There was a time when exporters usually made their products at home, from start to finish, and then exported the final product overseas as a finished product.  And when foreign markets were closed, multinational enterprises (MNEs) implanted themselves in the foreign markets by way of investment, and then produced and sold to the local market.

In recent decades, things have changed. 

The production process has fragmented.  This process is variously called production sharing, international production fragmentation, vertical specialisation, slicing the value chain and outsourcing.  As argued by Prema-chandra Athukorala from the Australian National University, this means that we need to analyse more closely international trade developments. 

This process has been led by what IBM’s Samuel J. Palmisano calls the “globally integrated enterprise”.  Simply put, the emerging globally integrated enterprise has as its goal the integration of production and value delivery worldwide. State borders define less and less the boundaries of corporate thinking or practice.  Companies are investing more to change the way they supply the entire global market. The global integration of production cuts costs and taps new sources of skills and knowledge.

Fragmentation process

Product design, component manufacture and assembly are now separated, often in different countries, according to their comparative advantages.  With a modest start in electronics and clothing industries in the late 1960s, multinational production links have gradually evolved and spread into many industries such as sport footwear, automobile, televisions and hand receivers, sewing machines, office equipment, power and machine tools, cameras and watches, and printing and publishing.

In the early days, the process involved locating small fragments of the production process in a low cost country and reimporting the assembled components to be incorporated in the final product.  Over time, production networks have begun to encompass many countries which are engaged in the assembly process at different stages, resulting in multiple-border crossing of product fragments before getting incorporated in the final product.    

Conventionally, international fragmentation of production took the form of a multinational enterprise building a subsidiary abroad to perform some of the functions that it once did at home.  Thus, there was a close relationship between FDI and trade in parts and components within vertically integrated manufacturiung industries.  In recent years, however, fragmentation practices have begun to spread beyond the domain of MNEs. 

As production operations in host countries have become firmly rooted, MNE subsidiaries have begun to subcontract some activities to local firms to which they provide detailed specifications and even fragments of their own technology.  At the same time, many firms which are not parts of MNE networks have begun to procure components locally through arm's length trade.  Moreover, many MNEs in electronics and related industries have begun to rely increasingly on independent contract manufacturers for the operation of their global-scale production networks -- a process that has been facilitated by the standardisation of some components and advances in modular technology.

Production fragmentation in Asia

Production fragmentation is perhaps most developed in East Asia, although the trend is evident everywhere.  Average manufacturing wages in East Asia still remain low compared to Europe and North America.  MNEs use Singapore as the regional centre for high-tech activities in component production, while undertaking more labour-intensive assembly of components and final goods in ASEAN countries (mostly in Malaysia, Thailand and the Philippines) and China. 

In this process, foreign direct investment (FDI) and trade have become two sides of the same coin.  Total FDI flows to developing Asia increased sharply from an annual average of $7 billion in the early 1980s to $200 billion in 2006.  The share of Asia in total FDI flows to developing countries increased from 30% to over 50% over this period, and as a share of global flows rose from 9% to over 15%.

Japan has been a big driver of this fragmentation trade, as, through its foreign investments, it is using developing East Asia as an assembly base for its manufacturing activities.  It is the model of the high wage country as the supplier of capital intensive components, while low wage countries have a comparative advantage in assembly activities.   

Why has trade fragmented so much in East Asia?  It all started with the appreciation of the yen, following the Plaza Accord in 1985 and again in the 1990s.  This pushed Japanese manufacturers to shift their production to developing Asian economies.  Since the mid-1980s, the geographical distribution of Japanese FDI with Asia has changed significantly, first from the NIEs to ASEAN, and then to China and other Asian countries.  In time, the more advanced emerging economies of Asia (like Korea, Singapore and Taiwan) followed suit.  Chinese investors are already the largest investors in the Cambodian garment industry, and have also begun to enter Vietnam. 

Naturally, openness to such outsourcing paved the way, as both home and host countries have liberalised trade and investment.  This was also facilitated by suitable wage differentials in between the different countries in the region.  And being early into this market, gave the region a head start on the rest of the world.  It thus offers agglomeration advantages for companies already located there, and site selection by new companies is strongly influenced by the presence of other companies. 

Further, rapid advances in production technology have enabled industry to slice up the value chain into finer, portable components.  Technological innovations in communication and transportation have shrunk the distance that once separated the world's nations, and improved the speed, efficiency and economy of coordinating geographically dispersed production processes.  This facilitated the establishment of 'service links' to combine various fragments of the production process in a timely and cost-effective manner.  Some fragments in the production process in certain industries have become standard fragments which can be effectively used in a number of products.  And as international networks of parts and components supply have become firmly established, producers in advanced countries have begun to move the final assembly of an increasing range of consumer durable (like computers, cameras, TV sets and motor vehicles) to overseas locations in order to be physically closer to their final users and/or to take advantage of cheap labour. 

Role of China

China has become the premier final assembly centre within global production networks of electrical goods and electronics.  Affiliates of Taiwanese, Hong Kong and Korean MNEs account for the lion's share (over 80%) of assembly exports by all foreign firms located in China.  However, developed country MNEs (in particular, US and Japanese MNEs) play a pivotal role in parts and component supply for these assembly firms from their home bases, as well as from plants located in China and other countries in the region.  

China has emerged as the premier low-cost assembly centre for a wide range of electrical and electronics products.  It can take advantage of its 'hinterland advantage', with its large supplies of cheap labour.  China is now the world's largest producer and exporter of personal computers.  China also dominates the world market for note book computers, display units, mobile phones, and DVD and CD players.  These are not high-tech products, but rather mass market commodities produced in huge quantities and at relatively low cost using imported parts and components.  They are not leading edge-technology products.  And the actual value added in China is generally not in high-tech activities.  It is not a sophisticated high-tech exporting country. 

That said, China's phenomenal export expansion has been underpinned by a shift in export composition away from primary products and towards manufacturing.  Manufactured exports increased from less than 40% of total in the late 1970s to nearly 80% in the early 1990s and to 92% in 2005/6.  And until the early 1990s, traditional labour-intensive manufactures like clothing, footwear, toys and sports goods were the prime movers of exports.  Since then, there has been a shift to ICT products.   

Over the past two decades, China has been by far the largest developing country recipient of FDI, and for the period 2000-2006, China has been the second largest FDI recipient in the world, with inflows of about $50 billion a year.  Investors from Hong Kong, Taiwan and Korea account for a large share of China's FDI, whereas 80% of total FDI inflows to all developing countries originate from developed countries.  Initially, virtually all of the output of foreign invested enterprises (FIEs) was exported.  The share of FIEs in China's total exports expanded from a mere 2% in the early 1980s to nearly 60% by 2006.  They are heavily concentrated in electrical goods and electronic industries.  

Production fragmentation and trade

For high-tech industries, the bulk of this trade fragmentation takes place within vertically integrated production processes managed by one company.  This is necessary because the production of final goods requires highly customised and specialised components whose quality cannot be verified or assured by a third party.  (Exports of information and communications technology products, and electrical goods account for almost three-quarters of exports from East Asia.) In other industries, multinational enterprises subcontract some activities to local firms, providing the latter with detailed specifications and even fragments of their own technology. 

So, a large part of the explosion of trade that we have witnessed in recent decades is the trade in parts and components associated with trade fragmentation.  It has grown faster than trade in final goods, and the region has grown even more dependent on final good demand from the US and EU..  There is in reality much double counting in trade figures, as trade statistics count the value of the good or service traded, and the one good may cross multiple borders on the way to becoming a final consumption good.  In 2003, the share of East Asia in total world exports of components increased from 31% in 1992 to 43% in 2003.

This is giving an inflated impression of the regional integration in East Asia.  Although intra-regional trade is growing strongly (up from 44% in 1992 to 53% in 2003), a lot of this is just parts and components trade.  East Asia is in fact becoming more dependent on external markets (primarily US and EU) for exports of final goods.  Also, these inflated trade statistics give an exaggerated impression to East Asia's importance in global trade.  China's export to GDP ration of around 40% grossly exaggerates its export dependence, as assembly exports account for over two-thirds of total merchandise exports.   

Trade fragmentation is taking place for many goods.  It started in electronics and clothing industries, and then spread to industries like sport footwear, automobiles, televisions and radio receivers, sewing machines, office equipment, power and machine tools, cameras and watches, and printing and publishing. 

Is such trade fragmentation a positive force for development? 

It opens up opportunities for countries to specialise in different slices or tasks of the production process, depending on their relative cost advantage and other relevant fundamentals.  A country need not set up a motor vehicle plant to benefit from the growth of the automobile industry.  It is enough to be competitive in the production of a single part. 

A country participating in part of the supply chain can enjoy the benefits of specialising in an area of its comparative advantage, and by reaping economies of scale from producing to a large market.  There are also many benefits in terms of knowledge transfers to local employees and enterprises, who work with and meet the production standards of the MNEs. 

MNEs are increasingly undertaking R&D in developing economies.  They may need to adapt production processes and product characteristics to local conditions and regulations.  MNEs may also undertake R&D in overseas locations in order to learn from local markets and enterprises, and for using local researchers and having contact with the local scientific community.source local technology.  Western MNEs are increasing their R&D expenditure in East Asian economies like Singapore, Korea, Malaysia and China.     

But it also requires an enabling environment.  The assembly stage is the most labour intensive and has the lowest value added.  And while low labour costs are important, many other complementary inputs are also required like the availability of world-class operators, technical and managerial skills, a good domestic basis of supplies and services, relatively free access to world-priced inputs including capital and excellent infrastructure. 

Can East Asia's dynamism allow it to de-couple from the world economy?

The rapid growth in intra-regional trade in East Asia led many to believe that the region had become a self-contained economic entity with the potential for maintaining its own growth dynamism independent of the economic outlook for the traditional developed market economies ('decoupling' hypothesis).  The dramatic drop in trade since the onset of the economic crisis demonstrated the close ties between countries within regional production networks.  There is no evidence of rapid intra-regional trade integration in final products.  Demand from China has not provided a cushion to the rest of East Asia against a global economic collapse, as postulated by the decoupling thesis.  The decoupling thesis is simply a statistical artifact.

The new mantra in East Asia is 're-balancing', the region should rebalance its growth strategy by reducing dependence on US and EU markets, and boost domestic and regional demand.  But domestic political pressures in countries like China are in favour of maintaining employment intensive export-oriented policies.  Could a regional free trade agreement help?  Yes, but experience shows that many difficult areas, like agriculture, are excluded from FTAs.  Rules of origin are also messy for network-related trade.  And ASEAN countries may be concerned that trade liberalisation would give an unfair advantage to China.  

Has the rise of China crowded out other Asian economies?

Counter-intuitively, the answer is no.  The major effect has been that the rise of China as an assembly hub, has provided increased business opportunities for other Asian economies back up the supply chain leading to complementary flows of FDI.  China could provide opportunities for the expansion of parts and components exports to China from Southeast Asia.  Network-related trade in components has strengthened Southeast Asia's trade links with China, opening up new opportunities for the expansion of component production/assembly.   

References:

Many papers by Prema-chandra Athukorala and his co-authors.

The Arndt-Corden Division of Economics, College of Asia and the Pacific, The Australian National University

http://rspas.anu.edu.au/economics/publications.php

Export Processing Zones: Past and Future Role in Trade and Development, by Michael Engman, Osamu Onodera and Enrico Pinali.  OECD Trade Policy Working Paper No. 53

www.oecd.org

The Globally Integrated Enterprise, Samuel J. Palmisano, Chair of the Board, President, and Chief Executive Officer of IBM.

Foreign Affairs, May/June 2006

www.foreignaffairs.org