The widening of the trade surplus has been driven mainly by a significant slowdown in imports, which started to lag export growth by large margins in early 2005. In contrast, during most of the past decade, import and export growth were typically on a par, consistent with China's role as a processing center. Imports of intermediate goods (including parts and components and semifinished goods) slowed the most, explaining more than half of the slowdown in total imports between 2003 and 2005 and accounting for the lion's share of the gap between the growth rates of imports and exports. This development has directly affected China's trade with the rest of Asia and may be altering China's role in regional production chains. Although China's trade surplus with the United States and the European Union continues to grow, its trade deficit with the rest of Asia, traditionally an offset, has shrunk over the past two years. This has raised concerns in some Asian economies, especially those for which exports to China have been a major driver of recent economic growth.

The slowdown in imports occurred during a period of booming investment, as China's increased domestic production capacity has enabled greater domestic sourcing for intermediate products. In some sectors, such as steel and chemical materials, vast capacity was created following the investment boom during 2003 and 2004 in response to surging commodity prices. In other sectors, such as electronics and machineries, foreign direct investment (FDI) has also played an important role, mirroring a major change in the global production network as more stages of production shift to China. For example, FDI flows into the electronics sector from Taiwan Province of China alone increased from $538 million in 1999 to $2.4 billion in 2005. Reflecting the rising domestic production capacity, exports of final products have continued to grow strongly in many sectors—notably home electrical appliances, ordinary machinery, and, to a lesser extent, higher-tech products such as precision apparatus—despite the recent slowdown in imports of intermediate inputs used in their production.

These developments highlight the evolving role of China in the regional processing trade. It is important to recognize that the category of processing trade is essentially a trade category defined by Chinese customs officials for tax purposes. It is not confined to low-value-added assembly operations, with all materials provided by foreign suppliers. Firms can choose to import all or some intermediate goods (for example, raw materials, parts and components, accessories, and packaging materials) from abroad, obtain the rest from domestic suppliers, and reexport the final products with tax exemptions on the imported inputs. The decision of whether to import or source domestically depends on the availability of the products in different markets and relative prices, similar to that for regular imports.

With the expansion of domestic supply, China is increasingly shifting from simple assembly operations toward operations that have greater scope for using domestic inputs. The share of the former has declined sharply, accounting in 2006 for only about 10 percent of the processing trade balance, down from more than 30 percent in the late 1990s. The latter, in contrast, has increased in importance. Moreover, its margin—defined as the domestic value added for each dollar exported, or the trade balance divided by exports—rose from the teens in the mid-1990s to about 40 percent last year, consistent with the rising domestic content of exports.

Have imports delinked from exports? That is, has the increased domestic production capacity had the predicted effect of weakening the traditionally close link between imports of intermediate products and exports of final products? Disaggregated trade data are used to examine this link for a group of subsectors in the electronics and machinery and transport equipment industries. The sample accounts for about half of China's imports of parts and components. Through panel estimation, each industry's imports of parts and components are regressed on the exports of final products of the same industry, controlling for other variables that represent the domestic demand for these final products, as well as the world price of the input relative to its price in China. The full sample (1994–2005) is also split into two equal periods to assess whether the strength of the relationship between imports and foreign demand, on the one hand, and domestic demand in China, on the other, has changed.

The results show that imports of parts and components are positively related to the exports of final products of the same industry for the full sample period, but this relationship is statistically strong only for the first half of the last decade. Consistent with the hypothesis that imports of parts and components have delinked from exports of final products in recent years, there is no statistically significant link in the second half of the decade. In the latter period, imported inputs have become more strongly associated with domestic demand, suggesting that China's imports of parts and components are increasingly used to meet domestic production needs (which grow with the expanding domestic production capacity).

Therefore, the conventional view of China's main role in international trade as an assembly center is not as good a fit as it once was. External shocks may have more potent effects on China's trade balance and domestic economy, because a slowdown in exports may not be offset by a commensurate decline in imports. At the same time, China's imports are being driven by the country's economic growth, rather than being directly used as inputs of its products to be exported.

Does sophistication affect the sensitivity of trade? That is, how have product characteristics—in particular, their growing sophistication—affected the response of trade flows to aggregate shocks? Again, disaggregated trade data are used to capture the potential product differences within industries, consistent with the view that countries specialize in international trade at much finer levels than industries. The statistical framework used to test the hypothesis is an extension of the standard trade model that links exports and imports to external and domestic demand and the real effective exchange rate while allowing trade elasticities to vary according to product sophistication.

The results show that, on the export side, the more sophisticated a product is, the more its exports tend to increase in response to a given increase in foreign demand, and the more its exports tend to drop for a given appreciation of the real effective exchange rate. On the import side, the more sophisticated a product is, the more its imports tend to increase in response to a rise in domestic demand, although they tend to increase less in response to a given appreciation of the real effective exchange rate. Therefore, the rising sophistication level also points to greater sensitivity of China's exports and trade balance to demand and price fluctuations than in the past.

The structural changes in China also have important regional implications for trade flows within Asia and the evolution of regional production networks. In recent years, China has displaced the United States as the largest export market for an increasing number of Asian countries. It has also been pivotal in boosting intraregional trade and FDI, particularly in the form of intermediate goods channeled through multinationals as part of cross-border chains. Indeed, intermediate products account for almost three-fifths of the increase in trade within Asia over the past decade. But as China begins to specialize in more parts of the production chain, its imports of intermediate goods from the region could start to fall.