Why do we care?
For most policy issues, it is vital to measure the extent of domestic content in exports. For instance, what is the result of a currency appreciation on a country’s exports? The answer depends crucially on the share of domestic content in the country’s exports. Other activities equal, confirmed exchange rate appreciation could have a smaller influence on trade volume, the low the share of domestic content in the exports.
As another example, what is the result of trading with China on European income inequality? The answer depends partly on whether China simply exports products that are intensive in low-skilled labour or whether China’s exports are more sophisticated. Dani Rodrik has noted that the per capita income typically linked to the sort of goods bundle that China exports is a lot greater than China’s actual income. He interprets this as evidence that the skill content of China’s exports may very well be higher than its endowment may imply. Peter Schott has documented an apparently fast upsurge in the similarity between your Chinese export structure and that of high-income countries, and interprets it as proof a rise in the amount of sophistication embedded in Chinese exports. However, if the domestic content in China’s exports is low, especially in sectors that could have already been considered sophisticated or high-skilled in america, then imports from China may still generate a big downward strain on the wage of the low-skilled Americans in the end (as described by Paul Krugman).
The prevailing formula
Hummels, Ishii, and Yi (2001) proposed an idea of vertical specialisation in a country’s trade, thought as "the imported input content of exports, or equivalently, foreign value added embodied in exports," and provided a formula to compute vertical specialisation share based exclusively on a country’s input-output table. However, an integral assumption necessary for their formula to work is that the intensity in the usage of imported inputs may be the same between production for exports and production for domestic sales.
This assumption is violated in the Chinese case because of pervasive processing exports. Processing exports are characterised by imports for exports with favourable tariff treatment: firms import parts and other intermediate materials from abroad, with tariff exemptions on the imported inputs and other tax preferences from local or central governments, and, after processing or assembling, export the finished products to the international market. The policy preferences for processing exports usually result in a big change in the intensity of imported intermediate inputs in the production for processing exports and in other productions. Since processing exports have accounted for a lot more than 50% of Chinese exports each year at least since 1996, the Hummels, Ishii, and Yi formula will probably lead to a substantial under-estimation of the share of foreign value added in its exports.
A fresh formula
To compute shares of foreign and domestic value added in a country’s exports when processing exports are pervasive, we developed an over-all formula, that Hummels, Ishii, and Yi’s is a particular case (Koopman, Wang, and Wei 2008). We take into account the possible difference in the intensity of imported intermediate inputs in the production for processing exports and in other productions by expanding the typical input-output (I/O) table with another take into account processing exports, and domestic sales & normal exports.
However, this formula isn’t directly applicable as a number of the input-output coefficients needed aren’t generally available from conventional I/O tables. We therefore developed a mathematical programming solution to estimate these coefficients by combining information from trade statistics (which separate processing and normal trade) with standard I/O tables. To be precise, we use information from an I/O table to determine sector-level total imports/exports, and information from trade statistics to look for the relative proportion of processing and normal exports within a sector.
Chinese value added
We applied our methodology to the Chinese data for 1997, 2002, and 2006 and discovered that the share of foreign value added in Chinese manufactured exports reaches about 50%, almost doubly high as that implied by the Hummels, Ishii, and Yi (HIY) formula, as is seen in Table 1.
Table 1 Shares of domestic and foreign value added altogether exports (%)
The HIY Method