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Chicago Fed Letter
Midwest manufacturing and trade with China
by William Testa, vice president and director of regional programs, Jay Liao, research intern, and Alexei Zelenev, associate economist

U.S. trade with China has grown dramatically in recent years. The growth in imports,
in particular, has raised some challenges for domestic manufacturers competing
against lower-cost Chinese production. At the same time, households benefit from
falling prices for imported goods, firms benefit from falling prices on intermediate
components and parts, and U.S.-domiciled multinationals benefit from selling to
and investing in the burgeoning Chinese market.

As U.S. imports from China have

climbed in recent years, some domestic manufacturers have voiced concerns about competing against low-cost
Chinese goods in the U.S. market. At
the same time, however, U.S. households
1. Import penetration of Chinese goods to U.S. regions
benefit from falling
prices for imported
IP level*
Percent change
goods; firms benefit
from falling prices
East North Central
on intermediate comWest North Central
South Atlantic
ponents and parts;
West South Central
and U.S.-domiciled
East South Central
multinationals benePacific
fit from selling to and
Middle Atlantic
investing in the burNew England
United States
geoning Chinese market. This Chicago Fed
*Figures are rounded to 1/1,000. IP is import penetration.
Letter examines our
growing trade relationship with China, especially as it
relates to the Midwest manufacturing
China’s growth

Although the accuracy of Chinese gross
domestic product (GDP) data is questionable, there is little doubt that China is experiencing rapid growth. Reported GDP
growth averaged 9%–10% annually during the 1980s and 1990s.2 China has been
able to sustain much of this growth

recently, when many of the world’s
economies have slipped below trend.
An increased openness to trade and investment has led China’s growth. Since
1990, China’s exports have grown at
an annual pace of 14%; imports have
grown apace.3 Foreign direct investment
(FDI) in China has averaged $44 billion
per year since 1995, originating from developed countries on every continent.4
Prior to the 1980s, very little trade and
FDI could be observed between China
and developed countries. However,
economic reforms beginning in 1978
launched China onto a robust path of
export-led industrial growth and urban
development. These reform efforts
reached a milestone with China’s entry
into the World Trade Organization
(WTO) in 2001. WTO membership
promises greater attractiveness for China
as a domicile for FDI, along with access
to the markets of other member countries. In return, China has to comply with
the rules of WTO membership, including nondiscriminatory tariff schedules
on imports and the protection of intellectual property.
To date, China’s internal policies have
favored the build-up of domestically
owned, mostly state-owned, industrial
plants. In addition, China has selectively

encouraged FDI, especially in manufacturing. Many of these FDI operations
produce goods that serve the Chinese
market, but many more are platforms to
export goods back to their country of origin or to other markets. Indeed, trade
statistics for China are difficult to interpret because, for one thing, re-export of
goods is quite common. For some products, such as computers and other electronics, high-value-added components
are shipped into China from countries
such as Taiwan and Japan for further
processing and ultimately re-exported.
Typically, this processing takes advantage
of the very low relative wages in China.
This sometimes leads to double counting
of underlying export values from China.
From the U.S. perspective, much of what
we see as imports from China—especially in electronics—has other Asian
country origins embedded in its value.
U.S. trade with China

From 1997 to 2002, trade volumes (combined exports and imports) between the
U.S. and China increased at an average
annual pace of 12.5%, reaching $147
billion last year. In comparison, trade
with America’s North American Free
Trade Agreement (Nafta) partner,
Mexico, increased at a pace of 6.3%
annually. As a result, in 2002 China became our fourth largest trading partner after Canada, Mexico, and Japan.
Both exports and imports have grown
rapidly, but China’s imports into the
U.S. have easily outpaced U.S. exports
to China. Since 1989, the nominal dollar value of U.S. imports from China
has multiplied more than eightfold,
reaching $125 billion in 2002, allowing
China to surpass Japan for the first time.
China’s manufactured exports to the
U.S. represented 10.8% of manufactured
imports for 2002.5
What has been the impact of rising imports on domestic U.S. manufacturing
production? We sometimes think of rising imports as displacing production at
home. Rather than displacing domestic
production, however, rising imports may
serve rising demand for some types of
goods in the home country. So too, imports can consist of intermediate components that become embodied in

domestic production of a final good.
To the extent that such components are
most cheaply sourced overseas, they may
help keep domestic production competitive for the final good in the domestic
market, or even allow domestic producers to export the final good to third
country markets.
To understand the extent that domestic
production is being superceded by imports, economists measure “import penetration” as the ratio of imports from
abroad relative to the domestic market,
where the domestic market includes
goods purchased in the home country,
regardless of whether the goods are produced at home or abroad. We use an

have entered the U.S. market from alternative low-cost countries.
U.S. manufacturing output growth has
been weak, and year-over- year job
growth in manufacturing has been negative for over three years. However, the
bulk of the current U.S. manufacturing
weakness cannot be attributed to rising
imports and outsourcing. The overhang
of excess capital goods investment and
other production capacity continues to
weigh on the pace of orders for new
manufactured goods, as does the shallow
U.S. economic recovery from the 2001
downturn. Moreover, flagging economic
growth in developed countries in Asia,
South America, and Europe continues

China functions for Asian manufacturing companies much
as Mexican maquiladora plant locations do for many U.S.
index that ranges between zero and one,
with a value of zero meaning that all
domestic purchases are produced at
home and a value of one meaning that
all domestic purchases are produced
abroad. For 2001, we estimate China’s
manufactured imports to be 2.7% of
the U.S. domestic market—defined as
domestic production plus imports—up
from .4% in 1989.6
There are several reasons to believe
that the growth in import penetration
overstates the potential displacement
of U.S. manufacturing production by
imports from China. This is especially
so when we consider that, owing to
China’s economic growth, exports from
the U.S. to China have also expanded,
lifting domestic production beyond
what it otherwise would have been. Exports to China grew from 0.5% of U.S.
manufacturing output in 1989 to 1.5%
by 2002.7 In addition, low-cost imports
from China have restrained price increases and raised the real income of
U.S. households, allowing them to purchase more goods—both domestic and
foreign. An additional factor that is not
easy to quantify is the extent to which
China’s exports to the U.S. are substituting for exports that would otherwise

to hold back U.S. exports. Most importantly, over the longer term, manufacturing jobs have grown at a slower pace
than jobs in services, largely because
productivity gains in manufacturing
have exceeded those in most service
It is also important to note that, so long
as it is based on real production cost
differences between the U.S. and China,
import displacement frees up resources
and workers in low-value production
to pursue higher-value and higherskilled activities in the U.S. economy,
thereby raising average wages and living standards. Developed nations specialize in producing a rich variety of
goods and services, trading with each
other, and thereby sustaining mutually
high standards of living. One measure
of the maturity of the trade relationship between developed countries is the
Grubel–Lloyd Index, which measures
the degree of intraindustry trade as a
proportion of all trade. Between the
U.S. and the UK, France, and Canada,
for example, these indexes are quite
high. For the U.S. and China, the index
is lower, but it climbed significantly between 1989 and 2001.8

China and the Midwest

How important has China’s emergence
as a major trading partner been for the
Midwest economy? One would expect
growth in China’s imports to have
penetrated the region’s domestic markets because the Midwest economy is
more highly concentrated in manufacturing than other U.S. regions.9
We construct measures of China’s import
penetration for the range of finely disaggregated U.S. manufacturing industry sectors. Then, we compare overall
import penetration between the U.S. and
the Midwest by weighting these industry-specific national measures of import
penetration by the employment importance of each industry in the Midwest.10
We find that the penetration of Midwest
manufacturing by Chinese production
remains smaller than at the national level. For 2001, we estimate Chinese trade
penetration of the Midwest to be 2.3%
versus 2.7% for the whole domestic U.S.
market (figure 1).11 These average levels
of import penetration put into perspective that China remains, on average, a
small-to-moderate player in many U.S.
(and Midwest) markets for manufactured goods.
However, China has become a dominant
player in individual product categories,
especially those that are very labor intensive. In particular, our estimates for
2002 suggest a Chinese market share for
the U.S. of over one-half for certain categories of dolls and stuffed toys, fur and
leather apparel, and women’s handbags.
These are not product categories in
which the Midwest specializes. Still, many
small Midwest manufacturers have begun to voice concerns about the difficulty of competing on price with production
operations in China. These concerns
may derive from several sources. In particular, the manufacturing sector is
hurting in the U.S., with output and
employment performing below trend
since late 2000. It may also be that the
Midwest’s industry base has only recently begun to experience significant import competition from China (figure 1).
For the 1997–2001 period, we estimate
that the Midwest experienced relatively
higher growth in import penetration

from China than other U.S. regions—a
65.6% increase from its base, compared
with 55.8% for New England, and 53.1%
for the Middle Atlantic (see figure 1).
Furthermore, the product categories
that contributed the most to the climb
in estimated import competition include
“all other motor vehicle parts,” a category that is of critical importance to
the Midwest. Other important categories that have seen strong import growth
are institutional and metal furniture (especially in Michigan), printed circuit
assembly, and household appliances.12
To illustrate the price pressures currently being experienced by U.S. auto parts
suppliers, automakers have reportedly
been asking suppliers for the “China
price” on their purchases.13 Some suppliers have been asked to relocate or
outsource at least some operations to
China—either to better serve customers overseas or to stay price-competitive
in domestic sales.
So far, overseas shifts of factories and
capital from the U.S. to China have been
substantial, but far from extraordinary.
U.S. flows of foreign direct investment
into China have climbed rapidly, doubling since the mid-1990s.14 However,
for 2002, this FDI accounted for just 8%
of total FDI into China, with countries
of the Pacific basin investing much more
in aggregate. In particular, FDI from
Hong Kong, Japan, Korean, and Taiwan
accounted for 42% last year. For these
countries, investment represents a way
to cut costs and stay competitive. Often,
their production operations involve reshipments and trade across multiple
countries, with components and parts
sent to China for (labor-intensive) assembly or further processing and then
shipped home or exported overseas.
In this way, China functions for Asian
manufacturing companies much as
Mexican maquiladora plant locations
do for many U.S. producers.15
Likely because of its distance from the
U.S., China has not tended to function
as a platform for U.S. manufacturers to
produce goods for the U.S market. In
the latest reported year, 2000, only 13%
of the sales of U.S. multinationals producing in China were shipped back to

the U.S. Instead, two-thirds of their products were sold to the Chinese market.
The pattern is even more pronounced
for machinery and chemicals, both of
which are important industries in the
Midwest. However, some U.S. FDI affiliates in China may serve to contract
with China-owned plants for export to
the United States. This phenomenon is
not reported on nor has it been investigated to date.
With its robust development and rapid
growth, China has become a growing market for U.S. (and Midwest) exports. But
while U.S. exports to China have grown
rapidly since 1988, they as yet comprise
only 1.5% of the value of U.S. manufacturing production. Some regions, such
as the Far West, have parlayed their concentration in computing equipment and
other electronics up to a 3.6% production share. However, the Midwest exports
only .6% of its manufacturing production to China.

China’s rapid economic growth has benefited U.S. consumers. And, for some
U.S. companies, the opening up of the
Chinese market represents an opportunity for growth in exports of U.S. manufacturing goods and services, or for
investment and production in China.
At the same time, the growth in imports
from China is challenging domestic
producers to lower costs to remain

Michael H. Moskow, President; Charles L. Evans,
Senior Vice President and Director of Research; Douglas
Evanoff, Vice President, financial studies; David
Marshall, team leader, macroeconomic policy research;
Daniel Sullivan, Vice President, microeconomic policy
research; William Testa, Vice President, regional
programs and Economics Editor; Helen O’D. Koshy,
Editor; Kathryn Moran, Associate Editor.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors’ and are not necessarily those of the
Federal Reserve Bank of Chicago or the Federal
Reserve System. Articles may be reprinted if the
source is credited and the Research Department
is provided with copies of the reprints.
Chicago Fed Letter is available without charge from
the Public Information Center, Federal Reserve
Bank of Chicago, P.O. Box 834, Chicago, Illinois
60690-0834, tel. 312-322-5111 or fax 312-322-5515.
Chicago Fed Letter and other Bank publications
are available on the World Wide Web at http://
ISSN 0895-0164


We define the Midwest here as Illinois,
Indiana, Michigan, Ohio, and Wisconsin,
which is also known as the East North
Central region.


The World Bank, 2003, ICT’s China at a
Glance. Others estimate China’s growth at
7%–8% per annum.




Ministry of Foreign Trade and Economic
Cooperation of the People’s Republic of


U.S. Census Bureau, “U.S. international
trade in goods and services,” No. FT-900,
annual revisions issues.


China’s import penetration is measured as:
M(China)/(VS – X + M), or the ratio of
Chinese imports to total domestic U.S.
market, where X = all U.S. manufactured
exports, M = all U.S. imports of manufactured goods, and M(China) = imports of
manufactured goods from China. VS, the
value of manufactured shipments in the
U.S., is reported by the U.S. Census Bureau, Census of Manufactures and Annual
Survey of Manufactures.




The index is based on the ratio of net to
gross trade across for each industry, averaged across all industries (at a country

This regional weighting of national penetration ratios assumes that 1) local industries sell into the U.S. market, and 2) employment by industry accurately reflects
industry production in each state.
Imports and exports by country, which
are mapped from international harmonized system categories into SIC and
NAIC codes, are reported at http://
Also see Robert C. Feenstra, John Romalis,
and Peter K. Schott, 2002, “U.S. imports,
exports, and tariff data, 1989–2001,”
National Bureau of Economic Research,
working paper, No. 9387, December.

As measured by GDP by industry (and
gross state product for states), the Midwest


relative to the nation and decreased in
regions with less concentrated manufacturing. The largest change was in the East
North Central region; the IP measure increased by 38%, making that region’s import penetration among the highest in
the country. By contrast, the IP of the
Mountain region decreased by 34% and
ranked toward the bottom.

Specifically, import penetration in state
i = Sum over all industries j MP i , where
MP i = Lij × MP j and Lij = state i’s share of
its own manufacturing employment employed in industry j, and MP j = U.S. import penetration of good j.
State-level industry employment is drawn
from the U.S. Dept. of Commerce, County
Business Patterns, available (and used here)
at the four-digit SIC (Standard Industrial
Classification) level and the six-digit NAIC
(North American Industrial Classification) level.

GDP by industry from the U.S. Bureau of
Economic Analysis, U.S. Department of

GL = 1/n Σ(1 – |Xi – Mi|/(Xi + Mi)).

concentration in manufacturing exceeded
the nation by 46% in 2001.

The import penetration (IP) measure that
we calculate above does not take into account the size of the manufacturing base
in each region. In view of this, we weighted
the regional IP by an index value based
on the share of each region’s overall GDP
in the manufacturing sector. The import
penetration thereby increased in regions
with more concentrated manufacturing


We corroborate these numbers by examining average annual growth in U.S. imports
from China for both the U.S. and Midwest
(top industries are proxied by rankings of
industry employment in the region). For an
aggregate of the import categories for the
30 most prominent categories measured at
both four-digit level and five-digit level
product codes, we find greater import
growth in the Midwest than in the nation.


See Robert Sherefkin and David Sedgewick,
2003, “Ford, GM push vendors toward
China: ‘World price’ frenzy threatens
U.S. jobs,” Crains Automotive News,
June 23, pp.1, 38.


Chinese agencies report annual FDI figures four times higher than reported by
U.S. agencies.


A recent theme has been that Mexico is
losing favor as a location of production
to China. See “The sucking sound from
the East,” in The Economist, July 26, 2003,
pp. 35–36. Domestic automakers often
have labor-intensive parts of their production value chain, such as the wiring
of interior consoles on automobiles for
example, performed in Mexico and
shipped back north for final installation
into the automobile.