## _061511

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### Executive summary — major trends and drivers
- World trade (gross exports) is almost three times the level prevailing in the 1950s.
- The expansion in trade is mostly accounted for by growth in noncommodity exports, especially high-technology products such as computers and electronics.
- The share of noncommodity trade rose to more than 20 percent of global GDP in 2008.
- Expansion characterized by:
  - the rise of emerging market economies (EMEs) as systemically important trading partners;
  - growing regional concentration of trade;
  - a shift of higher-technology exports toward dynamic EMEs.
- Drivers:
  - Multilateral and bilateral trade liberalization since the early 1950s reduced tariffs substantially (example: among major Western European and North American countries, average tariffs fell from 15 percent to 4 percent during 1952-2005).
  - Technology-led declines in transportation and communication costs enabled vertical specialization and global supply chains.
  - Income convergence and changes in factor endowments supported growth in intra-industry trade.

### Structure, regional patterns, and vulnerabilities
- Advanced economies tend to be upstream in supply chains: relatively small foreign content in their exports and large contributions toward downstream countries’ exports.
- EMEs tend to be downstream: relatively large shares of imported content in their exports and greater exposure to processing trade.
- Regional patterns:
  - Growth in trade was strongest for Europe and Asia.
  - Interregional trade remained virtually unchanged at about 12 percent of world GDP between 1980 and 2009.
  - Asia’s supply chain is more dispersed than North America or Europe; goods-in-process can cross borders several times (including a hub such as Japan), increasing vulnerability to disruptions.
  - In NAFTA and EU15, almost all foreign input is imported directly from the hub (United States in NAFTA, EU15 in Europe).
- Vertical specialization and foreign value added (FVA):
  - Foreign content embedded in gross exports almost doubled since 1970, to 33 percent in 2005.
  - Growth in vertical specialization accelerated recently, increasing by more than 20 percent in the ten-year period up to 2005.
  - China: share of imported content increased by 12 percentage points since the mid-1990s; Germany and Japan: increases of 7 percentage points; increase smaller for the United States.
  - Example measurement issue: for countries engaged heavily in assembly and processing trade (e.g., Singapore), gross exports can be more than twice as high as domestic value added (DVA) exports.

### Technology content, diffusion, and export similarity
- Technology intensity shifts:
  - High-technology and medium-high-technology exports (e.g., machinery and transport equipment) increased, while lower-technology products (e.g., textiles) declined.
  - Trade in high-technology products tends to grow faster than average and has larger spillover effects on skills and knowledge-intensive activities.
- High-technology trade and FVA:
  - Imported content of Chinese high-technology exports increased by close to 30 percentage points from the mid-1990s to the mid-2000s; by the mid-2000s China has by far the largest imported content in its high technology exports.
  - Japan and the United States make significantly less use of imported intermediates in their high-technology exports.
  - In Germany, if imports from Euro Area countries are considered part of DVA, the share of FVA in high technology exports becomes comparable to Japan and the United States (about 19 percent).
- Contributions to advanced-country export growth (1995–2005 decomposition):
  - overall, the increase in FVA contributed about 37 percent to the growth in advanced countries’ gross manufacturing exports;
  - growth in high-technology exports was almost entirely driven by growth in FVA;
  - China’s contribution to advanced countries’ manufacturing exports growth is significant and concentrated in high and medium-high technology sectors.
- Diffusion and FDI:
  - U.S. FDI generally driven by market access; Japanese FDI motivated by factor-price differentials and relative abundance of unskilled labor in Asia.
  - Labor-intensive stages move to lower-cost host countries; skilled-labor-intensive activities remain at headquarters.
- Export similarity and EXPY:
  - Export Similarity Index (ESI) shows rising overlap between EMEs and advanced economies; China’s export structure converging with advanced economies such as Germany and the United States.
  - EXPY findings: Japan consistently outperformed G-7 in increasing EXPY; EMEs’ EXPY remains below advanced countries’ levels; countries with higher-than-expected EXPYs tend to grow more subsequently (notably India, China, Thailand and many Eastern European countries).

### Systemic trade interconnectedness and policy implications
- Network analysis (DOTS, 169 jurisdictions) and composite ranking:
  - China moved from ninth place in 1999 to first in 2009 among jurisdictions with systemically important trade sectors; China and the United States are major systemically important trading hubs.
  - Almost perfect overlap between countries hosting systemically important trade centers and systemically important financial centers among the top 25 jurisdictions in 2009, with exceptions: Luxembourg and Ireland (systemic only in financial sector), Malaysia and Thailand (systemic only in trade sector).
  - Composite index combines size and interconnectedness using baseline weight splits (sensitivity tested with 0.8/0.2, 0.7/0.3, 0.6/0.4, 0.5/0.5); materiality threshold focuses on bilateral trade links ≥ 0.1 percent of a jurisdiction’s GDP.
- Policy-relevant observations:
  - Jurisdictions hosting both systemic trade and financial centers may warrant focused risk-based surveillance for bilateral, regional and global spillovers and contagion.
  - Expansion of global supply chains heightens potential cross-border spillovers from trade or financial shocks.
  - Exclusion of a key player (e.g., China) from regional FTAs could create bilateral tensions disruptive to supply-chain trade flows.

### Partial-equilibrium simulations of relative price shocks — design and key quantitative outcomes
- Modeling approach:
  - Two-stage model: partial equilibrium import-demand responses at HS2002 6-digit level (COMTRADE) using micro-level elasticities; input-output tables (STAN/OECD) adjust imports for trade-induced changes in aggregate demand.
  - Elasticity parameterization:
    - substitution elasticities scaled to mean of 2.25; resulting import-weighted mean elasticity 2.4 (with outlier capping).
    - import demand elasticities from Kee et al. scaled to mean of -1; resulting import-weighted mean elasticity -0.79.
  - Six core assumptions include Armington imperfect substitutability, isolation of each product market, and parameterization targeting long-run impacts.
- Simulation scenarios:
  - Baseline shocks: exogenous 10-percent increase in relative prices in China and a 10-percent decline in the United States; for illustration also a 10-percent relative price increase in the Euro Area and a 10-percent relative price decline in Japan; baseline year 2008.
  - Interpretation: 10-percent increase (decrease) interpreted as real appreciation (depreciation) against all trading partner currencies.
- Aggregate long-run simulated outcomes (full pass-through long-run interpretation):
  - A 10-percent depreciation for the United States would result in a 14-percent expansion in exports and a 7-percent contraction in imports.
  - Together these translate into a 40 percent improvement in the trade balance and roughly a halving of the U.S. current account deficit to GDP ratio.
  - A 10-percent real exchange appreciation for China would lead to a 50-percent reduction in its merchandise trade surplus.
- Supply-chain position matters:
  - China’s response to a 10-percent appreciation is smaller in absolute magnitude compared to Japan’s response to a 10-percent depreciation, reflecting China’s downstream position and relatively high share of foreign intermediates.
  - Japan’s larger export response is driven by upstream position and strength in consumer discretionary goods (vehicles and transport equipment) with low foreign content and high price sensitivity.
- Pass-through and adjustment speed:
  - Imperfect exchange rate pass-through and pricing-to-market substantially mitigate trade adjustment; Campa and Goldberg (2005) evidence cited: pass-through about 0.6 short-run and 0.75 long-run (U.S. import market: 0.25 short-run and 0.4 long-run).
  - High fixed costs imply gradual adjustment: on average about half of the long-run adjustment in trade balances materializes within 2 years, and 80 percent within 6 years.
- Historical perspective (DAREER and Box 7):
  - Peak-to-trough (two-year averages) shows U.S. trade balance improved (deteriorated) by 0.17 percent of GDP for every percentage point depreciation (appreciation) of the DAREER.
  - This historical estimate aligns with simulation suggesting a 1.4 percentage point of GDP improvement in the U.S. trade balance for a 10 percent real depreciation (assuming partial pass-through).

### Alternative simulation — appreciation within the Asian supply chain (Box 8)
- Scenario: 10 percent appreciation in the Chinese nominal exchange rate and concurrent 5 percent appreciation of nominal exchange rates of countries in the Asian supply chain.
- Key impacts:
  - Imported intermediates from upstream partners become more expensive, making Chinese processing-trade exports more expensive and contributing to lower exports.
  - Exports to Asian supply chain countries decline less than in the baseline; Asian supply chain remains an amplified destination for Chinese exports.
  - Exports of high-technology goods decline the least, increasing their share in total exports (especially machinery and electronics).
  - Aggregate rebalancing: alternative simulation suggests a 3.6 percentage point fall in the Chinese current account surplus (compared to 3.8 percent in the baseline).
  - Exports to Euro Area countries fall by 12.4 percent instead of 12 percent in the baseline; impacts on Chinese exports to Japan and the United States similar to the baseline.

### Supply-chain disruptions — empirical case: March 11, 2011 Pacific earthquake in Japan
- Japan’s role and observed impacts:
  - Japan is upstream in the Asian supply chain and a significant source of intermediates for Asia, the United States, and the European Union.
  - Following the earthquake: exports plunged in April and Japan recorded a trade deficit for the month for the first time in 31 years.
  - Sectoral variation: vehicle exports hit particularly hard relative to machinery; final goods (cars) declined more than intermediates (parts and accessories).
  - Equity and industry responses: semiconductor firms saw initial equity return impacts that did not persist for all firms; automobile manufacturers scaled back production globally and competitors expected to substitute production.
- Resilience and risks:
  - Short-run substitution harder in sub-sectors where Japanese exporters have high market share or where patent protections limit substitution.
  - Inventory buildups provided some cushion possibly until 2011:Q3; prolonged disruption could force re-sourcing and rethinking of just-in-time production.

### Policy implications and recommendations
- Surveillance and risk management:
  - Jurisdictions hosting both systemic trade and financial centers should be a focus for risk-based bilateral, regional, and global surveillance of spillovers and contagion.
- Protecting supply-chain trade flows:
  - Binding unilateral regional tariff cuts under the Doha Round to safeguard regional liberalization.
  - Including all key players (notably China) in regional FTAs such as the Trans-Pacific Partnership (TPP) to reduce the risk of disruptive exclusion.
- Increasing resilience and upgrading:
  - Create environments enabling firms to undertake quality upgrading of products.
  - Provide a reliable macroeconomic environment and lower costs of doing business and of establishing trade relationships to help firms withstand unfavorable exchange rate movements.
  - Recognize heterogeneous effects of exchange-rate and relative-price movements across countries depending on upstream/downstream supply-chain positions and sectoral technology composition.

### Methodology summary — systemic trade assessment and modeling data
- Systemic trade interconnectedness methodology (Appendix I):
  - Two-stage approach: separate ordinal rankings for size (four indicators: total exports X; total imports M; total turnover X+M; turnover relative to nominal GDP) and interconnectedness (four network centrality measures: In-Degree, Closeness, Betweenness, Prestige/eigenvector), median ranks aggregated, composite index combining size/interconnectedness with tested weight splits (0.8/0.2 to 0.5/0.5); materiality threshold bilateral links ≥ 0.1 percent of jurisdiction’s GDP.
  - Core data: IMF Direction of Trade Statistics (DOTS) covering 169 jurisdictions representing almost 100 percent of total world trade in both 1999 and 2009.
- Trade-response modeling (Appendix V):
  - Two-stage modeling: Stage 1 partial equilibrium import-demand responses at HS2002 6-digit level using COMTRADE; Stage 2 input-output (STAN/OECD) adjustment for changes in aggregate demand and imports of intermediates and final goods.
  - Key numerical examples preserved: e.g., a 10 percent exchange rate depreciation leads to a 5 percent fall in export prices in a sector with 50 percent domestic content; a 10 percent depreciation leads to an 8 percent fall when domestic content is 80 percent.
  - Elasticity parameterization and data curation steps (capping outliers, filling missing values, scaling to target means) explicitly applied to produce empirically grounded sector- and product-level elasticities.

*Source: _061511 (Executive Summary; Sections 6, 18, 32; Box 7; Appendix I; Appendix V) — IMF PDF chapter/section.*

### Executive Summary ......................................................................................................

### Executive Summary

### Major trends in global trade
- World trade (gross exports) is almost three times the level prevailing in the 1950s.
- The expansion in trade is mostly accounted for by growth in noncommodity exports, especially high-technology products such as computers and electronics.
- The share of noncommodity trade rose to more than 20 percent of global GDP in 2008.
- The expansion in trade is characterized by:
  - the rise of emerging market economies (EMEs) as systemically important trading partners;
  - growing regional concentration of trade; and
  - a shift of higher-technology exports toward dynamic EMEs.

### Drivers of the expansion
- Multilateral and bilateral trade liberalization since the early 1950s led to significantly lower trade barriers in advanced economies and more recently in developing countries.
- Technology-led declines in transportation and communication costs facilitated fragmentation of production stages across borders (vertical specialization), enabling regional and global supply chains.
- Income convergence and changes in factor endowments supported growth in trade relative to output, including intra-industry trade.

### Structure and roles in global supply chains
- Advanced economies tend to be upstream in supply chains:
  - Relatively small foreign content in their exports.
  - Relatively large contributions toward downstream countries’ exports.
- EMEs tend to be downstream:
  - Relatively large shares of imported content in their exports.
- The differing positions imply contrasting sensitivities of trade patterns to relative price changes.

### Regional patterns and vulnerabilities
- The Asian supply chain is more dispersed than those in North America or Europe:
  - Goods-in-process cross borders several times, including through the hub (Japan), before final destination.
  - In North America and Europe, almost all foreign input is imported directly from the hub—the United States in NAFTA and EU15 in Europe.
  - Greater dispersion in Asia renders it potentially more vulnerable to trade-flow disruptions (policy-induced or natural), for example the Pacific earthquake in Japan.

### Technology content and export similarity
- EMEs have increased the technology content of their exports and contribute imported inputs embedded in advanced-country high-technology exports.
- China’s share of high-technology exports increased remarkably since 1995, boosted by processing trade with significant imported contributions from Japan and other Asian countries.
- China is moving upstream in the value added chain; imports from China contribute significantly to advanced countries’ high-technology exports.
- As EMEs enter sectors traditionally dominated by advanced economies, export-structure similarity has increased and competitive pressure has risen.

### Trade interconnectedness and systemic importance
- Network-based analysis shows emergence of China, along with the United States, as major systemically important trading hubs, reflecting both trade size and the number of significant trading partners.
- There is almost a perfect overlap between countries hosting systemically important trade centers and systemically important financial centers.
- These countries could be a natural focus for risk-based surveillance on cross-border spillovers and contagion.

### Implications of relative price changes (partial equilibrium findings)
- The paper analyzes impacts of relative price changes for four systemically important trading partners: China (downstream), Euro Area, Japan, and the United States (upstream).
- Downstream position cushions the impact of relative price changes on exports and imports because higher foreign content in downstream exports mitigates exchange rate effects.
- Sectoral responses differ by country:
  - An appreciation induces an increase in the share of high-technology exports in China and (to a lesser extent) the Euro Area.
  - A depreciation results in an increase in the share of medium-high technology exports in Japan and the United States, largely driven by changes in the auto sector.
- Adjustment in the trade balance occurs mainly outside of the supply chain; exports to supply-chain partners are more resilient to relative price changes.

### Policy-relevant observations
- The expansion of global supply chains and growing trade interconnectedness heighten potential cross-border spillovers from trade or financial shocks.
- Countries that host both systemically important trade and financial centers may warrant focused risk-based surveillance.
- The differing positions of countries in global supply chains imply that exchange rate movements and other relative price changes will have heterogeneous sectoral and balance-adjustment effects, which policymakers should account for in trade and macro policy design.

*Source: Executive Summary of IMF paper (pages provided).*

### 6.      Growth in trade was strongest for Europe

### _061511 - 6.      Growth in trade was strongest for Europe

### Regional patterns and concentration
- Growth in trade was strongest for Europe and Asia.
- Interregional trade remained virtually unchanged at about 12 percent of world GDP between 1980 and 2009.
- Growth in intraregional trade was particularly strong in Europe and Asia.
- Europe retained centrality in the global trade network mainly through interconnectedness rather than size; Asia’s prominence reflected size more than centrality.

### Structural change in traded goods and technology intensity
- The structure of trade shifted toward a rising share of higher-technology goods.
- High-technology and medium-high-technology exports (e.g., machinery and transport equipment) increased, while lower-technology products (e.g., textiles) declined.
- Trade in high-technology products tends to grow faster than average and has larger spillover effects on skills and knowledge-intensive activities.
- Technological absorption is “capability” driven and depends on national ability to harness and adapt technologies; country-specific policies for technology learning and technology import, including those aimed at attracting FDI, can create comparative advantage.

### Drivers of changing trade patterns
- Trade liberalization:
  - Among major Western European and North American countries, average tariffs fell from 15 percent to 4 percent during 1952-2005, with the bulk of the decline occurring during the 1950s and 1960s.
  - Tariffs in many major developing countries remained high until the 1980s but have since come down sharply.
- Increase in vertical specialization:
  - Foreign content embedded in gross exports (foreign value-added, FVA) almost doubled since 1970, to 33 percent in 2005.
  - Growth in vertical specialization accelerated recently, increasing by more than 20 percent in the ten-year period up to 2005.
- Convergence in income levels:
  - As countries converged in income and factor endowments, trade-to-GDP increased and took the form of intraindustry trade (e.g., machinery, chemicals, manufactures).
  - Countries integrated in supply chains that experienced higher changes in intraindustry trade between 1985 and 2009 include China, Thailand, and Mexico.

### Measurement issues: gross exports vs domestic value added
- Official trade statistics are measured in gross terms and include intermediate inputs and final goods.
- Rising import content in exports means gross exports can substantially overstate domestic value-added exports.
- Example: for countries engaged heavily in assembly and processing trade (e.g., Singapore), gross exports can be more than twice as high as domestic value added (DVA) exports.

### Growing trade interconnectedness and systemic importance
- Trade interconnectedness increased cross-border transmission of shocks through the trade channel.
- Network analysis findings:
  - China moved from ninth place in 1999 to first in 2009 among jurisdictions with systemically important trade sectors.
  - China emerged as a major systemically important trading center along with the United States, increasing both size and the number of significant trading partners.
  - China surpassed Japan as a more significant regional and global consumer; Chinese real household consumption more than doubled and gross fixed capital formation increased nearly five-fold over the decade to 2009.
  - European countries remained central in the global trade network owing to interconnectedness.
- There is strong overlap between jurisdictions with systemic trade sectors and those with systemic financial sectors: an almost perfect overlap among the top 25 jurisdictions in 2009, with exceptions:
  - Luxembourg and Ireland: systemic importance limited only to the financial sector.
  - Malaysia and Thailand: systemic importance limited only to the trade sector.
- Jurisdictions hosting both systemic trade and financial sectors warrant focused risk-based surveillance for cross-border spillovers and contagion.

### Methodology notes on systemic trade assessment (key parameters)
- Analysis used IMF’s Direction of Trade Statistics (DOTS) merchandise flows.
- 169 jurisdictions representing almost 100 percent of total world trade in both 1999 and 2009 were considered.
- A two-stage process produced separate ordinal rankings for size and interconnectedness using four indicators each; indicators combined into single size and interconnectedness indicators.
- A composite index combined size and interconnectedness indicators using a 0.7/0.3 weight split (size/interconnectedness).
- A materiality threshold focused on bilateral trade relationships representing 0.1 percent or more of a jurisdiction’s GDP.

### Global supply chains and vertical specialization (regional features and roles)
- Vertical specialization increased since the mid-1990s:
  - China: share of imported content increased by 12 percentage points.
  - Germany and Japan: share of imported content increased by 7 percentage points.
  - The increase in imported content was smaller for the United States.
- Among advanced economies, the United States has the lowest share of foreign content in gross exports (noting that treating foreign content from the Euro Area as DVA reduces Germany’s foreign content estimates).
- Regional concentration:
  - China’s exports have high FVA content from Asia; more than half of FVA in China’s exports is from the region including other East Asian (OEA) economies.
  - In Germany, most FVA is from other EU countries, including EU accession countries; about 70 percent of FVA in exports of EU accession countries is from advanced Euro Area countries, Russia, or EFTA countries.
- Advanced economies tend to be upstream in supply chains; EMEs tend to be downstream:
  - EMEs have relatively large imported contents in their exports and a smaller share of indirect exports sent to third countries.
  - The ratio of imported content to indirect exports summarizes a country’s position, confirming the downstream position of EMEs.
- Processing trade and downstream roles:
  - Many EMEs’ exports rely on lower value-added assembly using imported intermediates (processing trade).
  - China and many Asian EMEs act as downstream hubs; Mexico plays a similar role through duty-free assembly plants serving the United States.
- Regional supply chain distinctions:
  - Asia’s supply chain spans several countries with goods-in-process crossing borders multiple times (including through a hub such as Japan).
    - Example: about 15 percent of Japanese value added embodied in Chinese products goes through other countries in Asia before reaching China (6.8 percent through direct imports of intermediates from Japan and 1.2 percent via regional inputs containing Japanese value added).
  - NAFTA and Europe: almost all FVA is imported directly from the hub (United States in NAFTA, EU15 in Europe).
  - A significant amount of U.S. value added (and EU15’s value added to a lesser extent) returns home after further processing abroad; this is less the case for Japan.
  - Processing trade in Asia relies heavily on the region as a whole.

### “Factory Asia” and regional dynamics
- East Asia’s “Factory Asia” emerged after mid-1980s liberalization and successive relocation of assembly operations from Japan to NIEs, then to China and ASEAN.
- Successive relocations enabled NIEs, China, and ASEAN countries to upgrade industrial capacity and contribute to a “recycling of comparative advantage.”
- Factory Asia developed largely via unilateral tariff-cutting rather than deep regionalism; regionalism in East Asia began in earnest only around 2000 with China–ASEAN FTA interest.
- The development of regional FTAs (ASEAN-Japan, Korea-ASEAN, Japan-Korea) followed ACFTA and may pose potential sources of tension given limited WTO discipline or top-level regional management.

*Source: _061511 - 6.      Growth in trade was strongest for Europe (PDF chapter/section).*

### 18.      The role of global supply chains for trade in high technology goods has increased

### 18.      The role of global supply chains for trade in high technology goods has increased

### Imported content in high-technology exports — trends and country differences
- The share of imported content in exports of high technology goods has increased for China, Japan, the United States, and the European advanced economies since the mid-1990s.
- Imported content of Chinese high-technology exports increased by close to 30 percentage points from the mid-1990s to the mid-2000s.
- By the mid-2000s, China has by far the largest imported content in its high technology exports.
- Japan and the United States make significantly less use of imported intermediates in their production of high technology exports.
- In Germany, if imports from Euro Area countries are considered part of DVA, the share of FVA in high technology exports becomes comparable to that of Japan and the United States (about 19 percent).
- Exports of low technology sectors have the lowest imported content in all countries; for countries other than China, the share of imported contents is also high in exports of medium technology sectors.

### Global supply-chain roles and contributions to advanced-country export growth
- China’s exports of intermediate products in the high technology sector increasingly contribute to advanced countries’ high technology exports.
- China and other Asian countries increasingly play a dual role: assembly country and exporter of intermediate inputs to other countries’ high technology exports.
- Decomposition results for Germany, Japan, and the United States (1995–2005) highlight three results:
  - (i) overall, the increase in FVA contributed about 37 percent to the growth in advanced countries’ gross manufacturing exports between 1995 and 2005;
  - (ii) growth in high technology exports was almost entirely driven by growth in FVA;
  - (iii) China’s contribution to advanced countries’ manufacturing exports growth is significant and concentrated in high and medium-high technology sectors.
- This suggests China may be rapidly catching up in terms of contribution to advanced countries’ exports of high-technology goods.

### Services, regional dispersion, and policy implications
- Imports of services contribute about 12 percent of the contribution of FVA in advanced countries’ manufacturing exports in 2005.
- Greater regional dispersion in the Asian supply chain implies that disruptions in intraregional trade flows could have large negative spillover effects on domestic production in partner countries.
- Policy recommendations to protect supply-chain trade flows:
  - Binding the region’s unilateral tariff cuts under the Doha Round.
  - Including all the key players in regional FTAs such as the Trans-Pacific Partnership (TPP).
- Warning: An exclusion of a key player such as China in regional FTAs could create bilateral tensions potentially disruptive to supply-chain trade flows.

### Diffusion of high-technology exporters and role of FDI
- Between 1995 and 2008, the contribution of high-technology exports to overall export growth was:
  - more than 30 percent for China,
  - 26 percent for the United States,
  - 17 percent for Germany,
  - 11 percent for Japan.
- Adjusting exports to exclude foreign content (showing domestic value added, DVA) changes the contributions:
  - China: 24 percent,
  - United States: 29 percent,
  - Germany: 20 percent.
- Mexico’s contribution of high-technology exports increases when only DVA is considered, suggesting broader upgrading of its export basket.
- FDI helps diffuse technology across global supply chains:
  - U.S. FDI generally driven by market access considerations.
  - Japanese FDI motivated by factor-price differentials and relative abundance of unskilled labor in Asia.
  - Labor-intensive stages (e.g., final assembly) move to lower-cost host countries; activities intensive in skilled labor (marketing, patenting, innovation) remain at headquarters.
- Japan retained production stages with the highest value added despite outsourcing lower-value stages.

### Upgrading in EMEs and LICs; determinants of export upgrading
- Factors enabling EMEs to upgrade technology content of exports: geographical proximity to advanced countries, existence of an educated workforce, favorable business environment.
- Countries gaining most in high-technology exports over the last decade tended to have intermediate development and some presence in high-technology exports in 1995 (examples: China, Thailand, Malaysia; Poland, the Czech Republic, Turkey).
- Low-income countries (LICs) have also seen upgrades in technology content of their exports, from a very low level:
  - Share of medium-high and high technology products in non-oil exports increased from about 3-4 percent in 1995 to about 7 percent in African LICs and 12-16 percent for LICs in Asia and Middle East and Central Europe in 2008.
- Destinations for LIC medium-high and high technology exports include EMEs (e.g., China, Thailand, Singapore) and advanced economies (more for lower-technology products, but increases to Japan for Asian LICs and to the United States for LICs in the Western Hemisphere suggest greater regional integration).

### Rising export similarity, quality differentiation, and EXPY
- Export similarity between EMEs and advanced economies has increased, partly reflecting global supply chains.
- Export Similarity Index (ESI) observations:
  - Japan competes most with Korea, the United States, and European countries.
  - The U.S. export structure continues to be similar to other advanced economies.
  - China has traditionally competed with other Asian countries; its export structure has been converging with advanced economies such as Germany and the United States.
- Rising export similarity can reflect complementarity (outsourcing and upstream/downstream roles) as well as competition.
  - Example: Japanese machinery increasingly assembled in China, appearing as increased Japanese exports to Asia and higher Chinese exports to the United States.
  - In Europe, technological intensity has shifted from Western to Eastern Europe (Poland, Hungary, Czech).
  - In North America, the United States has outsourced some high-technology activities to NAFTA partners, especially Mexico, and to Central America.
- Quality and price differentiation remain important and are not fully captured by gross export similarity measures.
  - Modified ESI distinguishing products by destination market (five destination markets by World Bank income classification) shows persistent increase in overlap (China, Vietnam, Indonesia, Poland, Turkey) but to a lesser extent than unadjusted ESI.
- EXPY (income level embodied in a country’s exports) findings:
  - Japan has consistently outperformed G-7 countries in increasing the value of its exports (EXPY).
  - Despite catch-up, EMEs’ EXPY remains below advanced countries’ levels; EMEs exports skewed towards lower-income product categories, including China.
  - Countries with higher-than-expected EXPYs tend to grow more in subsequent years, implying a potential growth push for certain EMEs (most pronounced for India, China, Thailand; positive for most Eastern European countries).

### Past trends and implications for the trade outlook
- Integration of rapidly growing EMEs is likely to induce a gradual shift in sources of global demand away from advanced economies.
- With China overtaking Japan as the second largest economy in the world already in 2010, East Asian countries are likely to emerge as the largest trading bloc by 2015, surpassing NAFTA and the Euro Area.
- A country’s position along global supply chains could have important implications for future trading patterns.

*Source: _061511 - 18.      The role of global supply chains for trade in high technology goods has increased*

### 32.      The emergence of global supply chains may have also changed the way trade

### 32.      The emergence of global supply chains may have also changed the way trade

### Impact of global supply chains on trade responsiveness
- Higher imported content in exports is likely to lower the sensitivity of trade to changes in the exchange rate because imported intermediates become cheaper when the domestic currency appreciates.
- The mitigating effect is lower if the currencies of partner countries that provide imported intermediates also appreciate (see Ahmed 2009 and Thorbecke, 2011).
- Advanced countries whose exports tend to be concentrated in medium-high technology goods are therefore likely to be more sensitive to relative price changes because of higher DVA, whereas those of EMEs are likely to be less sensitive given higher FVA in their exports.
- Global supply chains may result in closer relationships between producers in different countries and higher adjustment costs, which can:
  - further dampen the impact of (small) relative price changes on trade flows, and
  - represent a source of vulnerability to upstream production disruptions.

### Supply-chain disruption case: Pacific earthquake in Japan (Box 6)
- Event and focus:
  - The March 11, 2011 Pacific earthquake in Japan tests the resilience of the Asian supply chain, with emphasis on the semiconductor and automobile industries.
- Japan’s role in regional and global trade:
  - Japan’s intraregional exports as a share of global GDP has remained remarkably stable and accounts for more than two-thirds of industrial countries’ intra-regional trade.
  - Japanese exports to the region accounted for almost 60 percent of overall exports in 2010, mostly concentrated in machinery, chemicals, and transport equipment.
  - Japan accounts for a significant share of global exports in the semiconductor and auto subsectors and is an important source of intermediates for Asia, the United States, and the European Union.
- Upstream position and foreign value added (FVA):
  - Japan is upstream in the Asian supply chain; foreign content in gross exports of many Asian countries is relatively high (more than 80 percent in electronic equipment in Singapore).
  - A significant proportion of FVA in those exports comes from Japan, especially for Hong Kong and China (electronic equipment), and Thailand and Taiwan (motor vehicles).
- Observed impacts following the earthquake:
  - Exports plunged in April and for the first time in 31 years Japan recorded a trade deficit for the month.
  - Variation in impact across sectors: exports of vehicles hit particularly hard compared to machinery; exports to the United States are harder hit compared to China.
  - Within vehicles, decline most pronounced for final goods (cars subsector) versus intermediates (parts and accessories subsector).
- Industry and market responses:
  - Equity prices and supply projections suggest overall impact along the supply chain is likely to be short-lived, though affected Japanese firms’ returns remain significantly below expectations.
  - Staff micro analysis suggests an initial impact on semiconductor firms’ equity returns; effects did not persist for all firms within the ensuing month, partly reflecting previous buildup in global semiconductor inventory which may provide some cushion possibly until 2011:Q3.
  - In the automobile sector, Japanese MCU manufacturers experienced significantly negative ARs since March; manufacturers have scaled back production globally and competitors are expected to substitute for lost production.
- Transitory nature and risks:
  - Short-run substitution may be harder in sub-sectors where Japanese exporters have a high market share.
  - Firms may tolerate losses while Japanese production recovers, via inventory adjustment or temporary shutdowns.
  - Exports of sophisticated sub-products may be protected by patent rights, making substitution difficult in the short run.
  - If disruption persists and inventories run out, firms may be forced to replace Japanese exports from other sources.

### Modeling approach: sectoral elasticities and supply-chain adjustments
- Framework and data:
  - A highly disaggregated sectoral level approach combines a partial equilibrium model with input-output table analysis.
  - Data on imports at the 6-digit level is used for the full set of 162 countries available in COMTRADE.
  - The model uses micro-level trade elasticities (demand elasticity: HS 6-digit; substitution elasticity: HS 2-digit).
- Two-step modeling of a hypothetical change in relative prices:
  1. Import market demand responses and shifts in trade structure at the product level, reflecting import demand and substitution elasticities and the amount of imported intermediate inputs used in exports.
  2. Use of input-output tables to determine changes in the composition of import demand resulting from shifts in the structure of exports.
- Advantages and limitations:
  - Advantages: avoids aggregation bias of CGE models; allows high product detail; simple and transparent to adjust key parameters including effects of global supply chains.
  - Limitations: each product modeled in isolation; inter- and intrasectoral linkages and economy-wide impacts are not fully captured.

### Simulation design and assumptions
- Focus countries and shocks:
  - Simulations focus on China and the United States, assuming an exogenous 10-percent increase in relative prices in China and a 10-percent decline in the United States.
  - For illustration, also assume a 10-percent relative price increase in the Euro Area and a 10-percent relative price decline in Japan.
  - The baseline for the analysis is 2008.
- Interpretation:
  - The 10-percent increase (decrease) in relative prices can be interpreted as a real appreciation (depreciation) against all trading partner currencies.
  - These directions are consistent with policy recommendations to reduce global imbalances through a lower current account surplus in China and deficit in the United States.

### Aggregate simulation results and dynamics
- Key long-run simulated outcomes (assuming full pass-through in the long-run):
  - A 10-percent depreciation for the United States would result in a 14-percent expansion in exports and a 7-percent contraction in imports.
  - Together these translate into a 40 percent improvement in the trade balance and roughly a halving of the U.S. current account deficit to GDP ratio.
  - A 10-percent real exchange appreciation for China would lead to a 50-percent reduction in its merchandise trade surplus.
- Supply-chain position matters:
  - China’s response to a 10-percent exchange rate appreciation is smaller in absolute magnitude compared to Japan’s response to a 10-percent depreciation, reflecting China’s downstream position and relatively high share of foreign intermediates.
  - Japan’s larger export response is driven by its upstream position and strength in consumer discretionary goods (vehicles and transport equipment) with low foreign content and high price sensitivity.
- Pass-through and pricing-to-market effects:
  - Imperfect exchange rate pass-through and pricing-to-market are likely to mitigate adjustment in trade flows; accounting for less than perfect pass-through reduces exchange rate impact on both exports and imports significantly.
  - Pass-through evidence: Campa and Goldberg (2005) estimate exchange rate pass-through to be about 0.6 in the short run and 0.75 in the long-run, with the U.S. import market showing pass-through of 0.25 in the short run and 0.4 in the long-run.
- Adjustment speed and fixed costs:
  - High fixed production and trading relationship costs imply gradual adjustment.
  - On average, about half of the long-run adjustment in trade balances would materialize within the first 2 years, and 80 percent within 6 years.
  - Adjustment paths for external balances are derived using short-run to long-run elasticity ratios in the literature that vary between 2 and 5.

### Historical perspective on exchange rate changes and trade flows (Box 7)
- Dynamic adjustment:
  - A dynamically adjusted REER (DAREER) accounts for gradual realization of trade-flow impacts from real exchange rate changes.
  - Following Goldstein and Khan (1985) and Senhadji and Montenegro (1999), a midpoint ratio of 3 between long-run and short-run impacts is used: a third of the impact of a 10-percent change in the REER would manifest in the first year, with the remaining impact unfolding asymptotically.
- Historical confirmation:
  - For the United States, swings of 10 percent or more in the DAREER were relatively infrequent; the DAREER exhibited only two long waves of appreciation and depreciation since the 1980s, with attendant worsening and improvement in trade and current account balances.
  - The DAREER has historically been less volatile compared to the unadjusted REER.

*Source: Excerpt from IMF chapter on global supply chains, supply disruptions, and sectoral elasticities approach.*

### Box 7: Impact of Exchange Rate Changes and Trade Flows—A Historical Perspective

### Box 7: Impact of Exchange Rate Changes and Trade Flows—A Historical Perspective

### Historical response of external balances
- Peak-to-trough analysis (two-year averages) shows the trade balance improved (deteriorated) by 0.17 percent of GDP for every percentage point depreciation (appreciation) of the DAREER in the United States.
- This historical estimate is close to simulation results suggesting a 1.4 percentage point of GDP improvement in the U.S. trade balance in response to a 10 percent real depreciation (assuming partial pass-through).

### Sectoral effects and technology composition
- Appreciation effects on export composition:
  - China: appreciation increases the share of high-technology exports (machinery and electronics) and reduces the share of textiles (low-technology), reflecting limited price sensitivity of high-technology goods and larger contribution of imported intermediate inputs.
  - Euro Area: a more muted increase in high-technology export share due to a lower contribution of foreign value added (FVA) in high-technology exports.
- Depreciation effects:
  - Japan and the United States see important shifts in the share of medium-high-technology exports, largely driven by the auto sector.
  - Japan: transport sector accounted for 23 percent of overall exports in 2008; depreciation would reinforce Japan’s comparative advantage in medium-high-technology exports, with motor vehicles specialization potentially exceeding that of France, Germany, and Spain.
  - United States: response is more muted given higher FVA in its auto sector (26 percent in the United States versus 13 percent in Japan).

### Box 8 — Alternative simulation: appreciation within the Asian supply chain
- Scenario parameters:
  - 10 percent appreciation in the Chinese nominal exchange rate and a concurrent 5 percent appreciation of the nominal exchange rates of countries in the Asian supply chain.
- Aggregate and trade impacts:
  - Additional effects on Chinese exports:
    - Imported intermediate inputs from upstream partners become more expensive, making Chinese processing-trade exports more expensive and contributing to lower exports.
    - Chinese exports to Asian supply chain countries become relatively less expensive, so exports to these countries decline less.
    - Higher import prices from Asian supply chain countries lower overall imports in third markets through the income effect, leading to a larger decline in Chinese exports to third markets, while substitution between importing countries results in a smaller decline in exports from China.
  - Supply chain composition:
    - Exports to Asian supply chain countries decline substantially less than in the baseline; Asian supply chain remains an amplified destination for Chinese exports.
    - Despite higher export prices, the decline in Chinese exports to the rest of the world (including Japan) is not significantly higher compared to the baseline.
  - Sectoral composition:
    - Alternative simulation does not fundamentally change the upgrading in Chinese exports; exports of high-technology goods decline the least, increasing their share in total exports (especially machinery and electronics).
  - Aggregate rebalancing:
    - The alternative simulation suggests a 3.6 percentage point fall in the Chinese current account surplus (compared to 3.8 percent in the baseline).
    - Exports to Euro Area countries fall by 12.4 percent instead of 12 percent in the baseline; impacts on Chinese exports to Japan and the United States are similar to the baseline.

### Supply chain effects on imports and trade balance adjustment
- Import responses to relative price changes:
  - China: intermediate goods imports fall by more than 6 percent in response to appreciation, reflecting overall export decline and downstream position in the Asian supply chain.
  - Japan: a depreciation of the yen would lead to an increase of more than 3 percent in Japan’s intermediate goods imports, reflecting significant export expansion.
  - United States: a depreciation of the dollar would lead to a drop in imports of intermediates because exports would not react as much as in Japan.
  - Euro Area: assumed appreciation of the euro would result in a net increase in imports of intermediates because exports do not react as much as in China or Japan.
- Resilience and vulnerability within supply chains:
  - Exports to supply chain partners are affected less by relative price shocks than exports to other destinations.
  - Supply chain partners, however, can be more strongly affected when they export a high share of intermediates to the hub country: a large exchange rate shift causes significant responses in both exports and intermediate goods imports used in production.
- Trade balance adjustment:
  - In response to an appreciation, exports to supply chain partners fall by less than exports to the rest of the world, and imports from supply chain countries increase less than imports from the rest of the world.
  - Trade balance adjustment in response to relative price changes is weaker within the supply chain than outside it.

### Conclusion and policy implications (key findings)
- Structural shifts and systemic players:
  - Global trade has become more interconnected with diffusion of key systemic players; China is now on par with the United States in systemic importance for trade and bilateral relations.
- Correlation of trade and financial interconnectedness:
  - High overlap between countries hosting systemically important trade and financial sectors implies heightened potential for cross-border spillovers via trade and financial channels.
- Sensitivity to relative prices:
  - Changes in relative prices produce substantial trade flow responses in Japan, the Euro Area, and the United States, and less so in China due to China’s downstream production position and higher imported intermediates content.
  - Rebalancing effects in China are larger when other supply chain countries also appreciate.
- Persistence of trade networks:
  - Real exchange rate shifts of the magnitudes considered would not substantially reorganize trading networks and production chains; sectoral impacts are asymmetric but not large enough to significantly alter sectoral export shares.
- Quality upgrading and convergence:
  - Appreciation can increase a country’s share of high-technology exports and encourage intra-product quality upgrading, supporting convergence in product types and quality levels.
- Vulnerability of integrated supply chains:
  - Greater regional integration in Asia makes the region more vulnerable to country- or product-specific disruptions; protecting free flow of inputs and outputs should be a priority.
  - Policy measures suggested include binding regional tariff cuts in the WTO by concluding Doha or including all key players in regional FTAs such as the Trans-Pacific Partnership (TPP); exclusion of a key player like China could undermine the free flow of goods in the Asian supply chain.
- Short-run resilience and shocks:
  - The 2011 earthquake in Japan tests supply chain resilience; short-run substitution away from Japanese suppliers may be difficult given Japan’s dominant upstream position and potential patent constraints, though prolonged disruption and inventory rundown may force sourcing changes and rethinking of “just-in-time” production.
- Policy recommendations to increase resilience:
  - Create environments enabling firms to undertake quality upgrading of products.
  - Provide a reliable macroeconomic environment and lower costs of doing business and of establishing trade relationships to help firms withstand unfavorable exchange rate movements.

*Source: Box 7, "Impact of Exchange Rate Changes and Trade Flows—A Historical Perspective" (PDF chapter).*

### Appendix I: A Methodology for Assessing Systemic Trade Interconnectedness

### Appendix I: A Methodology for Assessing Systemic Trade Interconnectedness

### Overview
- Purpose: Develop a methodology for assessing systemic trade interconnectedness by defining “systemic” trade sectors and identifying the jurisdictions hosting them.
- Rationale: Complements financial interconnectedness analysis to provide a holistic view of potential spillovers and contagion at bilateral, regional, and global levels.
- Core data source: IMF’s Direction of Trade Statistics (DOTS) database (regularly updated by the IMF’s Statistics Department (STA)).

### Methodology — two-stage approach
- Two stages:
  - First stage: Jurisdictions ranked based on trade size and interconnectedness indicators.
  - Second stage: Rankings of trade size and interconnectedness combined into a composite index of systemic trade importance.

### First stage — Size indicators
- Four trade size indicators (nominal U.S. dollars unless otherwise stated):
  - (i) total exports (X);
  - (ii) total imports (M);
  - (iii) total turnover (X+M);
  - (iv) total turnover relative to nominal GDP (in U.S. dollars).
- Aggregation into single size ranking:
  - Rank all jurisdictions separately on each of the four indicators.
  - Take the median rank of the four indicators for each jurisdiction as the single ranking for trade size.

### First stage — Interconnectedness indicators
- Network construction:
  - Global trade network defined as a set of bilateral trade relationships (links) among jurisdictions (nodes).
  - A materiality threshold excludes trade links representing less than 0.1 percent of a jurisdiction’s GDP.
  - Network matrix Aij: value of total turnover between jurisdiction i and jurisdiction j; diagonal elements are zero; off-diagonal elements zero where no link exists.
  - Indicator Nij = 1 if Aij > 0, and 0 otherwise.
  - Because exports and imports are both considered the network is “undirected”; binary Nij makes it “un-weighted”.
- Four centrality measures used to infer “centrality” of a jurisdiction’s trade sector:
  - (i) In-Degree: number of links that point to a node; given by the sum ∑j Nji.
  - (ii) Closeness: inverse of the average distance from node i to all other nodes; distance δij equals the shortest path; average distance = ∑jδij/(n-1); closeness is inverse of this measure.
  - (iii) Betweenness: based on shortest paths passing through node i. Let gjk denote number of shortest paths between j and k, and gjk(i) denote number that go through i. Probability node i is on shortest path from j to k is gjk(i)/gjk. Betweenness of node i is (∑j≠i∑k≠i gjk(i)/gjk)/(n-1)(n-2).
  - (iv) Prestige (eigenvector centrality): considers identity of counterparties. Prestige vi of jurisdiction i satisfies vi = ∑j Rji vj, i.e., v = R'v; solution is eigenvector associated with the unit eigenvalue.
- Aggregation into single interconnectedness ranking:
  - Rank all jurisdictions separately on each of the four interconnectedness indicators.
  - Take the median of the four rankings as the single ranking for trade interconnectedness.

### Second stage — Composite index and sensitivity
- Composite index:
  - Combine rankings of size and interconnectedness into a weighted average “baseline” index to assess systemic trade importance.
- Sensitivity analysis:
  - Weight combinations tested: 0.8/0.2 (0.8 for size and 0.2 for interconnectedness), 0.7/0.3, 0.6/0.4, and 0.5/0.5.
  - Finding: while weight changes affect some individual country ratings at the margin, they do not introduce significant changes in the listing of jurisdictions in the upper echelons of the ranking.

### Data sources and scope
- DOTS (IMF) for global bilateral trade links—uniform coverage for entire Fund membership.
- STA updating enables dynamic analysis and recalibration.
- For global supply chain measures and foreign value added (FVA) decomposition: STAN/OECD input-output tables (36 emerging and advanced countries).
- For further decomposition of FVA by source country for Japan, China, the United States, and Germany: bilateral sectoral trade data from COMTRADE (no bilateral services data; foreign services included as a separate imported input).

### Measures used to characterize global supply chains (summary)
- Vertical specialization (VS) / foreign value added (FVA) share of gross exports:
  - Computed following Hummels and others (2001) using input-output framework: imported input coefficients matrix, Leontief matrix, gross exports vector, and total exports.
  - FVA shares computed for 36 countries using STAN/OECD input-output tables.
  - Imported intermediates include imported intermediates used directly in output and those used to produce domestic intermediate inputs; include inputs from agriculture, services, and mining sectors.
  - FVA shares calculated assuming the same ratio of intermediates to output holds for exports.
- Decomposition by source country:
  - Following Koopman and others (2010), supplemented by COMTRADE for four large economies (Japan, China, United States, Germany).
  - Tables A1.2 and A1.3 report FVA content in gross exports in billion US dollars and percent of gross exports (tables not reproduced here).

### Appendix III — Definitions related to export analysis
- Export Similarity Index (ESI) (Finger and Kreinin, 1979):
  - S(ab, c) = {∑i Minimum [Xi(ac), Xi(bc)]}100.
  - Measures extent of overlap in countries’ export structures; takes value of one if commodity distribution of a’s and b’s exports is identical (to market c).
- Revealed Comparative Advantage (RCA) (Balassa, 1965):
  - RCA = (Xij/Xi) / (Xjw/w) expressed in the formulation given where Xij is exports of country i of product j, Xjw is global exports of product j, Xi is total exports of country i, and w is total global exports.
  - Value greater than one indicates revealed comparative advantage in that product.

### Appendix IV — New drivers of global trade: key stylized facts and country-level findings
- General:
  - Changes in export composition by trading partner strongly reflect the emergence of EMEs.
  - Countries more strongly exposed to EMEs generally experienced higher trade growth.
  - Price competitiveness (REER) historically important; over past 20 years emergence of EMEs imposed a natural downward trend in advanced countries’ export market shares; REER depreciations could often halt decline, appreciations accelerated decline with lagged effects.
- United States:
  - Most stable export structure by destination among simulation countries over last decade and a half.
  - NAFTA partners remain largest trading partners.
  - Asia’s importance for U.S. exporters declined, though China’s share in U.S. exports increased at expense of other Asian countries, chiefly Japan.
  - With a lackluster domestic medium term outlook, U.S. firms may seek export opportunities in dynamic regions.
  - REER experience: 25 percent REER appreciation between 1995 and 2001 resulted, after some lag, in a large loss of export market share between 2000 and 2004; thereafter stabilized partly due to an offsetting REER depreciation.
- Japan:
  - Reoriented trade over last 15 years by outsourcing production processes to other Asian countries, mainly China; exports then shipped to Europe and North America.
  - Exports to Asia increased at expense of those to United States and Europe.
  - REER changes do not well explain Japan’s export market share loss; despite broadly stable or improving REER, Japan lost more than 40 percent of its export market share during the past two decades—outsourcing to other Asian countries a key driver.
- Euro Area:
  - Took somewhat better advantage of Asia’s emergence than United States, though unexploited potential remains.
  - Main reorientation toward production chain partners in Eastern Europe; share of exports to United States declined.
  - Strengthened role in emerging markets in Central Asia and MENA.
  - REER experience: 20 percent Euro depreciation at end of 1990s helped limit decline until 2003; a considerable appreciation at beginning of 2000s led to plummeting export market share.
- China:
  - Rapid export expansion and much more diversified composition over last 15 years; exports to Euro Area and EMEs outside East Asia gained share.
  - Share of exports to U.S. stayed constant; outsourced Japanese production helped compensate for what would otherwise have been a decline.
  - REER relationship to export market share hard to identify; WTO accession in 2001 and rapid integration are overwhelming drivers.
  - REER was relatively stable over most of period; exception: 20 percent appreciation between 1995 and 1998 which may have dented export market share growth between 1997 and 1999.

*Appendix I: A Methodology for Assessing Systemic Trade Interconnectedness — Prepared by Luca Errico and Alexander Massara (both STA).*

### Appendix V: Data and Modeling Strategy

### Appendix V: Data and Modeling Strategy

### Objective and data
- Objective: quantify at a high level of product detail the implications of sectoral and supply chain linkages on the trade impact of relative price changes.
- Trade dataset: imports by trading partner at the HS2002 6-digit level from UN COMTRADE.
- Reference year chosen: 2008, because (i) more countries reported 2008 at this disaggregation level than 2009, and (ii) trade flow composition was presumably less distorted by the crisis-induced collapse in trade.

### Modeling approach — overview
- Two-stage modeling of trade responses to relative price changes:
  - Stage 1: partial equilibrium model determines change in consumer demand for imports in every import market.
  - Stage 2: input-output tables adjust imports in response to the trade-induced change in aggregate demand.
- Stated advantages of this approach:
  - avoids aggregation bias implicit in CGE models using aggregate trade flows;
  - simple and transparent assumptions;
  - illustrates changing trade patterns at high product detail to quantify sectoral and supply chain linkages.
- Output: impact on global trade flows at the HS 6-digit level; results can be aggregated and used to compute ex ante and ex post indicators such as revealed comparative advantage (RCA), export similarity (ESI), and technology content in exports and imports.
- Limitations highlighted:
  - each product is modeled as a separate market in isolation; inter- and intra-sectoral linkages and economy-wide impacts are not fully captured;
  - primarily useful for analysis of sectoral and supply-chain linkages; aggregate-level predictions must be interpreted with these limitations in mind.

### First stage: partial equilibrium model of import demand
- Key conceptual point: export price changes after a real exchange rate shift are not symmetric across sectors because foreign content (intermediates and value added) in exports differs by exporting country and sector.
  - Implementation: assume export prices in a given sector change by the share of domestic content in the export value multiplied by the exchange rate shift.
  - Numerical examples from text:
    - a 10 percent exchange rate depreciation leads to a 5 percent fall in export prices in a sector with 50 percent domestic content in exports;
    - a 10 percent exchange rate depreciation leads to an 8 percent fall in export prices in a sector with 80 percent domestic content.
- Modeling setup:
  - representative consumer with Armington (1969)-style preferences;
  - two-step consumer response to price changes: (1) substitution between different exporters’ national varieties following relative price changes; (2) change in overall demand for the good as a result of the change in the average price of the product.
  - ex-ante price of all product varieties normalized to unity; if percentage change in relative prices is x, consumer price of each variety becomes 1+x.
  - the total price change for a given good is computed as a weighted average (by market share) of price changes of the different product varieties.
- Six core assumptions of the partial equilibrium setup:
  1. sector-level elasticities determine magnitude of demand response of trade flows to relative price changes;
  2. Armington (1969) imperfect substitutability between imports from different trading partners (within each product category);
  3. change in relative prices is defined as change in relative prices facing the consumer in each importing economy (i.e., not identical to exchange rate change when pass-through is incomplete);
  4. no direct substitution between different products — each product modeled as a separate market in isolation;
  5. parameterization targets long run impacts of relative price changes;
  6. given the partial equilibrium nature, inter- and intra-sectoral linkages (e.g., factor reallocation) or economy-wide impacts cannot be considered.
- Technical note: since demand responses are based on elasticities, market entry by new exporters as a result of price changes is not modeled (zero trade flows remain unchanged at zero).

### Elasticities and parameterization
- Substitution elasticities:
  - literature range referenced: elasticities may be lower on average and may lie in the range of -2 to -3.
  - approach used: Broda and Weinstein (2006) and Broda, Greenfield and Weinstein (2006) elasticities scaled to a mean of 2.25 as attained in Crozet and Koenig (2010).
  - resulting import-weighted mean elasticity: 2.4.
  - outlier treatment: remove outliers by capping elasticities at mean plus 2 standard deviations before scaling.
- Country- and product-specific import demand elasticities:
  - primary source: Kee and others (2008) provide price elasticities of import demand by import market and 6-digit HS level.
  - procedure: use Kee et al. elasticities but scale them to a mean of -1.
  - resulting import-weighted mean elasticity after scaling: -0.79.
  - data preparation steps: cap elasticities at mean plus 2 standard deviations, fill missing observations using product elasticities at higher aggregation levels where available, then scale to arrive at desired mean of -1.
- Rationale and literature context:
  - Crozet and Koenig (2010) find a mean elasticity of -2.25 at SITC 3-digit level in a heterogeneous-firms framework; Broda and Weinstein (2006) find -4 at high product detail.
  - The chosen scaling addresses upward bias that arises from summing high-disaggregation elasticities when cross-product substitution is ignored.

### Second stage: adjusting imports for trade-induced change in aggregate demand
- Purpose: account for impact of changes in exports on total value added and aggregate demand, and the consequent feedback on imports of intermediates and final goods.
- Procedure:
  - start from predicted changes in imports and exports from stage 1.
  - use input-output tables to determine:
    - fall in value added consistent with the change in exports;
    - change in imports of intermediates and final goods (by sector) resulting from falling/rising aggregate demand.
  - input-output tables distinguish 2-digit ISIC sectors and intermediate versus final goods; sectoral impacts are allocated across higher-disaggregation trade data sub-sectors according to market share.
- Mathematical expressions provided for impact on GDP and imports (symbols preserved as in source):
  - change in GDP:
    - ܧ݀·ܮ·ݒൌ ܻ݀
    - where ܻ݀ is the change in GDP, ݒ is a row vector of value added in each sector, ܮ is the Leontief matrix, and ܧ݀ is a column vector of changes in exports in each sector.
  - change in intermediate imports:
    - ܣൌ ܯݐ݊݅݀
ெ
ܧ݀·ܮ·
    - where ܯݐ݊݅݀ is a column vector of the change in imports of intermediate inputs by sector and ܯܣ is the imported inputs coefficients matrix.
  - change in final goods imports:
    - ܻ݀·݉݌݉ൌܯ݂݊݅݀
    - where ܯ݂݊݅݀ is a column vector of the change in imports of final goods by sector and ݉݌݉ is a column vector of marginal propensity to imports by sector.
- Aggregate simulation results are summarized in the main text (subsection Aggregate Results in Section III).

*Source: Appendix V: Data and Modeling Strategy (content unit provided).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_061511.pdf_