Since Hong Kong and Singapore have large shares of unclassified IIT, they are omitted in Table 4.


Table 4Vertical IIT in East Asian machinery trade in the 1990s

Index: vertical IIT Share of vertical IIT with exportprices higher than import prices in

total vertical IIT

Total (including partsand components)

Parts andcomponents

Total (including partsand components) (%)

Parts andcomponents (%)

1990 2000 1990 2000 2000 2000

The machinery sector as a wholeChina 20 64 18 81 9 12Indonesia 5 30 7 36 61 55Philippines 37 42 49 48Thailand 36 73 47 86 36 35Malaysia 42 69 48 80 31 32Korea 51 34 77 34 8 6Japan 41 64 38 68 40 43

The electric machinery sectorChina 23 65 25 80 13 14Indonesia 12 35 14 39 78 78Philippines 49 47 44 45Thailand 54 80 53 87 54 52Malaysia 54 68 59 75 45 46Korea 58 32 81 31 8 6Japan 20 74 26 73 47 37

Sources: Author’s calculation, based on UN Comtrade and UN PC-TAS.

In the case of Korea and Japan, two countries with relatively high incomes, the share ofvertical IIT with export prices higher than import prices is low at 8% (indices for vertical IITwith higher export prices and whole vertical IIT are 3% and 34%, respectively) for Korea andsomewhat higher at 40% (25% and 64%) for Japan. At the same time, most of their one-way tradeis export-based one-way trade: 77% (indices for export-based one-way trade and whole one-waytrade are 21% and 27%) for Korea and 98% (26% and 26%) for Japan. These numbers suggestthe presence of exports of capital goods or of specific and complicated parts and componentsin certain commodity categories, and of imports of products with some production conducted inother East Asian countries, using upstream parts exported from them.

The opposite is true for Indonesia with relatively low income: the portion of vertical IITwith export prices higher than import prices is 61% (indices for vertical IIT with higher exportprices and whole vertical IIT are 18% and 30%), and 27% of Indonesia’s total machinery trade isimport-based one-way trade. This implies that Indonesia imports capital goods or some specificand complicated parts and components in certain commodity categories, and at the same timeexports products with some production conducted at the local level, using imported up-streamparts in the same commodity categories at the HS six-digit level.

Fifth, in the transport equipment sector, in which one-way trade is still the main pattern oftrade, vertical IIT became important for parts and components trade.24 The electric machinerysector accounts for around half of the machinery trade of each country and has a large portion of

24 Although the indices for machinery trade of each sector (general machinery, electric machinery, transport equipment,and precision machinery) are calculated by country, the detailed results are omitted in this paper. See Ando (2004) for thedetailed results.


Table 5Trade patterns in the transport equipment sector

Index: one-way trade Index: vertical IIT

Total (including partsand components)

Parts andcomponents

1990 2000 1990 2000

China 55 60 3 77Indonesia 90 65 9 32Philippines 63 68Thailand 93 45 3 72Malaysia 27 48 2 79Korea 56 84 70 81Japan 50 44 15 24

Source: Author’s calculation, based on UN Comtrade and UN PC-TAS.

vertical IIT (Table 4). In the transport equipment sector, on the other hand, one-way trade is stillmore important than vertical IIT. We, however, observe that for parts and components trade in thetransport equipment sector, there was a drastic shift from one-way trade to vertical IIT. The sharesof vertical IIT in parts and components are 3% in 1990 and 76% in 2000 for China, 9% and 32%for Indonesia, 3% and 72% for Thailand, 2% and 79% for Malaysia, 70% and 81% for Korea,and 15%, and 24% for Japan. These indicate that vigorous transactions in parts and componentsacross borders are observed in 2000 in contrast to cases at the beginning of the 1990s even in thetransport equipment sector, though one-way trade is still the main pattern of trade in the wholesector, reflecting import-substituting policies in many developing countries (Table 5).

6. Conclusion

This paper has explored developments in trade structure and vertical international productionsharing in East Asia in the 1990s. During the last 10–15 years, trade in machinery parts andcomponents increased sharply in both exports and imports, pushing up the share of machineryproducts, including general machinery, electric machinery, transport equipment, and precisionmachinery. As a result, the commodity composition of exports and imports converged in manyEast Asian countries. As suggested by convergence of commodity composition of exports andimports as well as the strong increase in machinery parts and components trade, intra-industrytrade has become much more important in East Asia.

Given the significance of machinery trade, the paper decomposed each country’s machinerytrade at the HS six-digit level for 1990, 1996, and 2000 into one-way trade, vertical IIT, andhorizontal IIT, employing the decomposition-type threshold method, in which we incorporatedtrade patterns reflecting international fragmentation in the conceptual framework. Our empiricalanalysis at the finely disaggregated level confirms that vertical international production sharingdid become an essential part of each East Asian economy in the 1990s, particularly with theexplosive increase in vertical IIT in machinery parts and components. The significance of verticalIIT increased, while the relative importance of one-way trade dropped in East Asia over the lastdecade. Although theoretical models of intra-industry trade often analyze horizontal IIT, and acertain amount of such horizontal IIT is indeed observed, for instance, in intra-EU trade, horizontalIIT is rarely found in East Asia in machinery trade. We emphasize the significance of verticalIIT, particularly vertical IIT in machinery intermediate goods in East Asia. Even in the transport


equipment sector, in which one-way trade is still the main pattern of trade as a whole, verticaltransactions of parts and components across borders are observed in 2000, while they were seldomfound at the beginning of the 1990s.

The increase in vertical IIT was largely due to the expansion of back-and-forth transac-tions with value-added embodied in vertically fragmented production processes, rather thanintra-industry trade of quality-differentiated commodities. If most vertical IIT in lower-incomecountries is systematically of commodities with export prices lower than import prices andmost vertical IIT in higher-income countries is of commodities with export prices higher thanimport prices, the hypothesis of “quality ladder” may hold. Our empirical observation, how-ever, confirms that for vertical IIT, some higher-income countries import more expensive prod-ucts than they export and some lower-income countries export more expensive products thanthey import. We conclude that vertical international production sharing developed in East Asiaand with it the expansion of back-and-forth transactions in vertically fragmented productionprocesses.

These changes in the patterns of production location and international trade occurred withthe help of the region’s aggressive promotion of FDI. In the process of the evolution of verticalinternational production networking, various location advantages have determined the pattern offragmentation of production and international trade. In East Asia, there exist large differencesin the components of location advantages, such as static and dynamic service link costs andagglomeration effects in addition to wages and technology transferability. Such elements haveshaped the evolving pattern of fragmentation of production and trade and the vertical division oflabor in East Asia.

Acknowledgements

The paper was presented at the Claremont Regional Integration Workshop with Particular Ref-erence to Asia and at the Japan Economic Association. The author would like to thank anonymousreferees, Fukunari Kimura, Masaru Umemoto, Chisa Fujioka, and participants of the conferencesfor useful comments and suggestions.

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