Input trade liberalization and import switching: Evidence from Chinese firms

• Date: 01 September 2019
• Published date: 01 September 2019
• Author: Miaojie Yu,Wei Tian
• DOI: http://doi.org/10.1111/roie.12410

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wileyonlinelibrary.com/journal/roie Rev Int Econ. 2019;27:1002–1020.

© 2019 John Wiley & Sons Ltd

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INTRODUCTION

Since entering the World Trade Organization (WTO) early this century, China has experienced re-

markable trade opening. The country‘s simple average tariff dropped from 15.3% in 2001 to 7.5% in

2017. China‘s trade liberalization brought huge changes in foreign and domestic markets, including

the rising quality and value added imbedded in exports and imports. China‘s exports have increased

rapidly, as noted by many studies in the literature. Increasing imports, which take off later than exports,

will be the next benefit of China‘s opening‐up strategy. China is the second largest importing coun-

try, and its annual imports increased by more than four times between 2000 and 2016. The Chinese

government has launched several policies and activities to promote imports, especially consumption

goods, including holding the first China International Import Exposition and further reducing the

simple average tariff to 7.5% in late 2018.1

Received: 1 May 2019

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Accepted: 1 May 2019

DOI: 10.1111/roie.12410

SPECIAL ISSUE PAPER

Input trade liberalization and import switching:

Evidence from Chinese firms

WeiTian1

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MiaojieYu2

1School of International Trade and

Economics,University of International

Business and Economics, Beijing, China

2National School of Development and

CCER,Peking University, Beijing, China

Correspondence

Miaojie Yu, National School of

Development, CCER, Peking University.

Beijing, China. Tel: (+86)10‐6275‐3109.

Email: mjyu@nsd.pku.edu.cn

Funding Information

We thank the financial support from the

China‘s Natural Science Foundation (Nos.

71625007 and 71573006), the China Social

Science Foundation (No. 16AZD003) and

the University of International Business

and Economics Young Scholars Project

(No. 14QN02).

Abstract

This paper investigates how input liberalization affects

firm import behavior. Using comprehensive production

and trade data of Chinese firms, the paper shows that firms

switch import sources from developing countries to devel-

oped countries as Chinese input tariffs fall. This finding is

evident for import value and import scope. The observa-

tion holds after excluding the possible influence of reduc-

ing processing trade. The paper further demonstrates that

the mechanism can be attributed to quality upgrading and

innovation led by input cost reductions. The analysis han-

dles the possible endogeneity problem, and the findings are

robust and significant to different empirical methodologies

and measurements.

JEL CLASSIFICATION

F1; F13; F14

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1003

TIAN ANd YU

Chinese firms have adjusted their strategies in response to the more liberalized circumstances. The

firms are more active in importing and exporting, invest more in research and development (R&D),

and are changing their importing and exporting decisions. For example, Liu and Qiu (2016) argue that

input trade liberalization hampers firm R&D in China. Tian and Yu (2016, 2017) find that Chinese

firms have increased export intensity (i.e., the ratio of exports to domestic sales) as a response to input

liberalization.

Among the various changes, the change in import sources is rarely studied, although it may have

an important impact on the map of international trade. Chinese firms that used to import a large pro-

portion of inputs from developing countries are switching to imports from developed countries. This

is happening not only because of the decline in processing trade in China, but also to meet the needs

of firm innovation and product upgrading. Many studies have documented that input tariff reduction

encourages import scope and import quality and lowers import prices, which further drives innovation

and leads to productivity and welfare gains, but the link behind this process is complicated and con-

troversial. In this paper, we shed some light on the first step of firms’ reaction to reduced input tariffs,

that is, how firms adjust their import sources and quality.

The paper shows that firms have engaged in import source switching and the importance of import

quality a Fan, Li, and Yeaple (2015). We use a matched data set of comprehensive transaction‐level

trade and firm production data to generate a firm‐level input tariff index, following Yu (2015). We fur-

ther distinguish the tariff imposed on developing country import sources. We find that, instead of pro-

moting imports from developing countries, the reduction in the tariff on developing country sources

has enhanced the shift of import sources toward developed countries. This finding suggests a strong

cost‐saving effect of input trade liberalization. We further investigate the heterogeneous impacts on

firms with different levels of productivity, and show that less productive firms are more largely in-

fluenced to switch import sources than more productive firms. This impact is also true for firms in

high‐technology industries and engaged in intensive innovation. To figure out the driving force of

the switching, we examine the impacts on different types of importers and find that most switching

has happened to new importers. This suggests that, as tariffs are reduced, more domestic firms are

stimulated to start importing high‐quality inputs from developed countries to replace domestic inputs.

An important alternative explanation for source switching might be the decline of processing trade

in China since 2005. As Brandt and Morrow (2017) argue, to some extent, this decline can be at-

tributed to the reduced input tariff, which decreases the opportunity cost of engaging in ordinary trade.

This effect is unlikely to be important here, given that the sample ends in 2006, the starting year of

the decline in import‐processing trade. We also compare capital‐intensive and labor‐intensive indus-

tries, and processing firms and capital goods‐intensive importers to exclude the effect of the decline

in import‐processing trade. We use the difference in the tariff as an instrumental variable to control

for endogeneity in the first‐difference regressions, following Trefler (2004). The switching happens

not only in the intensive margin, but also in import scope. We show that input tariff reduction leads

to greater import scope from developed countries, and this finding is robust to different measures of

import variety and different types of firms.

To verify the mechanism of quality upgrading, we first generate a quality measure, following

Khandelwal (2010), which handles the impact on market price of idiosyncratic demand shock. We

take a further step to measure the quality function separately for ordinary firms and processing firms.

The impact shows that firm profit and relative import quality from developed country origins increase

as the input tariff decreases, suggesting that firms import higher quality goods from developed coun-

tries, outpacing imports from developing countries.

This paper is linked to the emerging literatures on imported intermediate inputs, innovation, and

trade liberalization. The literature documents that imported intermediate inputs have a strong impact