Authors: Uri Dadush, Shimelse Ali
Originally published by the Carnegie Endowment for International Peace
Imported intermediate inputs—parts and materials sourced from abroad that are used to make products either consumed domestically or exported—are a growing force in world trade. Catalyzed by the globalization of production, the large and rising share of imported inputs in exports has important policy implications: it means that bilateral trade balances are not appropriately measured, and protectionism is more costly, trade more volatile, and exports less significant as drivers of short-term demand than is often understood. To address these issues, policy makers must develop better measures of trade flows, foster more multilateral cooperation on trade, and build better safeguards against financial instability.
The rise of trade in intermediates
Lower trade barriers, organizational innovations, and progress in information and communication technologies have made slicing up the production process cheaper and easier. Coordination costs have fallen, and different stages of production are now more frequently located in different countries. High labor costs and heavy regulations in rich countries have also helped to catalyze the shift in the production process through a wave of outsourcing and off-shoring to developing countries.
As a result, intermediate inputs have become an important part of world trade, particularly as they are increasingly being sourced through imports rather than domestic production. Intermediate inputs now represent more than half of the goods imported by OECD economies and close to three-fourths of the imports of large developing economies, such as China and Brazil.
Most importantly, they account for a significant chunk of exports, with large differences across countries. According to OECD estimates1, imported intermediate input content accounts for about one-quarter of OECD economies’ exports, and the European Central Bank (ECB) estimates that such imports accounted for about 44 percent of EU exports (or 20 percent for imports from outside of the EU) in 2000, ranging from about 35 percent in Italy to about 59 percent in the Netherlands2. In the United States, imported intermediate input content in exports reached about 10 percent in 2005. Among emerging economies, imported content’s share in exports is particularly high in China―about 30 percent, or twice that for India and Brazil.
With globalization, the use of imported intermediates for exports has been growing. According to the OECD, all but one of its 34 member countries increased the import content of its exports over 1995–2005. The increase was particularly marked in small countries like Luxemburg and Israel, which saw increases of about 20 percentage points, compared to 3–8 percentage point increases in large countries, such as the United States, Japan, and Germany. This is in keeping with the general trend of import content accounting for a larger share of exports in smaller economies.
Four implications
1. The Importance of Bilateral Trade Balances Is Exaggerated
Economists have long argued that overall—not bilateral—trade balances matter. Acting on bilateral imbalances without addressing the underlying causes of the total imbalance simply redistributes that imbalance across trading partners.
As the role of trade in intermediates increases, bilateral trade balances are even less meaningful, as they fail to reflect value-added (e.g., the value of exports minus imported inputs). As World Trade Organization (WTO) Director General Pascal Lamy argued recently, many countries’ exports—including those of China—are economically less significant than they look because they consist of imports that are subsequently re-exported and intermediates that are modestly reprocessed. In the case of an iPod Touch, for example, China adds only $4 to the value, but each one registers as a $150 entry in the U.S.–China bilateral deficit.
Various studies find that China’s surplus with the United States, for example, is 20–40 percent lower when estimated in value-added terms—reflecting the fact that only 20–35 percent of China’s exports to the U.S. contain domestic value-added. Japan’s and South Korea’s balances with the United States, on the other hand, may be understated, as China relies on content imported from them to produce its exports. As they have exported more parts to China, Japan’s and South Korea’s share of U.S. imports has declined.
2. The Importance of Exports as a Driver of Demand is Overestimated, While the Importance of Trade as a Source of Efficiency is Underestimated
Over the last several decades, world exports have grown at about twice the rate of world GDP on average. The increased trade in intermediate goods—commonly exported several times before they become part of a final product—helps account for this3. The sectors that have registered large export growth, such as machinery, are also the sectors that have the highest imported intermediate input contents in their exports.
The growth of trade in intermediate goods also helps explain why exports account for an enormous share of GDP in a few mega-trade countries, such as Singapore and Hong Kong, which are sometimes called entrepôt (or re-export) economies. Because policy makers fail to recognize that imported inputs feed into exports, they often overestimate the importance of exports in driving short-term demand but underestimate the importance of trade and specialization as sources of increased efficiency in the longer term.
3. Trade Has Become More Volatile and a Larger Source of Shocks
Generally, intermediate imports appear to be more important for exports of manufactures than those of services, particularly in industries such as electronic and communications equipment, and electrical machinery and instruments. In the United States and Japan, the import content of manufactures’ exports—nearly 20 percent—is four times that of services exports; in China, it is twice that of services exports.
At the same time, manufactures, especially durable goods, play a larger role in trade than in GDP. In the United States, for example, durables accounted for more than 60 percent of trade in goods in 2008, compared to 24 percent of GDP. But the demand for durable goods tends to fluctuate more than that for services. As a result, trade is more volatile than GDP, with the effect compounded by the fact that durable goods account for a high share of trade in components.
The Great Recession provided a dramatic illustration of this. Global exports declined by 14 percent in volume terms between the third quarter of 2008 and the first quarter of 2009, while world GDP fell by about 3 percent over the same period. Not surprisingly, trade in capital and durable goods was hit particularly hard; according to an International Monetary Fund (IMF) study, during the worst of the crisis, it fell about 10 times faster than trade in consumer non-durables as consumers postponed any purchases that could be delayed amid a global credit crunch and loss of confidence. In addition, due to countries’ specializations in different stages of production, shocks in one country could lead to shocks in another country that manages a separate stage of production, magnifying the disruption.
Though such trade volatility does not necessarily translate into equivalent changes in domestic value-added, it is nonetheless highly disruptive. With trade in intermediates growing, economies are becoming more intertwined, implying greater vulnerability to shocks emanating from abroad. At the same time, increased reliance on foreign demand and supply is making economies less vulnerable to domestic shocks.
4. The Cost of Protection is Higher
Trade in intermediates means the cost of protectionism is higher than is generally understood, and rising. As economists have long known, the effective rate of protection—the tariff as a share of domestic value-added—is higher than the nominal tariff. Consider, for example, a T-shirt produced in the United States. Assume it trades at $10 and uses $5 worth of imported fabric. The domestic value-added is therefore $5. Now, if the United States imposes a tariff of 50 percent on T-shirts, the price of an imported T-shirt will rise to $15, giving domestic industry a 100 percent price advantage over importers4.
By the same token, levying a 50 percent tariff on the fabric imports would increase the costs for T-shirt exporters to $7.50—raising it by 50 percent of their value-added and effectively creating an export tax. Because imports increasingly feed into exports, an import tariff on parts and raw materials has a big impact on exports. Tariffs on intermediates that increase the costs of capital imports may also discourage inward-bound foreign direct investment and encourage outward-bound investment instead5.
The danger of higher protection is particularly pronounced for smaller economies where the share of intermediate imports in a country’s overall exports is large.
In addition, higher trade barriers may be particularly disruptive to intra-regional trade, as countries tend to import intermediate inputs from other countries in their region, partly reflecting production networks’ high sensitivity to time constraints, trade, and transportation costs6. European Union countries tend to import intermediates from other EU members, NAFTA countries from other NAFTA partners, and Japan, China, Korea, and Indonesia from other countries in Asia (see chart above).
Inefficiency in logistics and customs is a type of trade barrier—one that is often more important than tariffs. Thus, the rise in trade in intermediates also underscores the importance of trade facilitation in fostering a country’s involvement in global production networks. Studies have found that the costs of trade delays are higher in countries that trade more time-sensitive goods7. This is particularly true for intermediate imports of manufactures that have high time value because they depreciate quickly or have high inventory cost. While there is no simple correlation between the share of intermediate imports in a country’s exports and the quality and efficiency of its logistics, several countries, such as Ireland and South Korea, that have high import content in their exports have among the highest scores in the World Bank’s Logistic Performance Index8.
Policy
It is important for policy makers to develop better measures of trade flows net of intermediate imports. A failure to do so can lead to inaccurate policy conclusions about the importance of bilateral trade imbalances, and to significant underestimates of the cost of protection. Large trade in intermediates can lead countries to overestimate the role of exports as a source of demand growth, but also to overlook the crucial role that imports play in enhancing efficiency and exports. Generally, the existence of large and growing trade in intermediates, which is associated with foreign direct investment and the globalization of production, greatly raises the stakes on countries that have an open and predictable trade regime, including efficient logistics.
Large trade in intermediates also has its dangers, as evidenced by the huge global trade shock that took place during the financial crisis. The answer, however, lies not in less trade, but in building better safeguards against financial instability and fostering more trade cooperation at the multilateral level.
A previous version of this article was published by VoxEU.
1 Unless otherwise indicated, data on import content of exports is from OECD Input-Output database. It should be noted that estimates vary widely depending on the data, assumptions, and methodology used. For example, estimates of the share of Chinese exports accounted for by imported intermediates can vary from 45 percent to 65 percent. See CBO (2008), “The domestic value added of Chinese exports”.
2 This estimate is based on five European economies―Germany, Italy, the Netherlands, Austria, and Finland―which account for around 60 percent of Euro area GDP. See ECB (2005), “Competitiveness and the Export Performance of the Euro Area”, ECB Occasional Paper, No. 3.
3 A study by Hummels, Ishii, and Yi (2001) calculate vertical specialization for 10 OECD countries and 4 emerging countries and find that 30 percent of the increase in these countries’ export is from growth in vertical specialization. See also Nordås, Hildegunn Kyvik (2003), “Fragmented Production: Regionalization of Trade?”.
4 The Effective Rate of Protection (ERP) is given by (V* – V)/V, where V* is the domestic value added with a tariff on imports and Vis the domestic value added under free trade.
5 In addition to the direct impact of higher costs on intermediate imports, which are needed for domestic firms to compete internationally, import barriers on such imports have an indirect effect on real wages of workers induced by the increase in the cost of capital. See H. Hopenhayn, P. Neumeyer (2002), “Economic Growth in Latin America and the Caribbean; Country Study for Argentina. The Role of Capital and Labor Reallocation in the Argentine Great Depression of the 1980s”, Universidad Torcuato Di Tella.
6 Yi, Kei-Mu (2009), “The Collapse of Global trade: The Role of Vertical Specialization” in Baldwin and Evenett (eds.), The Collapse of Global Trade, Murky Protectionism, and the Crisis: Recommendations for the G20.
7 Hummels, David. “Time as a Trade Barrier”, Mimeo, Purdue University, 2001.
8 Luxemburg and Ireland are among the top 11 countries in World Bank’s Logistic Performance Index ranking of 155 countries.
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