**_East Asia today._** Production networks have been at the heart of the recent growth in trade among East Asian countries. Fragmentation trade, reflected mainly in the trade in parts and components, is expanding more rapidly than the conventional trade in final goods. The degree of dependence of this new form of international specialization is proportionately larger in East Asia than in other parts of the world. This is mainly due to the relatively more favorable policy setting for international production (unilateral trade liberalization, policies favorable to exports such as duty drawback, the opening up of foreign direct investment [FDI] for the purposes of exportation), the agglomeration benefits arising from the early entry into this new form of specialization, and the considerable intercountry wage differentials in the region, combined with the lower trade costs (tariffs and transportation). The fact that East Asia is at a level in the technology ladder where products exhibit increasing returns to scale (such as machinery, parts, and components) has exacerbated the degree of specialization within production networks.

The economic integration of China has deepened production fragmentation in East Asia to an unprecedented level. The rapid integration of China into regional production networks has countered fears that China’s global integration would crowd out the opportunities of other countries for international specialization. International production fragmentation has intensified the dynamism of East Asian economies and increased economic interdependence within the region. This has not meant less dependence on the global economy. Indeed, this growth dynamism based on vertical specialization has depended heavily on extraregional trade in final goods, and this dependence has increased over the years.

Many questions arise within this East Asian model. Is China a substitute or a complement for other East Asian countries? Are production networks leading to technology spillovers? Is the dependence of lowerincome countries, especially China, on foreign capital and technology long-lasting, or will China develop its own technological capabilities? In the latter case, will the production networks in the region collapse? Does the strong interdependence across countries because of these production networks make them vulnerable to shocks in the absence of regional agreements?

This paper will (1) outline a conceptual framework on trade in East Asia by drawing on insights from recent theoretical and empirical research on production sharing, economic geography, intermediation, and innovation and growth; (2) review changing trends and patterns in trade within East Asia; (3) assess the nature of production sharing networks within East Asia and their technology spillovers; (4) assess the impact of the rise of China on other East Asian countries; and (5) provide views on the risks and challenges of the East Asian model as we look ahead.

# **TRADE DYNAMICS IN EAST ASIA: A CONCEPTUAL FRAMEWORK**

In the global economy, intermediate goods are playing an important role in trade. The growing trade in inputs has resulted from the global fragmentation of production, whereby multinational firms outsource production to suppliers in various countries. Economies in East Asia have been at the forefront of this development. Yeats (2001) finds that the trade in inputs has grown much more rapidly than the trade in final goods and estimates that intermediates now account for 30 percent of world trade in manufactures. One source of trade in inputs is processing exports, defined by customs officials as export goods that are produced through the processing or assembly of imported intermediate inputs. This activity has grown enormously in China, for which Hong Kong (China) often acts as the intermediary, as well as in other countries in East Asia. Between 1988 and 2002, processing exports grew from 32 to 55 percent of total Chinese exports, and multinational firms had a major part in this development. China’s outward processing (which is one form of global outsourcing) serves the newly industrializing economies (NIEs) in Asia,<sup>2</sup> as well as developed countries and regions such as Europe, Japan, and the United States.

The fragmentation of production across borders and the integration of national economies have been coincident events in East Asia.<sup>3</sup> To explain this fragmentation of production, we need to go beyond 3