A theoretical assessment on the trading arrangements for a small Asian economy with footloose entrepreneur movement toward China

China’s devaluation of yuan in 1994 was one of the major reasons causing weak export in the countries affected by the crisis.

Source: Taiwan’s Investment Commission, Ministry of Economic Affairs (MOEA).

The ratio of Taiwan’s export orders produced in China for all industries combined was 51% in 2015. Notably, the ratio of information and communication products produced in China reached 89.2% in 2015. It suggests the hollowing out of the information and communication industry in Taiwan.

If only the second condition is satisfied, small economy and the third region are endowed with similar factor endowments, and the trade between them is the North–North type or the intra-industry trade and cannot be explained by comparative advantage. If only the first condition is satisfied, that is the trade between the small and the large economy addressed in the present paper. If both conditions are not sustained, that corresponds to the trade among regions of a country, e.g., domestic trade within the USA. Under the third and fourth circumstances, free trade leads to footloose entrepreneurs moving toward the center, i.e., the larger market, as suggested by the NEG models.

The Puga and Venables (1997) analysis started from very high trade barriers among all countries, each with self-sufficient, domestically oriented production in its manufacturing sector. An initially symmetric equilibrium exists where all countries have the same number of firms. By contrast, Puga and Venables (1998) assumed an initial equilibrium in which manufacturing is concentrated in two of four countries, labeled North, and the other two countries with no industry are labeled South. The policy implications are different in three ways between this analysis and Puga and Venables’. First, unlike Puga and Venables (1997) and Puga and Venables (1998), the relationship between reductions in trade costs and agglomeration is monotonic in this model so that the reindustrialization will not occur in a small country at low enough trade costs. Second, Puga and Venables (1998) suggested a North–South preferential trade agreement (PTA) that is favorable to the liberalizing southern economy compared to the other southern economy. In this model, the favorable outcome of a North–South PTA arrangement for the liberalizing southern economy, such as Taiwan, depends on whether the trade costs across Strait are high enough, or whether Taiwan can successfully transform itself as a hub with high trade efficiency.

Third, in Puga and Venables (1998), for both southern economies, multilateral liberalization among all countries is more beneficial than the North acting as a hub, since first industrialized southern country gets a larger share of industry. However, because the size of China is extremely larger than Taiwan, the spread of industry to Taiwan will not arise under multilateral liberalization. All the differences in the effects of trade policies between this paper and Puga and Venables (1998) are mainly brought about by the assumption related to the size of the two developing countries.

For instance, in Baldwin et al. (2003)’s footloose capital model, all members in the preferential trade agreement gain from any level of preferential liberalization. However, Puga and Venables (1997) find a counter example to this result in a different model with vertical linkages among firms, which has much stronger agglomeration forces.

Commendatore et al. (2014) consider the impacts of two aspects of trade liberalization: regional integration and globalization.

That is, entrepreneurs can only migrate within the country composed of two domestic regions, while there is no factor mobility between the country and the third region.

Most inter-regional migration from Taiwan to China, mainly done by skilled works or entrepreneurs, comes along with the flow of FDI to China by the Taiwanese firms, and that will create a circular causality to produce agglomeration of manufacturing firms in a single location.

Due to the clustering of industry, the disappearing of demographic dividend, certain policies implemented by the Chinese government, such as the Employment Contract Law and the rise in minimum wage, and the appreciation of China’s yuan since 2005. China’s manufacturing wage was increased by 791% in terms of US dollars between 2000 and 2014 according to China Statistical Yearbook.

There is a US$ 50 million ceiling on any investment project to China and upper limits on accumulated amount invested in China for Taiwan’s companies ranged over 20–40% of equity according to the size of an enterprise.

The US$ 50 million ceiling on individual investment project to China had been cancelled, and the NT$ 60 million limit on accumulated investment made by person or small- and medium-sized enterprises to China had been lifted to NT $80 million. In 2002, there was an addition of over 2000 items to the existing list of legal imports from China to Taiwan, and the final list would embrace almost 5700 products. However, cross-Strait imports and exports still required to be shipped via a third territory, and domestic vessels unable to participate in shipment before 2008.

To avoid excessively economic dependence on China, Taiwan’s mainland policy guideline was adjusted to “proactive management and effective liberalization” in 2006. The Taiwanese government newly stipulated “Directions Governing Policy Review and Coordination for Major China-bound Investment Projects,” which defined major investments, the review procedures and items for major investment projects, investor coordination items, and due investor commitments. However, the enforcement period of the new policy is short and its effects can hardly be evaluated since Taiwan’s ruling party changed in 2008.

For instance, the upper limits on accumulated amount invested in China for Taiwan’s companies were lifted to 60% of equity (the former limits ranged over 20–40%). However, firms establishing headquarter or being the subsidiary of global enterprise in Taiwan can be exempted from the 60% upper limit. Direct cross-Strait flights and transportation began in December 15, 2008. Memorandum of understanding on financial regulation and supervision with China effected in January 16, 2010, mutually opened up banks of both areas to set up new branches in the other.

According to DGBAS and the World Bank, Taiwan’s average fixed capital formation as a percentage of GDP decreased by 3.5%, from 26.30% over the period 1997–2000 to 22.82% over the period 2001–2014, compared to the much smaller decrease of 1.5%, from 31.61 (over the period 1997–2000) to 30.5% (over the period 2001–2014) that occurred in South Korea over the same periods.

If firms enter and exit in response to positive and negative profits, at equilibrium manufacturing sector profits will be exhausted in both economies. There is a unique level of output that gives firms zero profit, see (6).

The profit-maximizing price for firms in the large economy is \(p_1 (1-1/\delta )=w_1^{1-\theta } {\varvec{\Omega }}_{\mathrm{m},1}^\theta b\) . The price index of the large economy and the global market is \({\varvec{\Omega }}_{\mathrm{m},1} =(n(\tau \cdot p)^{1-\delta }+n_1 p_1 ^{1-\delta })^{1/(1-\delta )}\) and \({\varvec{\Omega }}_{\mathrm{m},0} =(n(\rho _c \cdot p)^{1-\delta }+n_1 (\rho \cdot p_1 )^{1-\delta })^{1/(1-\delta )}\) , respectively.

The zero-profit condition for the large economy is \(1\!=\!p_1 ^{-\delta }\!\big (\tau ^{1-\delta }{\varvec{\Omega }} _\mathrm{m}^{\delta -1} E\!+\!(\rho )^{1-\delta }{\varvec{\Omega }}_{\mathrm{m},0}^{\delta -1} E_0 \!+\!{\varvec{\Omega }}_{\mathrm{m},1}^{\delta -1} E_1 \big )\).

On the contrary, Baldwin et al. (2003, CH 14) suggest that, when the spokes maintain very high levels of protection but trade between hub and spoke is quite free, then there will be proportionally less share of world industry in hub, assuming that each nation accounts for equal share of world expenditure. However, if the differential in the trade freeness between hub–spoke and spoke–spoke is small, hub has a share of world industry larger than its share of world expenditure.

The downward shift of line \(L_{\mathrm{m},1,0} \) occurs as the manufacturing employment in the large economy shrinks due to its rising wage.

However, if the level of trade barriers between the two economies is high enough, the incentive to supply the small economy’s domestic market locally and the rising labor costs in the large economy will draw industry into the small one.

The industrial policy of Taiwan’s government mainly regulated in the Statute for Upgrading Industry before 2010 and the Statute for Industrial Innovation after 2010.