'Made in China': the impact of low-cost imports on US industry

American shoppers who have benefited from a flood of cheap toys and clothes stamped, 'Made in China,' can hardly have failed to notice the impact of increasing trade from low income countries over the past decade. The effects on the American businesses struggling to compete in a rapidly changing market, however, are harder to measure.

In a new CEPR paper, CEPR Research Fellow, Andreas M Fischer and his co-author, Raphael Auer, investigate the changes wrought by a decade of low-cost imports from China, India and other developing economies, and find that the effect on manufacturers in the US has been profound, driving down prices and improving productivity.

Prices and demand in US industry are affected by a wide range of factors, including changes in the spending power and choices of consumers in their home market. Disentangling any causal links with imports from low income countries is difficult.

The authors' starting-point for solving this methodological problem is the insight that low income countries tend to specialise in industries which are labour intensive. Their workers are cheap, relative to their counterparts in the US and other developed countries, so these are the sectors where they have a comparative advantage.

By comparing changes in the labour intensive sectors with what happened to firms in other industries, the authors can then understand what impact imports have had.

In order to test this idea, Auer and Fischer use a decade's worth of data covering the years 1997-2006, across nine low income countries: China, Brazil, India, Indonesia, Malaysia, Mexico, the Philippines, Thailand and Vietnam, and relate them to detailed statistics on prices, productivity and costs for 325 specific industry sectors in US manufacturing.

First, they check their basic premise - that labour intensive sectors are those where the effects of trade with low income countries will most clearly be felt. They measure the labour intensity of each of their 325 industry sectors as the share of firms' costs which are spent on employing staff. Then, using an instrumental variable regression the authors show that in general, when industrial output in China expands, imports from China increase much more in labour intensive industries than in capital intensive sectors.

They then repeat the regression analysis to confirm this finding, using data from Vietnam, Mexico and India, and find that it is also true of these countries. Then using data from Japan, which show that for more developed economies the pattern is different, and growth in imports is directed to capital intensive sectors where Japan has a comparative advantage.

Having confirmed this idea, the authors can then use what they call 'comparative advantage induced' changes in labour intensive sector imports, to stand for the effects on industry of trade with low income countries. Using what is known as a 'difference in difference' approach, they carry out a series of statistical regressions to analyse these effects.

The most striking change wrought by the flow of low income country imports is on the price charged by American firms for their goods, as they battle to remain competitive. The authors find that on average, for every 1 per cent of market share captured by low income countries, producer prices in the relevant sector decline by 3%.

Using detailed data from the government's Bureau of Labor Statistics, Auer and Fischer are also able to calculate what changes firms are forced to make to accommodate those price cuts. They find that as much as2.4% of it comes through improvements in productivity. Somehow, in order to adjust to the onslaught of cheap goods, US firms managed to boost their efficiency, producing more output for the same level of costs. A much smaller proportion of the change, around 0.3%, came from manufacturers trimming their profit margins.

Although most of their analysis uses a weighted average of all the nine low income countries, the authors also separate out the special impact of China - the so-called 'China effect;' and find that it is large, accounting for as much as half of the total changes in prices and productivity.

These shifts only affect the manufacturing sector, which is competing most directly with firms in China and elsewhere. Nevertheless, the authors say their analysis suggests the changes are large enough to have an impact on the macro-economy as a whole.

In total, they suggest that imports from low income countries have depressed producer prices across the US economy as a whole by approximately 2 percentage points each year - which would in turn have had a significant downward effect on economy-wide inflation.

That created helpful 'tailwinds' for central bankers aiming to keep prices under control; but if they failed to appreciate the full importance of these effects it may also have fanned the potentially dangerous idea that inflation was 'dead'. Auer and Fischer's findings suggest that understanding how competition from low-cost imports affect domestic firms will have to be an important element in understanding how inflation is likely to evolve in the years ahead.

DP 6819 The Effect of Trade with Low Income Countries on US Industry

Raphael Auer and Andreas M Fischer