Firm R&D, Processing Trade and Input Trade Liberalisation: Evidence from Chinese Firms

• DOI: http://doi.org/10.1111/twec.12367
• Author: Miaojie Yu,Wei Tian
• Published date: 01 February 2017
• Date: 01 February 2017

Firm R&D, Processing Trade and Input

Trade Liberalisation: Evidence from

Chinese Firms

Wei Tian

1

and Miaojie Yu

2

1

School of International Trade and Economics, University of International Business and Economics

(UIBE), Beijing, China and

2

China Center for Economic and Research (CCER), National School of

Economics, Peking University, Beijing, China

1. INTRODUCTION

THE nexus between firm innovation and trade liberalisation is an important research sub-

ject in the empirical trade literature, as firm innovation is an important channel for firms

to realise productivity gains from trade. Some work in this area has focused on how output

trade liberalisation affects firm research and development (R&D) inputs (Iacovone et al.,

2013; Bloom et al., forthcoming). Since tariff reductions usually happen bilaterally, other

research has concentrated on how cuts in foreign tariffs boost firm R&D activity (Aw et al.,

2007, 2011; Lileeva and Trefler, 2010; Bustos, 2011). Some researchers have been paying

more attention to the role of imported intermediate inputs by exploring how input trade liber-

alisation affects firm R&D behaviour (Kim and Nelson, 2000; Griffith et al., 2004; Hu et al.,

2005; Goldberg et al., 2010).

The present paper examines the effect of input trade liberalisation on firm R&D by taking

into account China’s special treatment on imported intermediate inputs. After China’s acces-

sion to the World Trade Organization (WTO) in 2001, the country experienced significant

trade liberalisation in final outputs and intermediate inputs (Yu, 2015). Different from ordi-

nary imports, processing imports in China enjoy zero tariffs and were not affected by the

input trade liberalisation caused by the WTO accession. We thus take China’s accession to

the WTO as a quasi-natural experiment and perform difference-in-difference (DID) analysis

by taking processing import firms as a control group. We also carefully deal with the possible

endogeneity and serial correlation problems. We identify and drop imported capital goods to

avoid potential contamination of our estimates. Overall, we find strong evidence that input

trade liberalisation due to the WTO accession significantly fosters firm R&D activity.

This paper contributes to the literature in three important ways. First, it enriches our under-

standing of China’s innovation activity in the new century. As China’s labour costs have

increased in recent years, the country’s apparent comparative advantage based on its abundant

labour endowment is shrinking. As a result, Chinese firms are eager to invest more in R&D

to boost firm productivity to maintain their international competitiveness. Aggregated data

from the China Statistical Yearbook on Science and Technology ascertain this conjecture. For

example, the share of R&D in GDP rose from 0.6 per cent in 1995 to 1.23 per cent in 2004.

The number of employees in the R&D sectors increased over 77 per cent during the same

We thank Zhiyuan Li, Dan Liu and Liugang Sheng, the Associate Editor and two anonymous referees

for their very helpful comments and suggestions. All errors are ours. Miaojie Yu thanks the financial

support from National Natural Scientific Foundation of China (No. 71573006) which is gratefully

acknowledged.

©2015 John Wiley & Sons Ltd 297

The World Economy (2017)

doi: 10.1111/twec.12367

The World Economy

period. However, this idea is rarely supported by Chinese micro firm-level production data.

This paper aims to fill this gap. We use disaggregated and firm-level production data and

highly disaggregated transaction-level customs data from 2000 to 2006, to explore the rela-

tionship between firm R&D and input trade liberalisation.

Second, the paper contributes to understanding the channels and mechanisms of the effects

of trade liberalisation on firm performance. Although firm innovation is a crucial channel to

realise firm productivity gains from trade, previous studies have mostly focused on output

trade liberalisation. A fall in domestic output tariffs generates tougher import competition,

which in turn forces firms to invest more in R&D activities. By contrast, a reduction in for-

eign tariffs creates a large foreign market, which could make firms more profitable, so that

they can invest more in R&D activities. Few papers have considered the impact of input trade

liberalisation on firm R&D. However, import trade liberalisation plays a substantial role in

firms’ ability to realise productivity gains from trade (Amiti and Konings, 2007; Goldberg

et al., 2010; Topalova and Khandelwal, 2011; Tian and Yu, 2015; Yu, 2015). The present

paper thus picks up this job.

Third, the paper makes a contribution to the issue of empirical identification. Firm R&D

activity may be endogenous to import tariffs. Usually firms with lower R&D investment are

less productive. Accordingly, they could lobby the government for temporary protection

(Bown and Crowley, 2013). It is well recognised that it is a challenging job to find an ideal

instrument for import tariffs. However, China has special, zero-tariff treatment on processing

imports. Further trade liberalisation has not impacted processing imports. Thus, we are able to

take advantage of this situation using processing import firms as a control group to mitigate

the endogeneity problem, and hence to explore the causal relation between input trade liberal-

isation and firm R&D.

The paper is related to two strands of the growth literature. The first strand is on the nexus

between firm R&D and external trade liberalisation from trading partners. Grossman and

Helpman (1991) was one of the pioneering works to model the impact of foreign trade liberal-

isation on firm R&D. In line with this idea, Yeaple (2005) shows that firms have a greater

incentive to increase investment in technology in response to a fall in trade costs under a

framework in which firms choose either high or low technology according to the observed

random ability of workers. Verhoogen (2008) examines the impact of currency validity on

firm R&D activity using Mexican data. By assuming that more productive firms choose to

produce higher quality products and pay higher wages, he shows that home currency deprecia-

tion forces high-productivity firms to invest more in improving product quality, which is

accompanied by greater within-industry wage discrepancies. Lileeva and Trefler (2010)

forcefully argue that foreign tariff reduction leads to more exports from high-productivity

Canadian firms; the increase in exports is associated with more R&D inputs in new product

innovation. By comparison, we also control for foreign market size, but focus on input trade

liberalisation.

The second strand of literature examines the impact of output trade liberalisation on firm

R&D. Iacovone et al. (2013) study the impact of China entering the WTO on Mexican firms,

and they find that more productive firms invest more in R&D. Bloom et al. (forthcoming) find

that the elimination of import quotas on Chinese goods in Europe since 2001 has increased

domestic competition, which in turn has improved firm-level technology upgrading as well as

the mobility of labour towards more productive firms. Finally, some other research explores

reductions in foreign tariffs and import tariffs. Bustos (2011) studies the effect of bilateral

trade liberalisation and finds that bilateral tariff reductions in import tariffs and external tariffs

©2015 John Wiley & Sons Ltd

298 W. TIAN AND M. YU