The Linkage between the FDI and Trade of

China, Japan and Korea: The Korean

Perspective

Chang-Soo Lee
Korea Institute For International Economic Policy

Prepared for presentation at the DRC/NIRA/KIEP symposium on Strengthening

Economic Cooperation in Northeast Asia: Facilitating Investment between China, Japan
and Korea held in Beijing on September 29, 2002.

1
I. Introduction

This paper tries to find the FDI-trade linkage between host and home countries,
reflecting a special interest in the links between trade and FDI flows and their
contribution to regional integration. The key players of this process of regional
integration would be intrafirm and intraregional trade as well as intra-firm and intra-
regional procurement of materials. We expect that regional integration in Northeast
Asia is positively influenced by intra-firm trade and investment within international firms.
To clarify this point, Korea’s FDI into China and Japan’s FDI into Korea are explored
in this paper using primary data from a survey of individual firms.

This paper consists of five chapters. Section II begins with a review of past literarture
on existing empirical literature on the linkages between FDI and trade. The impact of
FDI on China’s international trade is explained in Section III. The focus is on the role
of foreign invested firms in Chinese exports and trade and their participation in the
international segmentation of production. Section IV analyzes the FDI–trade linkage at
the firm level, using survey data of Japanese investment in Korea and Korean
investment in China. The demand structure for final goods and procurement structures
of intermediate goods of the affiliates are emphasized. Section V summarizes the results.

2
II. The Impact of FDI on Trade

FDI’s Effect on Trade

Does FDI facilitate or restrict international trade? To what extent does FDI (affiliates’
production and sales in a foreign market) replace or increase exports to the same
market? While there are theoretical reasons to suggest both substitution and
complementary effects, surprisingly, empirical work in this area almost invariable shows
a net complementary relationship between exports and foreign production.

Lipsey and Weiss (1984), Graham (1996), Kawai and Urata (1998), Brenton, Di
Mauro and Lucke (1999), and Lipsey, Ramstetter and Blomstrom (2000) find that
affiliates’ sales positively correlated with exports and foreign production. According to
Lipsey and Weiss (1984), the higher the level of output by a U.S. firm in a foreign area,
the higher in general were that firm’s exports to that area. Foreign production is strongly
related to the firm’s export of intermediate goods for further processing, but also
positively related to the export of finished products from the United States. According
to Lipsey, Ramstetter and Blomstrom, within individual Japanese manufacturing firms,
parent companies’ exports from Japan to a foreign region are positively related to
production in that region by the affiliates of that parent. The relationship is similar for
U.S. and Swedish firms in parallel studies.

Abe (2002) and Lee (2002) test the effects of Japanese and Korean FDI on trade
under the framework of a gravity equation. The estimated coefficients on FDI in the
equations for trade and exports are positive and statistically significant in most years,
indicating that Japan’s (Korea’s) FDI tends to promote its exports and overall trade. In
the case of imports, the estimated coefficients are not statistically significant in most
years.

3
Reasons for Complementarity

What drives a positive effect of FDI on trade? As argued by Blonigen (2001), Kawai
and Urata (1998), and Lipsey and Weiss (1981; 1984), there are two important
factors driving complementarities: demand complementarity and complementarity from
vertical relationships. Lipsey and Weiss (1981) suggest that their finding of a positive
correlation at the industry level shows that manufacturing presence in another country
‘tends to promote’ the firm’s exports to that country. Specifically, a firm’s production
presence in a foreign market with one product may increase total demand for all of its
products through a number of channels including (1) provision of important sales and
after-sale services, (2) commitment-to-market effects on consumers, and (3) more
efficient and quicker deliveries and distribution. In this way, foreign production and
sales of one good promotes export sales of goods produced by the firm in its home
country (Blonigen, 2001).

A vertical production relationship is another way that complementarity may occur.

Investment by a manufacturer may increase exports of inputs to the host market.
Swenson (1997), Frankel and Wei (1996) and Lipsey and Weiss (1981) find that
Japanese automakers transplanted in the U.S. import a large amount of parts from
Japan and are much less willing to substitute U.S. parts for imported inputs. Blonigen
(2001) analyzes this vertical relationship in detail using product-level data. Production
of Japanese automobiles (the input-using industry) in the United States should increase
Japanese exports of automobile parts to the United States (a complementary effect),
while the location of Japanese automobile parts production in the United States should
decrease Japanese exports of automobile parts (substitution effect).

Kawai and Urata (1998)’s explanation for procurement and import patterns of
Japanese multinationals is simply a vertical relationship argument. According to them,

4
approximately 40 percent of the total intermediate goods procured by foreign affiliates
come from Japan. The degree of reliance on Japan for the supply of intermediate goods
is higher in the four machinery sectors such as general machinery, electric machinery,
transport machinery, and precision instruments. High export shares to Japan for the
machinery sectors are largely attributable to the global strategy of Japanese firms in
these sectors. Under the strategy of inter-process specialization, Japanese firms seek to
minimize production costs by dividing the entire production process into a number of
subprocesses and by locating each subprocess in a country where that particular
subprocess may be performed most efficiently or inexpensively. Korea’s multinationals
follow this Japanese method of production arrangement in Asia. And like Japanese
firms such a production arrangement gives rise to a production system under which a
vertical division of labor is pursued internationally within a firm, leading to the
emergence of inter-process, intra-firm, and intra-industry trade.

5
III. FDI into China and its Effect on Trade1

China has become the second largest FDI recipient in the world, after the United
States, and the largest host country among developing countries. So far, a major
portion of the FDI is drawn by the manufacturing field, and within the manufacturing
sector, approximately half of the FDI has been directed towards labor-intensive
industries. This suggests that the main motivation of foreign companies is to take
advantage of China’s low labor costs. The main fields of investment of developing
source countries differ from those of developed source countries, even in the
manufacturing sector. Developing source countries tend to invest towards labor-
intensive production technology and standard manufacturing products while developed
countries are inclined to invest in high technology and differentiated products.

It is widely accepted that FDI has been at the core of China’s foreign trade expansion.
Furthermore, it has been a decisive factor in China’s involvement in the international
segmentation of the production process. This conclusion is based on the following
empirical evidence.

China’s major structural strengths in international trade have been concentrated in a

limited number of labor intensive manufacturing products: leather and shoes, apparel,
and miscellaneous manufactured products. Its major structural weaknesses have been in
capital and technology intensive goods such as machinery, engines, intermediate textile
products, and plastics. The labor intensive industries in which China has the biggest
comparative advantage has accounted for the bulk of China’s exports, while the capital
and technology intenisve industries in which China has the biggest comparative
disadvantage has accounted for the bulk of its imports. These characteristics, strength in

1
The contents of this section are largely extracted from OECD (2000).

6
consumer goods and weakness in intermediate products and to a lesser extent in capital
goods, indicate that China may be involved in the international segmentation of the
production process, specializing in the assembly and transformation of imported
intermediate goods for export. We can find this specialization in assembling operations
in the textile industry and more technologically advanced industries.

Foreign invested enterprises (FIEs) have been responsible for almost all the visible
improvement in China’s export and import performance. FIEs have led export and
import growth in China, while domestic firms’ shares in Chinese exports and imports
have shown a declining trend.2 FIE firms have dominated most major manufactured
exports from China. In 1995, FIE firms accounted for 51.2 percent of China’s total
manufactured exports. In terms of the industry groups of factor intensity, FIE firms
accounted for 51.4 percent of China’s total labor intensive manufactured exports and
for 69.8 percent of China’s total technology intensive manufactured exports (OECD:
22).

In particular, FIEs took a major part in the rapid growth of processing trade, which
increased much faster than ordinary trade. FIEs were responsible for 70 percent of
China’s imports for processing and for 66 percent of its processing exports. Over the
period 1994-98 FIE processing activities were by far the most dynamic component of
China’s trade and they represented almost 38 percent of total exports and 34 percent
of imports in 1998.

2
The difference in the export behavior of FIE firms and Chinese domestic firms is even more
significant in labor intensive industries and technology intensive industries than in the
manufacturing sector as a whole. For the FIE firms, the export to sales ratio was 46.2 percent in
labor intensive industries and 45.3 percent in technology intensive industries, while for
Chinese domestic firms, the export to sales ratio was only 14.5 percent in labor intensive
industries and 7.8 percent in technology intensive industries. The sharp difference between
FIE firms and Chinese domestic firms in export behavior confirms that FIE firms in China are
more export-oriented than Chinese domestic firms (OECD: 22).

7
The overwhelming share of processing activities in the trade of foreign affiliates reflects
their role as a production base for parent companies. Foreign firms have transferred the
downstream, labor intensive stages of production to China. Most imported inputs for
processing come from Asian countries, suggesting that Asian firms have taken a major
part in this transfer of production capacities in order to maintain their competitiveness in
world market. FIEs located in China have imported mainly intermediate goods to be
processed and re-exported. A large part of these imports correspond to the supply of
inputs from parent firms to their affiliates and can thus be characterized as intra-firm
trade (OECD: 21).

FIE processing activities have led to bilateral trade patterns which help illustrate the
reorganization of production which has taken place in Asia with China becoming an
assembly base for finished products for the supply of world markets. For instance,
foreign affiliates in China have had a relatively balanced processing trade with Japan, an
indication that intra-firm trade played an important part in Japan-China two-way trade.
In contrast however, those affiliates have had a large processing trade deficit with
Taiwan and South Korea (OECD: 21).

8
IV. The FDI–Trade Linkage: Japanese FDI in Korea and
Korean FDI in China

This section is based on a survey of independent firms. The questionnaire used for the
survey established the determinants of intrafirm trade links by eliciting information on the
procurement and sales patterns of Korea’s affiliates in China and Japan’s affiliates in
Korea.

Data Description

The Korean research team conducted one-to-one interviews for the survey. Finally, the
team succeeded in collecting 196 completed questionnaires: 166 from Korean affiliates
in China and 30 from Japanese affiliates in Korea. The industrial distribution of the
Japanese firms in Korea is as follows: Of the manufacturing firms, 33% are classified as
electrical and electronic equipment, and 20% as chemicals and chemical products. The
industrial distribution of the Korean firms in China is different from the Japanese ones:
Of the manufacturing firms, 34% are classified as textile, clothing and leather, and 21%
as electrical and electronic equipment.

Firms of the two countries also differ in terms of affiliates’ size. Korean firms are bigger
than Japanese ones in terms of number of employees: on average, 453 persons in
Korean firms and 215 persons in Japanese firms. The two sample sets showed
differences in the type of firms. Specifically, 68 percent of the Korean firms are
exclusively foreign-owned enterprises while equity joint venture firms constitute 19
percent. In contrast, the Japanese sample showed that only 40 percent are wholly
foreign-owned firms while equity joint ventures constitute 60%. The investment scale of

9
both the Korean and Japanese firms ranged from very large, with an investment of
US$50 million, to those with investments of less than US$500 thousand.

Table 4.1 Basic Facts about the Sample (Manufacturing Firms)

Japan Korea
Cases 30 166

(1) Number of Employees (person)

≤50 36.4 20.5
51~ 200 36.4 27.7
201~ 500 12.7 28.3

＞500 14.5 23.5

MEAN 214.5 452.6

(2) FDI Type (%)

Exclusively foreign-owned enterprise 40.0 68.1
Equity joint venture 60.0 18.7
Contractual joint venture 13.3

(3) Manufacturing (%)

Food, beverages and tobacco 3.3 6.1
Textiles, clothing and leather 6.7 33.9
Wood and wood products 0.0 3.5
Publishing, printing and reproduction of recorded media 0.0 1.7

Chemicals and chemical products 20.0 6.1

Rubber and plastic products 10.0 8.7
Non-metallic mineral products 0.0 2.6
Metal and metal products 10.0 7.8
Machinery and equipment 3.3 6.1
Electrical and electronic equipment 33.3 20.9
Precision instruments 3.3 0.0
Motor vehicles and other transport 10.0 2.6
Equipment

(4) Investment Scale (10 thousand US ＄)

≤50 16.7 22.9
51˜100 13.3 19.3
101˜500 36.7 31.9
501˜1000 10.0 13.3
1001˜5000 16.7 10.2
＞5001 6.7 2.4

10
Sales Structure

Sales destinations and channels in the two countries are presented in Table 4.1. The
survey found that Japanese manufacturing affiliates in Korea sell about 56 percent of
their products to local (Korean) consumers, and export about 44 percent. They also
export back to the home country (Japan) about 19 percent of their products. In
contrast, local (export) sales share in total sales is about 29 percent (71 percent) for
Korean manufacturing firms in China, showing a much lower local sales share, while
sales share to the US market recorded 22 percent, much higher than the case of
Japanese affiliates in Korea (4.8 percent). Thus, we can conclude that there are notable
differences in sales and export patterns between Korean firms in China and Japanese
firms in Korea. This is not surprising remembering the differences in their FDI
motivations. Japanese FDI is largely motivated by local markets, while Korean FDI is
also motivated to export outside the region after exploiting the low production costs in
China.

There is a possibility that the export orientation (pattern) is related to firm size,
considering that the sample of the survey showed that Korean firms had much bigger
workforces than the Japanese ones. We can confirm this argument by dividing the
whole sample of 166 Korean firms in China into large conglomerates and small and
medium-sized enterprises (SMEs). In the case of the large conglomerates, local sales
share (China) is much higher and at the same time, their U.S. market share is far lower
than in the case of SMEs. Thus, notable differences in sales and export patterns
between Korean and Japanese firms can be explained largely by the size of the firms.

The firm-level survey also provided insights into intrafirm trade. There was evidence of
a high level of intrafirm sales. For Japanese affiliates in Korea, intrafirm sales accounted

11
for about 22 percent of total sales; the share of sales to parent companies is 13.9
percent of total sales, and sales to affiliates are 9.1 percent. For Korean affiliates in
China, the share of intrafirm-trade in total sales amounts to about 24.9 percent, with
13.8 percent of this figure consisting of sales to the parent and 11.2 percent to other
affiliates. We can conclude that Korea’s FDI in China triggers more intrafirm trade than
Japanese FDI. This finding is not consistent with the conventional wisdom that intrafirm
sales (sales to parent and interaffiliate sales) are very common in Japanese firms. This
conventional wisdom might be applied more persuasively to ASEAN countries than to
Korea.

Table 4.2 Sales Structure and Intra-firm Sales

(Manufacturing Firms)

Japan Korea
(Large (SMEs)
Congl.)
(1) Sales Structure
Total sales (thousand dollars) 53185 24463 85414 15158
Local sales (%) 55.8 29.3 69.7 23.8
Export sales (%) 44.2 70.7 30.4 76.2

(2) Final Market

China 8.8 29.3 69.7 23.8
Japan 19.4 10.9 0.8 12.2
Korea 55.8 20.2 10.3 21.5
Hong Kong 0.9 1.9 0.5 2.1
Taiwan 1.0 1.3 0.7 1.3
Singapore 0.6 0.3 0.2 0.4
ASEAN4 2.7 1.3. 1.2 1.3
The U.S. 4.8 22.2 5.2 22.2
EU 4.1 9.4 6.6 9.8
Others 1.9 5.2 5.0 5.2

(3) Intra-firm Sales

Proportion of intra-firm trade 22.2 24.9 16.2 26.1
Sales to parent 13.9 13.8 10.0 14.3
Sales to affiliates 9.1 11.2 6.2 11.8

No. of Observations 30 166 20 146

12
Procurement Structure

Table 4.3 presents information on the sourcing of raw materials and components for the
firms surveyed. The data confirms that affiliate firms in Korea and China depend heavily
on foreign sources for materials and components.

Japanese affiliates in Korea procured about 51 percent of materials and components

from local (Korean) producers, and about 49 percent through imports. Specifically,
they import about 36 percent from Japan and 13 percent from other countries.
Similarly, the share of goods procured locally (through imports) is about 42 percent
(58 percent) for Korean firms in China, showing a similar pattern of local and import
procurement to that of Japanese affiliates in Korea. A slight difference is that Japanese
firms are more dependent on the local market in procurement of raw materials and
intermediate goods than the case of Koeran firms in China. This is not surprising
considering the development gap between the two cases. However, there is a
possibility that the import procurement patterns of Korean firms are exaggerated
compared with that of Japanese firms. Remember that the sample of the survey showed
much bigger employment in Korean firms than Japanese ones.

The firm-level survey also provided evidence of a high level of intrafirm procurement.
For Japanese affiliates in Korea, intrafirm procurement accounted for about 34 percent
of the total procurement of materials; the share of sourcing from the parent is 31
percent and sourcing from other affiliates is about 4 percent. For Korean affiliates in
China, the share of intrafirm-sourcing in total procurement amounts to about 40
percent, recording 35 percent of sourcing from the parent and about 5 percent of
sourcing from other affiliates. We can conclude that Korea’s FDI in China triggers

13
similar intrafirm sourcing as in the case of Japan’s FDI. This finding is not consistent
with the widespread conception that intrafirm sourcing is more common in Japanese
firms than in Korean ones. However, this finding may also be a result of the sample
bias showing a greater number of employees in Korean firms than Japanese ones.
Other interpretations are also possible. The high level of import sourcing would mean
that the two countries are still not very vertically integrated, and import sourcing remains
dominant. The inability of local suppliers would be an additional factor preventing more
local sourcing.

Table 4.3. Procurement Structure and Intra-firm Sourcing

(Manufacturing Firms)

Japan Korea
(Large (SMEs
Congl.) )
(1) Intermediate-good Procurement
Total material inputs (thousand dollars) 20257 16204 68965 7502
Local procurements 50.9 42.4 48.6 41.6
Imports 49.1 57.6 51.4 58.4

(2) Procurement Structure

China 4.3 42.4 48.6 41.6
Japan 36.0 3.9 1.0 4.3
Korea 50.9 43.9 43.7 43.9
Hong Kong 0.1 1.2 0.0 1.3
Taiwan 0.3 0.8 0.3 0.9
Singapore 0.2 0.1 0.0 0.1
ASEAN4 0.8 0.9 2.2 0.7
The US 3.5 2.3 2.5 2.3
EU 1.8 1.3 0.3 1.4
Others 2.3 3.3 1.4 3.5

(3) Intra-firm Sourcing

Intra-firm sourcing 34.4 39.7 40.5 39.6
Sourcing from parent 30.9 35.0 36.5 34.8
Sourcing from affiliates 3.5 4.7 4.0 4.8

No. of Observations 30 166 20 146

14
Summary

Considering the patterns of procurement and sales of foreign affiliates of Japanese and
Korean firms, we find a strong, positive relationship between Japanese (Korean) FDI
into China and trade with China. Japan’s (Korea’s) FDI in China tends to stimulate
Japan’s (Korea’s) exports significantly, and this positive effect appears consistently.

15
V. Summary and Concluding Remarks

This paper treats three issues of FDI from the perspective of regional integration: the
relationship between FDI and trade, effects of FDI inflows in China on Chinese trade
and economy, and the FDI–trade linkage of Japanese affiliates in Korea and Korean
affiliates in China at the firm level.

The basic results of the paper are summarized as follows.

Empirical literature shows a net complementary relationship between exports and

foreign production. According to studies by Abe (2002) and Lee (2002), which test the
effects of Japanese and Korean FDI on trade under the framework of a gravity
equation, Japan’s (Korea’s) FDI tends to promote its exports and overall trade.

FDI has been at the core of China’s foreign trade expansion. Furthermore, it has been a
decisive factor in China’s involvement in the international segmentation of the
production process. In particular, FIEs took a major part in the rapid growth of
processing trade. The overwhelming share of processing activities in foreign affiliates’
trade reflects their role as a production base for parent companies which have relocated
segments of production in China: FIEs imported mainly intermediate goods to be
processed and re-exported.

Considering the patterns of procurement and sales of foreign affiliates of Japanese and
Korean firms, we find a strong, positive relationship between Japanese (Korean) FDI

16
into China and trade with China. Japan’s (Korea’s) FDI in China tends to stimulate
Japan’s (Korea’s) exports significantly, and this positive effect appears consistently.
This is because some Japanese (Korean) firms apply the strategy of breaking up the
production process into several subprocesses and locating specific subprocesses to
Korea (China). Such an arrangement gives rise to a production system in which an
international division of labor is pursued within a firm, leading to the emergence of
interprocess, intra-firm, and intra-industry trade. In this way Japanese FDI in Korea
and Korean FDI in China are thought to contribute to regional integration in Northeast
Asia through intra-regional sales and intra-firm trade as well as intra-regional
procurement and intra-firm sourcing of intermediate goods.

17
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