Determinants of vertical integration in export processing: Theory and evidence from China

a r t i c l e i n f o JEL classification: F14 F23 L14 Keywords: Intra-firm trade Vertical integration Export processing Outsourcing This paper examines the determinants of vertical integration versus outsourcing in export processing, by exploiting the coexistence of two export processing regimes in China, which designate by law who owns and controls the imported components. Based on a variant of the Antràs-Helpman (2004) model, we show theoretically that control over imported components for assembly can affect firm integration decisions. Our empirical results show that when Chinese plants control the use of components, the export share of foreign-owned plants is positively correlated with the intensity of inputs provided by the headquarter (capital , skill, and R&D). These results are consistent with the property-rights theory of intra-firm trade. However, when foreign firms own and control the components, there is no evidence of a positive relationship between the intensity of headquarters' inputs and the prevalence of vertical integration. The results are consistent with our model that considers control over imported components as an alternative to asset ownership to alleviate holdup by export-processing plants. Export processing, in which a final-good producer offshores the final stage of production to an assembly plant in a foreign country, has been an important part of developing nations' economies. It employed over 63 million people in the developing world, 1 and accounted for over half of total exports in countries such as China and Mexico in recent years (Bergin et al., 2009). Recent studies have shown how export processing and offshoring in general have important macroeconomic impacts on the host countries. 2 In export processing, final-good producers are often confronted with the decisions of whether to out-source to or integrate with the foreign assembly plant, which in turn affect the macroeconomic effects of offshoring. This paper studies the prevalence of vertical integration versus outsourcing in export processing using detailed product-level trade data from China's Customs. We exploit the special regulatory regimes governing processing trade in China. These legal arrangements designate by law which party of a global production relationship has control rights over the imported materials, which are critical for export processing. Specifically , export processing in China has been governed under two regimes since the early 1980s, which are referred to as pure-assembly and import-assembly. 3 The main difference between the two regimes lies in the allocation of control rights of the imported inputs. …