By Long Guoqiang, Research Department of Foreign Economic Relations of DRC

Research Report No. 152, 2008

China's processing trade, which was initiated in 1979, now accounts for half of the country's foreign trade volume. The development of processing trade has always been accompanied by controversies. Since the central government put forward the principle on the restructuring and upgrading of processing trade, there have also been diverse explorations on this issue. Therefore, it is of major practical significance to summarize the historical experience in developing processing trade and to consider the direction of and policy on the future restructuring and upgrading of processing trade at a time when China marks the 30th anniversary of its opening to the outside world.

I. Processing Trade Is an Important Part of China's Opening-up Strategy

After China began reform and opening up, it adjusted its economic development strategy, switching from the "import substitution" strategy under the planned economy to the strategy of "combining import substitution with export orientation". In other words, the capital and technology-intensive sectors would continue to pursue the import substitution strategy, while the labor-intensive sectors would pursue an export-oriented strategy. The main task of the sectors opening to the outside world was to earn foreign exchanges for the import substitution sectors to import technologies, equipment and raw materials. Therefore, the core goal of China's opening up at the time was to earn foreign exchanges through export.

Focusing on the core goal of "earning foreign exchanges through export", China's open-up strategy was implemented along two main lines. One was to attract the export-oriented foreign direct investments and the other to encourage Chinese enterprises to expand export. Along the first main line, the government adopted diverse measures to encourage export-oriented projects, such as establishing special economic zones, improving infrastructure, offering preferential tax policies to foreign investors and screening foreign-invested projects. On the one hand, it set performance requirements for the foreign-invested projects, mainly concerning local contents, foreign exchange balance and export ratio. On the other, it cut the income tax by half for the export-oriented enterprises (whose export exceeded 70% of its output value). One of the most important measures was to introduce a policy on processing trade.

China began to implement the opening-up policy at a time when the labor-intensive industries in Japan and other East Asian emergent economies were looking for low-cost production and processing places due to their rising costs. These investment projects were characterized with "mass imports and mass exports". They must import their raw materials and spare parts from their home countries or other economies and export their products. Whether China could adapt itself to this characteristic of these foreign-invested projects became a key factor for whether China could seize the opportunities arising from the industrial transfers from the East Asian region. On the one hand, China's import substitution sectors still needed the protection of high tariffs and non-product tariff barriers. On the other, high tariffs and other trade barriers obstructed the export-oriented foreign-invested projects from entering China. How could China protect the import substitution sectors and at the same time ensure the low-cost operations in China of the export-oriented foreign-invested projects? The Chinese government introduced a policy on processing trade, which meant the raw materials and spare parts imported by enterprises for export-oriented processing were exempt from the import duties and import taxes (they were mainly the product tax before 1994 and the value-added tax and consumption tax later on). This policy eliminated the obstruction of China's high tariffs and value-added tax to the use of imported raw materials and spare parts. As processing trade constantly extended the value-added chains of the domestic industries, the departments in charge of customs, inspection and quarantine also constantly improved their regulations, greatly facilitating customs clearance and inter-house and inter-region settlement. As a result, processing trade developed across the country.

Processing trade played irreplaceable roles in turning China into a major foreign investment attractor. Since 1993, China has been the largest foreign investment attractor among the developing countries in the world, with its attracted foreign direct investment totalling over 800 billion dollars. But the foreign direct investments had their unique operational features. Worldwide, two-thirds of cross-border investments were in the service sector. But in China, 71% of the attracted foreign investments were in the manufacturing sector. Before China joined the World Trade Organization, China imposed various restrictions on the domestic sales by foreign-invested enterprises. For this reason, most of the foreign investments in China's manufacturing sector were in processing trade. Foreign-invested enterprises accounted for over 80% of the processing trade export. It is an indication of how important the processing trade policy was to attracting foreign investors to engage in export activities in China. In other words, China could not have been so successful in foreign investment attraction without the processing trade policy.

China's processing trade has played tangible roles in developing China's foreign trade. In general, the industrialization and economic development of developing countries is restricted by low export competitiveness, which resulted from low competitiveness in manufacturing and the lack of international sale channels. China was no exception. But as it introduced the processing trade policy, China has successfully attracted the export-oriented foreign direct investments. By organically combining the advantages of the foreign-invested enterprises in technology, management, equipment, marketing channels and brands with the country's advantages in labor, land cost and infrastructure, China turned itself rapidly into a world-oriented low-cost processing and manufacturing base. The fast-growing processing trade has accounted for over half of China's export and become the most important form of China's foreign trade.

Table 1 Roles of Processing Trade & Foreign-Invested Enterprises in China's Foreign Trade (2007)

Item		Export		Import
		USD100m	%	USD100m	%
Total value		12180.1	100	9558.2	100
Form of trade	General trade	5385.8	44.2	4286.5	44.8
	Processing trade	6176.5	50.7	3684	38.5
	Other forms of trade	617.8	5.1	1587.7	16.6
Nature of enterprise	State-owned enterprises	2248.1	18.5	2697.2	28.2
	Foreign-invested enterprises	6955.2	57.1	5594.1	58.5
	Other enterprises	2976.8	24.4	1266.9	13.3

Source: The Ministry of Commerce of the People's Republic of China: the 2007 Statistical Summary on Foreign Economic and Trade.

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