Catalog

Is intra-Asian trade growth driven by independent regional demand?

The final destination of intra-Asian trade

Asia is undergoing a process of rapid economic expansion accompanied by growing regional trade, investment, and financial linkages. Since the 1990s in particular, growth in intra-Asian trade has been remarkable (Figure 1.5.1). Trade is often an important channel through which economic shocks can be transmitted from one country to another, but it may not be the whole story. Indeed, export-driven growth tends to make a country's economy vulnerable to the cyclical movements in economic activity of major trading partners. The rapid expansion of intraregional trade may indicate that Asian countries are strengthening their mutual economic ties. At the same time, the relative decline in Asia's trade with the rest of the world suggests Asia's reliance on external trading partners might be diminishing.

Overall, Asia's reliance on external demand remains strong. The export-to-GDP ratio has continued to trend upward, reaching nearly 55% of GDP in 2005 (Figure 1.5.2) compared with the world average of 28.5%. The incremental export-to-GDP ratio, measured by the year-on-year increment in exports over that in GDP, has also been on an upward trend. Steady increases of both ratios illustrate the importance of the export sector as the engine of growth in developing Asia.

Asia's increasing trade openness has been accompanied by significant progress in the diversification of its export base. Figure 1.5.3 shows the composition of Asian exports by destination. The share of intraregional trade in total exports rose from 26.2% in 1985 to 37.3% in 2005. The geographic composition of Asia's export market has become much less concentrated, with the share of the single largest market, the US, at only 17.6% in 2005, down from 23.2% in 1985. Japan and the EU-25 now account for 25.8% of Asia's total export market, much larger than the US share. But taken together, the G3 economies (the major export destination of global exports) account for only 43.3% of Asia's total exports, down from 53.2% two decades ago.

Greater diversification in the geographic composition of Asian exports suggests that an external demand shock stemming from a downturn in G3 could be mitigated to some extent by stronger growth in the rest of Asia's export markets, including Asia itself. This increasing degree of trade diversification, along with strong growth in intra-Asian trade, is often taken as evidence of an increase in Asia's resilience to a slowing of growth in the world's major economies.

However, changing demand conditions in these economies-particularly the US-appear to remain a dominant factor in Asia's export growth. Figure 1.5.4 demonstrates a close relationship between US non-oil import growth and that of Asian exports. G3 non-oil imports are also included for the period where data are available. US non-oil imports account for nearly 50% of total G3 non-oil imports and are highly synchronized with movements of G3 non-oil imports. Consequently, the correlation between Asian exports and G3 non-oil imports is also quite significant. Although the share of G3 markets in terms of Asia's total export market is on a decline, the figure indicates that the relationship in growth rates rather than levels has strengthened over time. The decadal correlations between growth rates of US non-oil imports and Asian exports confirm that this linkage has been significant and tighter in the first years of this century.

Underlying this strong linkage is the nature of intra-Asian trade. A notable feature of such trade is that it is driven by vertical integration of production chains, whose final output is destined for final demand outside the region (see the chapter Trade and structural change in East and Southeast Asia: Implications for growth and industrialization). Figure 1.5.5 shows a breakdown of Asian exports in terms of exports that are destined for other countries within the region and of exports that leave the region, on the basis of the input-output structure of global production and trade. Intra-Asian trade is then factored into the region's final demand and what is used in the production process. A similar decomposition is made in the trade among the rest of the world. On both ends are reported total final demand by different regions, which take into account the trade in intermediate goods in the production process.

The decomposition, which is based on the latest release of the Global Trade Analysis Project database, 2 shows that more than 70% of intra-Asian trade consists of intermediate goods used in production, and of this, half is driven by final demand outside Asia. Consequently, about 61.3% of total Asian exports (instead of 43% of total exports as shown in Figure 1.5.3) is eventually consumed in G3 countries.

Within Asia, the PRC is the largest driver of regional exports, but its final demand accounted for only 6.4% of total Asian trade, which was only half the contribution from Japan and slightly below a quarter of that from the US. 3 The results show that the G3 economies are still the main ultimate export destinations for final goods leaving Asia, when taking into account the share of intermediate goods trade that is for assembly and production within the region but that is eventually shipped out of the region.

This is confirmed by other sources. The Monetary Authority of Singapore (2003) estimates that only about 22% of total Asian exports are eventually absorbed by the region's domestic demand, based on the 1995 Asian Input-Output table (AIO table). According to Citigroup (2006), based on the newly released 2000 AIO table, only 11% of Asian exports are now destined for consumption within Asia. Meng et al. (2006) also conclude that, comparing the

2000 AIO table with the 1995 AIO table, the dependence of Asian production on overseas markets strengthened rather than weakened. Using a slightly different approach, Goldman Sachs (2002) estimates that Asia's domestic demand accounts for only one fifth of Asia's total export growth. Rough estimates based on these sources indicate that about 60% of Asia's total exports are ultimately headed for G3.

Figure 1.5.6 highlights the significance of G3 demand as final demand for intraregional trade by demonstrating that intraregional trade dynamics are tightly associated with the US non-oil import cycle. In the same vein, the relationship between Asia's private domestic demand and Asian imports has weakened, despite rising intraregional trade. Figure 1.5.7 shows that the correlation between Asia's private demand and its imports has trended downward.

As intra-Asian trade originates from demand outside the region, growth of intraregional trade's share in total Asian exports does not automatically lead to Asia's insulation from an external demand shock. On the contrary, the extent to which intraregional trade is dictated by intrafirm and intra-industry processing and assembly through vertically integrated production chains determines how vulnerable the Asian economy can be to a shock, particularly an industry-specific one emanating from major demand destinations. For example, the last US slowdown in 2001-2002 originated in the information technology (IT) industry, and its ripple effects through the global IT industry to Asian manufacturers was a vivid example of such vulnerability. The next section explores the structure of intra-industry trade within Asia.

Vertical supply networks and the role of the People's Republic of China

Figure 1.5.8 shows that intra-industry trade has been rising in Asia's trade with the rest of the world, along with increasing intraregional trade since the 1990s. 4 Beneath this picture lie intricately interconnected supply chains among Asian economies. ADB (2006) reports that strong growth in intrafirm and intra-industry trade through MNCs' vertical supply networks has boosted intra- and interregional Asian trade. It suggests that regional production sharing networks established by MNCs to take advantage of specific local conditions and low-cost labor might have been an underlying force behind intraregional trade in intermediate goods destined for final consumption outside the region. Fukao et al. (2003) provide supporting evidence, namely that Asian affiliates of Japanese and US firms export more than 50% of their products to destinations outside Asia, much higher than the export-sales ratios for other locations (Table 1.5.1). The subsidiaries of US firms in Japan export only about 10% of sales, similar to the share of exports in total sales by Japanese subsidiaries operating in the US.

The PRC appears to be at the center of this growing intrafirm and intra-industry trade as the region's main production base. The country's accession to the World Trade Organization (WTO) in 2001 has also played a catalytic role in its emergence as a major player on the world trading scene. With its strong commitment to implementation of WTO agreements, the PRC has removed trade barriers in virtually all product markets and further opened its market to foreign companies. In just two decades between 1985 and 2005, the PRC's exports (imports) grew from $27.3 billion ($42.5 billion) to $762.3 billion ($660.2 billion).

During this period of rapid growth, the pattern of PRC trade changed significantly (Figure 1.5.9). In the 1980s, the share of Asian neighbors in the PRC's total exports rose steadily, while that of G3 markets declined (similar to the export pattern of the rest of Asia, as previously mentioned). However, since the 1990s, the share of G3 markets has started to increase in terms of total PRC exports, reaching over 50% by 2005. Meanwhile, the PRC continued to import more from the rest of Asia in the 1990s, even with the declining share of Asian neighbors in its total exports.

Figure 1.5.10 shows that the growth rates of PRC exports to G3 have been highly correlated with those of PRC imports from the rest of Asia since the late 1990s. The basic pattern of PRC trade can be characterized as increasing exports to the global economy, while importing more intermediate goods from the rest of Asia. This trend is particularly pronounced in the electronics and automobile industries. For example, 15.5% of the PRC's total exports consisted of machinery and transportation equipment in 1992. By 2005, this figure had risen to 46.2%. In the same period, the share of machinery and transportation equipment in the PRC's total non-oil imports increased from 39.7% to 48.4%.

There is little doubt that foreign direct investment (FDI) has played an important role in promoting Asian growth via encouraging intra- and interregional trade of host countries. Growth in FDI inflows to the region has been substantial, rising from $21.3 billion in 1990 to $151.3 billion in 2005. But the pattern of FDI flows to Asia is quite different from those to the rest of the world. As noted previously, foreign affiliates in Asia established by FDI inflows tend to export a large share of sales, whereas FDI flows to other regions tend to serve local demand by getting around trade barriers protecting firms that compete in local markets.

This reflects the fact that the rapid expansion of FDI inflows to Asia has been closely associated with the establishment of regional production networks by MNCs (Fukao et al. 2003, Kawai and Urata 2004). Eichengreen and Tong (2005) also find that rapid growth in FDI inflows to the PRC has positive spillovers to other Asian economies, as these form part of the same global production networks. Indeed, the rise of the PRC as Asia's main assembly and production center appears to have influenced the region's cross-border investment flows as well. Growth in FDI inflows to the PRC has been marked and, more importantly, the share of FDI flows from regional economies to the PRC has been noteworthy (Figure 1.5.11).

As the PRC emerges as an important nexus between intra- and interregional trade and financial linkages for Asia, economic interdependence arises between the PRC and the rest of Asia as well as between the PRC and G3. To the extent that rapid growth in trade and investment has been a driving force behind PRC growth, a sharp fall in exports and a subsequent reduction in FDI may present a significant downside risk to the PRC economy, and thus to the rest of Asia. Because the PRC imports a large share of intermediate goods from the rest of Asia to serve final demand from G3, a slowdown in the G3 economies could have a negative impact on PRC exports and consequently PRC imports from the rest of Asia.

At the same time, to the extent that FDI flows are related to intrafirm and intraregional trade to serve external demand, FDI flows are likely to be responsive to the prospect of export growth. In turn, a sharp and prolonged reduction in external demand might also hold back FDI inflows to the region.