Journal of International Economics 67 (2005) 241 – 257

www.elsevier.com/locate/econbase

The effect of outward processing trade on wage

inequality: the Hong Kong case
Lok Sang Ho, Xiangdong Wei*, Wai Chung Wong
Department of Economics, Lingnan University, Hong Kong

Received 28 June 2002; received in revised form 25 February 2004; accepted 1 September 2004

Abstract

This study uses time series analysis to investigate the impact of Hong Kong’s increased outward
processing trade with the Chinese Mainland on wage inequality. We found a significant positive
association between outward processing trade and the wage premium of university graduates over
primary school graduates and that over secondary school graduates. Moreover, a standard test
showed one-way causality from outward processing trade to the widening of skill wage gap.
Furthermore, the increase of outward processing trade is found to both increase the pay for well-
educated people and decrease the pay for less well-educated people, thereby widening the wage gap.
D 2004 Elsevier B.V. All rights reserved.

Keywords: Wage inequality; Outward processing trade; Causality

JEL classification: F16

1. Introduction

Since the 1970s, the rising wage gap between skilled and unskilled workers has become
a common phenomenon in many developed countries. The issue has triggered a series of
studies on what are the causes behind such a phenomenon. Amongst various theories
proposed by economists, the effect of increased international trade and competition from

* Corresponding author. Tel.: +852 26167205; fax: +852 28917940.

E-mail address: xdwei@ln.edu.hk (X. Wei).

0022-1996/$ - see front matter D 2004 Elsevier B.V. All rights reserved.
doi:10.1016/j.jinteco.2004.09.005
242 L.S. Ho et al. / Journal of International Economics 67 (2005) 241–257

developing countries on wage inequality in developed countries has received a lot of

attention. So far, the empirical evidence on this theory has been quite mixed. While studies
by Murphy and Welch (1991,1992), Borjas et al. (1992), Wood (1994), Borjas and Ramey
(1994), Sachs and Shatz (1996), Baldwin and Cain (2000) and Feliciano (2001) all found
that increased trade and competition are responsible for at least some proportion of the
rising wage inequality in the US and other countries, Bound and Johnson (1992), Lawrence
and Slaughter (1993), Ghosh et al. (2000) and Chakrabarti (2000) found that trade only
produced insignificant or even an opposite effect on wage inequality. The opponents of the
trade and wage inequality theory (e.g. Bhagwati and Dehejla, 1994; Learner, 1994) argue
that, for trade to affect wage inequality, there must be an increase in the relative prices of the
skill-intensive products over other products, assuming developed countries specialize in
skill-intensive products and developing countries specialize in non-skill-intensive products.
Furthermore, the fact that the rising demand for skilled workers is mainly contributed by
within-industry skill upgrading rather than demand shift between industries also seems not
to favor the theory of trade and wage inequality. The latter evidence strongly suggests skill-
biased technological progress as the cause for wage inequality.
Recently, a new wave of theoretical and empirical studies has emerged to suggest that,
despite the absence of a rise in the relative price of the skill-intensive products, increased
international trade could still be a major cause for rising wage inequality.1 The key lies in
the recognition that increased international trade today is often in the form of increased
trade in intermediate rather than final products. This form of international trade is also
called outsourcing or outward processing trade (thereafter OP trade). So while one may
observe small changes in the ratios of trade to GDP in many industrialized countries over
the last century, there have been substantial changes in the contents of trade for these
countries, i.e. shifting towards more trade in intermediate goods or OP trade.2 Such a shift
in the content of trade means that fewer non-skill-intensive production processes are
carried out in developed countries and hence the demand for unskilled workers declines
even within the same industry. This decline in the demand for unskilled labor in turn
causes rising wage inequality. This theory is also consistent with the phenomenon that
there may be no relative price increase of skill-intensive products, and the observation that
increases in the demand for skilled workers appear to occur mainly within rather than
between industries. So far, evidence for a positive association between OP trade and wage
inequality has been found for the US (Feenstra and Hanson, 1996), the UK (Anderton and
Brenton, 1999), Japan (Head and Ries, 2000), Mexico (Feenstra and Hanson, 1997) and
Hong Kong (Hsieh and Woo, 1999).
Hong Kong presents an interesting, telling case as like many developed countries, it has
experienced rising wage inequality since the mid-1980s. Based on the Population Census
data, the estimated Gini-coefficient reached 0.52 in Hong Kong in 2001 up from 0.47 in
1991 (estimated by the Census and Statistics Department of Hong Kong using household

1
See Feenstra and Hanson (2001) for a detailed survey.
2
Using input–output tables for 10 OECD and 4 emerging market countries, Hummels et al. (2001) estimated
that 21% of these countries’ exports are attributable to outsourcing trade, and the ratio grew by almost 30%
between 1970 and 1990. Campa and Goldberg (1997) found that the share of imported inputs in total
manufacturing inputs doubled in the US between 1975 and 1995, and is well over 20% for Canada and the UK.
 L.S. Ho et al. / Journal of International Economics 67 (2005) 241–257 243

income). From 1991 to 2002, the wage premium for university graduates over primary
school leavers and that over secondary school graduates increased by 60% and 40%,
respectively (see Fig. 1). Thus, the issue of rising wage inequality in Hong Kong deserves
attention both from the research and the policy point of view.
The study of the relationship between trade and wage inequality in Hong Kong is also
interesting as Hong Kong is a well-known international trade center. Since the opening up
of the Chinese economy in the late 1979, the export-oriented Hong Kong manufacturers
have gradually moved their production base to the Pearl River Delta region, leaving only
their head offices or controlling centers in Hong Kong. Hong Kong has increasingly
become a sourcing and controlling center for manufacturing goods produced on the
Mainland. From the period of 1980 to 2000, the share of Hong Kong’s manufacturing
output in its GDP declined from about 40% to 12%, while the share of manufacturing
employment dropped from about 50% to 17%. At the same time, Hong Kong’s external
trade volumes increased fivefold, making Hong Kong now the world’s ninth largest
trading entity. Furthermore, the bulk of this increased trade with the Mainland China is
related to outward processing (see Table 1). During the same time income inequality
increased significantly. It is therefore interesting to see to what extent the widening wage
inequality is associated with the increased OP trade between Hong Kong and the Mainland
China.
Hsieh and Woo (1999) carried out a similar study on the relationship between OP trade
and wage inequality for Hong Kong. Our study differs from theirs mainly in data and
methodology. They used Hong Kong Population Census data, which is available once
every 5 years, and ran cross-section regressions to show the linkage between OP trade and
wage inequality. We employed, on the other hand, quarterly time series data and co-
integration analysis. Our study is unique in that it used the Quarterly General Household

Fig. 1. Experience-adjusted wage differentials 1991–2002. Source: Estimated from the General Household
Survey (GHS) data provided by the Census and Statistics Department.
244 L.S. Ho et al. / Journal of International Economics 67 (2005) 241–257

Table 1
Trade with mainland China involving outward processing: estimated value and proportion in total trade with
mainland China (million HKD)
Year Total OP-related Trade (% in Total Trade)
1991 418,834 (70.9%)
1995 892,028 (78.5%)
2002 1,125,742 (78.3%)
Annual % change in value 1991–2002 15.3%
The definition for total OP related trade is goods re-exported through Hong Kong and imported to Hong Kong of
which all or part of the raw materials or semi-manufactures have been exported from or through Hong Kong to the
mainland of China for processing with a contractual arrangement for subsequent re-importation of the processed
goods into Hong Kong. Figures in brackets are the corresponding proportions of OP trade in total trade with the
mainland.
Source: Hong Kong Census and Statistics Department, Hong Kong Monthly Digest of Statistics, various issues,
Government Printer, Hong Kong.

Survey data to derive quarterly, experience-adjusted wage gaps between workers with
different education qualifications over the period 1991–2002. This time series data enable
us to carry out co-integration analysis and fit a vector error-correction model (VECM) to
test if there is a causal relationship between the increasing OP trade and the increasing
wage inequality in Hong Kong during the 1990s.
The rest of the paper is divided into four sections. In Section 2, we calculate the
experience-adjusted wage gaps between the well- and the less well-educated workers and
discuss the possible link between OP trade and wage inequality in Hong Kong. Section 3
discusses our data and methodology. Section 4 presents our main empirical findings.
Finally, Section 5 concludes our study.

2. The wage inequality and OP trade in Hong Kong

We start this section with the estimation of experience-adjusted wage gaps in Hong
Kong over the past decade. We then discuss the possible link between wage inequality and
OP trade engaged by Hong Kong manufactures.

2.1. The trend of wage inequality

The time series data for the earnings of workers with different educational attainment
are obtained from the unpublished statistics collected by the Hong Kong Census and
Statistics Department (C&S) through its Quarterly General Household Surveys. The
original data provided by the C&S gave the median monthly earnings of employees by
sex, educational levels and age groups from the first quarter of 1991 to the third quarter of
2002. We assume that experience is equal to age minus years of schooling minus 6 and
thus derive people’s years of working experience. We then estimate the following
Mincerian earnings equation using cross-section data for each quarter:
X
lnWt ¼ at þ bjt EDUjt þ ct MALE þ dt EXPt þ gt EXP2t þ et ð1Þ
j
 L.S. Ho et al. / Journal of International Economics 67 (2005) 241–257 245

where ln W t is the natural logarithm of median wage of employees in quarter t; EDUjt

( j=primary, secondary, tertiary–non-degree and tertiary–degree) is a vector of dummy
variables indicating people’s highest educational attainment; EXPt and EXP2t are years of
experience and its square term, respectively; MALE is a dummy variable for male
employees and 3 t is an error term; a t , b jt , c t , d t , g t are estimated parameters. The
regressions were run separately for each quarter from the first quarter of 1991 to the
second quarter of 2002, to produce a time series of 46 observations. Each observation
consists of two pairs of the experience-adjusted log wage gaps between the well and less
well-educated workers, calculated as (b ut b pt )(GAPTP) and (b ut b st )(GAPTS), where
subscripts u, p and s denote university graduates, primary school graduates and secondary
school graduates, respectively.
Fig. 1 shows the experience-adjusted log wage differential series, (b ub pt ) and
(b ut b st ). We can immediately see a sharp rise in wage gaps in the early 1990s. It
indicates that workers with university education earn about 97% more than those
with primary education in 1991. This premium increased to about 155% in 2002,
representing an increase of almost 60 percentage points in the earnings gap over this
time period. The wage gap between the university graduates and the secondary
school graduates also recorded a nearly 40 percentage point increase. Note that the
share of the university graduates in the total labor force stood at about 5.9% in
1991 and increased to 12.7% in 2001, while the share of labor force with only
primary school education dropped from 25.2% to 20.5% during the same period
(Population Census Summary Results, Hong Kong Census and Statistics Department,
2001).

2.2. The link between wage inequality and OP trade

Feenstra and Hanson (1996) argue that bglobal production sharingQ has much the same
effect on labor demand as skill-biased technical change. This form of trade is often
associated with the practice of boutward processingQ or boutsourcingQ. Outsourcing
increases the demand for skilled workers at home as the need for design, market research
and strategic marketing increases. The demand for unskilled workers at home, however,
will be reduced. These changes will result in an increase in the wage gap between these
two groups.
The Hong Kong case lends support to this theory. As mentioned before, the large
increase of Hong Kong’s trade is related to trade with the Chinese Mainland. The
trade with the mainland now amounts to 42% of Hong Kong’s total trade, with 44%
of Hong Kong’s imports sourced from the mainland and 32% of Hong Kong’s
domestic exports and 40% of Hong Kong’s re-exports heading there. According to the
statistics reported by Hong Kong’s Census and Statistics Department in the third
quarter of 2002, 46% of Hong Kong’s total exports to the mainland of China were for
outward processing, while 76% of Hong Kong’s imports from the mainland were
related to outward processing. Over the same period, 81% of Hong Kong’s re-exports
of the mainland of China origin to other places were produced through outward
processing in the mainland (also see Fung, 1997; Hanson and Feenstra, 2004). This large
volume of OP trade is a result of a huge migration of Hong Kong’s manufacturing
246 L.S. Ho et al. / Journal of International Economics 67 (2005) 241–257

firms3 (estimated about four-fifths) to the Pearl River Delta region, which is just across the
border from Hong Kong. In what follows, we will test whether the empirical evidence in
Hong Kong supports the thesis that OP trade is an important driver of wage inequality in
Hong Kong.

3. Data and methodology

To test the relationship between OP trade and the changes in wage gap in Hong Kong,
we propose to use co-integration techniques and causality tests using data spanning over
the period of 1991–2002.
Feenstra and Hanson (1996) define outsourcing as production from offshore assembly
plants and purchasing from subcontractors. The available data in Hong Kong that match
this definition most closely consist of a time series officially published by the Hong Kong
Census and Statistics Department called bimports from the mainland of China plus re-
exports of the mainland of China origin to other places involving outward processing in
the mainlandQ. This consists of: (a) goods imported to Hong Kong from the Chinese
Mainland involving outward processing and (b) re-exports of Chinese Mainland origin
through Hong Kong to third countries involving outward processing. The usual OP
arrangement is to export raw materials or semi-manufactures from or through Hong Kong
to the Mainland for processing, with a contractual arrangement for subsequent re-
importation of the processed goods into Hong Kong. Both these are boutput measuresQ as
distinct from binput measuresQ such as bdomestic exports to the mainland of ChinaQ or bre-
exports to the mainland of ChinaQ. Notice that the survey conducted by the Census and
Statistics Department to collect information on OP trade only covers Hong Kong domestic
firms. So this measure excludes any OP trade with the Chinese mainland conducted by
foreign firms and using Hong Kong as a trade hub. We believe that this measure of OP
trade is a more accurate one than other measures, such as those used by Hsieh and Woo
(1999).4 However, it may still under-estimate the OP trade with the mainland of China as it
does not include the goods outsourced by Hong Kong firms that are not re-exported
through Hong Kong. Nevertheless, the extent of under-estimation is probably small, as the
majority of Hong Kong firms prefer to export their goods via Hong Kong due to the
reliability and efficiency of its port and other incidental services.5
Unfortunately, this measure of OP trade is only available from the first quarter of 1991.
So our empirical analysis employs quarterly data from the first quarter of 1991 to the

3
Typically, they shift their whole production base to the Pearl Delta region and retain a controlling center in
Hong Kong.
4
Hsieh and Woo (1999) also mentioned this data set in their article. But as the Hong Kong Census and
Statistics Department only started to publish this data from 1991, and since they have to use the 1976, 1981 and
1986 Hong Kong Population Censuses for their analyses, other measures of OP trade had to be used. The OP
measures used by them are the re-exports of Chinese origin, ratio of imports from China in the sum of domestic
shipments and imports from China, and the ratio of inputs imported from China in total intermediate inputs. None
of these measures are as direct as the measure used by us.
5
Hanson and Feenstra (2004) give detailed analyses on why Hong Kong is preferred as a trade hub for re-
exports of Chinese goods.
 L.S. Ho et al. / Journal of International Economics 67 (2005) 241–257 247

Fig. 2. Outward processing trade measures 1991–2002. Source: Hong Kong Census and Statistics Department,
various issues, Hong Kong Monthly Digest of Statistics.

second quarter of 2002. To properly gauge the impact of OP trade on the demand of
workers in Hong Kong, we use both the absolute level of OP trade and the ratio of OP
trade over GDP in our empirical analysis. The extent of increases of OP trade is presented
in Table 1. As we can see from Table 1, our OP trade measure recorded substantial
increases in values from 1991 to 2002, with an average annual increase rate of 15.3%. We
also plot our measures in Fig. 2. The total OP trade over GDP increased from about 45% in
1991 to over 90% in 2002. The sharp rise of the OP trade relative to the growth of
domestic production is therefore expected to have a significant impact on the domestic
labor demand.
Our measures of skilled vs. unskilled wage gaps are those defined in Section 2. We plot
the de-trended wage gap measures along with the OP trade measures in Figs. 3 and 4.
From these two graphs, it is already apparent that the OP trade measures seem to lead the
changes over the wage gap measures, suggesting possible causality running from OP trade
to wage inequality.
Our estimation approach follows that of Borjas and Ramey (1994) and Ghosh et al.
(2000). We first check the stationarity of all the time series using the Augmented Dickey-
Fuller (ADF) test. Next, the Johansen (1988) co-integration approach is implemented to
test whether the OP trade is co-integrated with the wage gap, i.e., if there is a non-spurious
long-term relationship between the two series. Finally, we run the vector error correction
model (VECM) to establish the direction of causality, if any, between them. Seasonality is
handled by including quarterly seasonal dummies in all regressions.6

6
There is no need to seasonally adjust the explanatory variables. Regardless of the source of movements in the
explanatory variables, seasonality or otherwise, the regression equation holds that there will be effects on the
dependent variables as implied by the coefficients. However, there may be seasonality in the relationship that
must be captured independently by dummy variables.
248 L.S. Ho et al. / Journal of International Economics 67 (2005) 241–257

4. Results

We begin the analysis by examining the stationarity properties of the variables using the
ADF test (Dickey and Fuller, 1981). The following equations are estimated for each of the
time series:

X
k
DXt ¼ a0 þ a1 t þ b0 Xt1 þ bi DXti þ gt ð2Þ
i¼1

where D is the first difference operator, t is the time trend, k denotes the number of lags
used and g is the error term; a’s and b’s are parameters. The null hypothesis that series X t
is non-stationary can be rejected if b 0 is statistically significant with negative sign. The
optimal lag k is chosen carefully by the Akaike Information Criterion (AIC). Table 2
shows that the test statistics for all the series in level form and in their first differences,
respectively. The fact that the null hypothesis of unit root cannot be rejected when the
series are in level but can be rejected when the series are in first differences indicates that
all the series are integrated of order one.
Since the variables are integrated of the same order (I(1)), the next step is to carry out
co-integration analyses of the variables. We first try to identify the long-run relationship
between our measures of OP trade (ROP and ROPGDP) and the wage differentials
measures (GAPTP and GAPTS), and then their causal relationships by using the Johansen
procedure (1988).
In order to ensure a correct lag specification for the Johansen test and avoid the
possibility of obtaining misleading results, the lag length of the VAR for each case is

Fig. 3. GAPTP GAPTS and ROPGDP (detrended).

 L.S. Ho et al. / Journal of International Economics 67 (2005) 241–257 249

Fig. 4. GAPTP GAPTS and ROP (detrended).

determined by AIC. The co-integration test results are presented in Panel A of Table 3. The
number of co-integrating vectors r is determined by k max and/or trace statistics. We start
with the null hypothesis of r=0 and moving the value of r up step-by-step until the H o
cannot be rejected. The results show that except for the relationship between GAPTS and
ROPGDP (the critical value of testing for one co-integrating vector between them was
very close to 10% level), there is only one co-integrating vector r between our OP
measures and each of the wage differential measures.

Table 2
Augmented Dickey-Fuller test of unit root (period: 1991–2002)
Variable name Test on No trend Trend Conclusion
GAPTP Level 0.4502 1.5503 I(1)
1st diff. 5.3973** 5.4586**
GAPTS Level 0.3216 1.3513 I(1)
1st diff. 5.5105** 5.3783**
ROP Level 1.8497 2.3197 I(1)
1st diff. 3.1110** 4.1024**
ROPGDP Level 2.2337 1.6578 I(1)
1st diff. 3.0429** 3.2923*
EDUP Level 0.0139 1.5702 I(1)
1st diff. 6.2463** 6.1291**
EDUS Level 1.0745 2.3864 I(1)
1st diff. 6.4083** 6.4450**
EDUT Level 0.6178 1.5147 I(1)
1st diff. 3.0179** 2.8863
The number of lags in the two unit root tests is determined by the AIC criteria.
* 10% significance level.
** 5% significance level.
250 L.S. Ho et al. / Journal of International Economics 67 (2005) 241–257

Table 3
Co-integration test using the Johansen procedure
Co-integrating relation Null hypothesis Alternative Test statistics
hypothesis
GAPTP=f(ROP) Trace tests: Trace value
r=0 rN0 28.7571**
rQ1 rN1 4.5809
k max tests: k max value
r=0 r=1 24.1763**
r=1 r=2 4.5809
GAPTP=f(ROGDP) Trace tests: Trace value
r=0 rN0 23.3701*
rQ1 rN1 8.7097
k max tests: k max value
r=0 r=1 14.6604
r=1 r=2 8.7097
GAPTS=f(ROP) Trace tests: Trace value
r=0 rN0 31.1663**
rQ1 rN1 3.1677
k max tests: k max value
r=0 r=1 27.9986**
r=1 r=2 3.1677
GAPTS=f(ROPGDP) Trace tests: Trace value
r=0 rN0 22.6570
rQ1 rN1 7.9000
k max tests: k max value
r=0 r=1 14.7571
r=1 r=2 7.9000
EDUP=f(ROP) Trace tests: Trace value
r=0 rN0 19.5799**
rQ1 rN1 6.5640*
k max tests: k max value
r=0 r=1 13.0159**
r=1 r=2 6.5640*
EDUP=f(ROPGDP) Trace tests: Trace value
r=0 rN0 17.2862*
rQ1 rN1 5.2868
k max tests: k max value
r=0 r=1 11.9995
r=1 r=2 5.2868
EDUS=f(ROP) Trace tests: Trace value
r=0 rN0 29.0637**
rQ1 rN1 5.4589
k max tests: k max value
r=0 r=1 23.6048**
r=1 r=2 5.4589
EDUS=f(ROPGDP) Trace tests: Trace value
r=0 rN0 31.8002**
rQ1 rN1 6.7815
k max tests: k max value
r=0 r=1 25.0187**
r=1 r=2 6.7815
 L.S. Ho et al. / Journal of International Economics 67 (2005) 241–257 251

Table 3 (continued)
Co-integrating relation Null hypothesis Alternative Test statistics
hypothesis
EDUT=f(ROP) Trace tests: Trace value
r=0 rN0 36.6400**
rQ1 rN1 4.6626
k max tests: k max value
r=0 r=1 31.9773**
r=1 r=2 4.6626
EDUT=f(ROPGDP) Trace tests: Trace value
r=0 rN0 23.4665*
rQ1 rN1 7.4148
k max tests: k max value
r=0 r=1 16.0518
r=1 r=2 7.4148
r indicates the number of co-integrating vectors.
Lag orders are determined by AIC criteria.
As the series of EDUS and EDUT clearly exhibit trend, we consider regressions with unrestricted constant and
restricted trend. Since the series of EDUP does not indicate a clear deterministic trend, we run regressions with
only unrestricted constants to allow for one or more common stochastic trends with deterministic trend
components.
* 10% significance level.
** 5% significance level.

Panel A of Table 4 reports the normalized co-integrating coefficients that are interpreted
as long run equilibrium coefficients. These coefficients indicate that both OP trade measures
have a positive and significant impact on the wage differential between university and
primary school graduates. For the case of wage differential between university and
secondary graduates, we also found a positive coefficient for both OP measures though the

Table 4
Normalized co-integrating coefficients (bivariate estimates) using the Johansen procedure
Co-integrating regressions Coefficient t-statistic
Panel A
GAPTP=f(ROP) 0.1285 2.6333**
GAPTP=f(ROPGDP) 0.3043 1.9393**
GAPTS=f(ROP) 0.0628 1.7536*
GAPTS=f(ROPGDP) 0.1014 0.8119

Panel B
EDUP=f(ROP) 0.1404 1.9756**
EDUP=f(ROPGDP) 0.5775 4.1460***
EDUS=f(ROP) 0.0993 2.4168**
EDUS=f(ROPGDP) 0.1656 2.2937**
EDUT=f(ROP) 0.1537 3.9076***
EDUT=f(ROPGDP) 0.2547 1.7120*
* 10% significance level.
** 5% significance level.
*** 1% significance level.
252 L.S. Ho et al. / Journal of International Economics 67 (2005) 241–257

coefficient on ROPGDP is insignificant. Hence, it can be said that there are long run
positive association between OP trade and wage differentials (particularly for the wage gap
between university graduates and primary school leavers) in Hong Kong. In addition, the
results also confirm that the VECM is appropriate for examining their long run causal
relationships. This is because in the presence of co-integration between two I(1) series, the
standard Granger causality test that requires all series are stationary I(0) only picks up the
short run interactions and is not appropriate for detecting long run relationships.
The VECM requires that we incorporate the error term obtained from the co-integration
into the standard Granger causality tests. The corresponding regressions to run are:
X
k X
k
DYt ¼ c þ ai DYti þ bi DXti þ ddt1 þ lt ð3Þ
i¼1 i¼1

X
k X
k
DXt ¼ f þ gi DXti þ hi DYti þ rut1 þ mt ð4Þ
i¼1 i¼1

where D denotes first difference, l and m are the error terms with the usual properties; d and
u are the lagged error terms taken from the bivariate co-integration test between X and Y; c,
a i , b i , d, f, g i , h i and r are parameters. In Eq. (3), the lagged dynamic terms DX ti capture

Table 5
Causality tests using the VECM approach
Null hypothesis Coefficient for t-statistics for
ECM(1) ECM(1)
Panel A
ROP does not cause GAPTP 0.5594 5.0950*
GAPTP does not cause ROP 0.3903 1.1137
ROPGDP does not cause GAPTP 0.3423 3.8227*
GAPTP does not cause ROPGDP 0.1451 0.8338
ROP does not cause GAPTS 0.6302 5.6518*
GAPTS does not cause ROP 0.3305 0.7668
ROPGDP does not cause GAPTS 0.3846 3.8318*
GAPTS does not cause ROPGDP 0.2335 1.1249

Panel B
ROP does not cause EDUP 0.2213 3.5669*
EDUP does not cause ROP 0.1349 0.7088
ROPGDP does not cause EDUP 0.1582 2.9522*
EDUP does not cause ROPGDP 0.1515 1.3757
ROP does not cause EDUS 0.4232 5.0707*
EDUS does not cause ROP 0.2535 0.6309
ROPGDP does not cause EDUS 0.4276 5.3056*
EDUS does not cause ROPGDP 0.0868 0.3419
ROP does not cause EDUT 0.7144 6.1656*
EDUT does not cause ROP 0.1496 0.4108
ROPGDP does not cause EDUT 0.4209 4.0077*
EDUT does not cause ROPGDP 0.1151 0.6350
* Denotes significance at 1% level.
 L.S. Ho et al. / Journal of International Economics 67 (2005) 241–257 253

Fig. 5. Actual and fitted value of DGAPTP (explanatory variable: ROPGDP). Note: (1) The fitted value based on
the estimated VECM. (2) D denotes first diffrence.

the short run effect of X on Y, while the lagged error correction term Dt1 captures the
adjustment toward the long run equilibrium. If d is statistically significant with a negative
sign, Y then is said to be Granger-caused by X in the long run. The same can be
said for X if r is negative and statistically significant.
The coefficients of the error correction terms (d and r) and their t-statistics are shown in
Panel A of Table 5. The coefficients for the error correction terms enter significantly with
negative sign only when the wage gaps are the dependent variables. The significant negative
coefficients, which represent the channel of causality in the long run, also confirm our earlier
findings that co-integration exists between them. Based on these results, we can conclude
that the direction of causality runs from OP trade to wage differentials. Moreover, based on
the estimated VECM, we plot the actual and fitted values of the change in GAPTP and
GAPTS in Figs. 5–8. We can see that our OP trade measures can predict the
changes in wage gaps quite well.
The finding that the OP trade causes wage gaps to increase is consistent with our theory.
The theory also predicts that this causal relationship is based on the fact that the OP trade
has a positive impact on the wage of skilled workers and negative impact on the wage of
unskilled workers. To show this is also true, we carry our analysis forward to examine the
impact of the OP trade on the changes of returns to university (EDUT), secondary school
(EDUS) and primary school education (EDUP) individually. From Table 1, we know that
all these three series are I(1) series.
Panel B of Table 3 shows that all of them are co-integrated with OP trade measures.7
The estimated coefficients presented in Panel B of Table 4 further show that the OP trade
generates a significant and negative impact on the return to primary education and a
significant and positive impact on university education. The impact on secondary
education is also positive but less than that of university education. Finally, we also
identify the causality runs only from the OP trade to EDUP, EDUT and EDUS, but not
the other way round (see Panel B of Table 5). Overall, these results support the theory
7
For the series of EDUP, the results indicate there are two co-integrating vectors (only marginally rejected at
10% for rQ1). Since we only have one explanatory variable, so, we consider there is also one co-integrating
vector for this case.
254 L.S. Ho et al. / Journal of International Economics 67 (2005) 241–257

Fig. 6. Actual and fitted value of DGAPTS (explanatory variable: ROPGDP). Note: (1) The fitted value based on
the estimated VECM. (2) D denotes first diffrence.

that the increased OP trade raises the wages for skilled workers and pull down the wages
for unskilled workers thereby widening the wage gap between skilled and unskilled
workers.
To further confirm our findings, we carried out some sensitivity tests. First, it may be
argued that manufacturing jobs are not seriously affected by OP-related imports as they
have to go through further processing by Hong Kong firms. We therefore used re-exports
of the mainland of China origin to other places involving outward processing in the
mainland as an alternative and more restricted measure of OP trade to carry out the same
empirical test. The results are consistent with those reported here. Secondly, we also tried
to capture the potential effect of skill-biased technical change on wage inequality by
including the capital labor ratio. Our results are not affected by the inclusion of this extra
explanatory variable.8

5. Concluding remarks

The wage gaps between the university graduates and primary school leavers and
between university graduates and secondary school graduates in Hong Kong have increased
by nearly 60% and 40%, respectively, during the period of 1991–2002. This study aims to
show whether this sharp increase in wage gaps is associated with the increased OP trade
with Mainland China. Using the quarterly time series data for the period of 1991–2002 and
the co-integration analysis, we have found a long run causal relationship between the OP
trade with the Mainland China and the wage inequality in Hong Kong. It is further
confirmed that the OP trade not only raises the pay for the more skilled workers but also
compresses the pay for the less skilled workers, thereby raising the wage gaps in Hong
Kong. This finding is in line with those suggested by the theory of increasing OP trade on
rising wage inequality. Our findings here are also consistent with those found in the United

8
To save space, we did not present these results here. They are available from the authors upon request.
 L.S. Ho et al. / Journal of International Economics 67 (2005) 241–257 255

Fig. 7. Actual and fitted value of DGAPTP (explanatory variable: ROP). Note: (1) The fitted value based on the
estimated VECM. (2) D denotes first diffrence.

States, Canada, the United Kingdom, Germany and Japan. It also complements the cross-
section study on Hong Kong done by Hsieh and Woo (1999).
Our analysis covers mainly the period just prior to China’s accession to the WTO. It is
expected that more Hong Kong firms will move their production bases or less skill-
intensive operations to the Mainland to take advantage of cheap labor, low land costs, and
the improved investment environment after China’s accession to the WTO. OP trade could
then play an even more important role. Our results suggest that this may further accentuate
Hong Kong’s wage inequality.
To ease this problem, the government has to act more swiftly to upgrade Hong Kong’s
labor force. The current share of public expenditure on education in GDP is still below
5% and the share of university graduates in the total labor force is still below 15%—both
of these two figures are well behind that of leading industrialized economies. These
figures suggest that the government will need to devote more resource to manpower
investment.

Fig. 8. Actual and fitted value of DGAPTS (explanatory variable: ROP). Note: (1) The fitted value based on the
estimated VECM. (2) D denotes first diffrence.
256 L.S. Ho et al. / Journal of International Economics 67 (2005) 241–257

Acknowledgement

We thank Jonathan Eaton and an anonymous referee for their valuable comments. We
are responsible for any remaining errors.

Appendix A

Table A1
Key to variables
Variables Description
GAPTP Wage differentials between university
and primary school graduates (b ut b pt ):
calculation from Eq. (1)
GAPTS Wage differentials between university and
secondary school graduate (b ut b st ):
calculation from Eq. (1)
ROP Log of bthe imports from the Chinese
Mainland plus the re-exports of the mainland
of China origin to other places involving
outward processing through HKQ
(constant price)
ROPGDP Ratio of bthe imports from the Chinese
Mainland and the re-exports of the mainland
of China origin to other places involving
outward processingQ to GDP (constant price)
EDUP Return to primary school education (b pt )
EDUS Return to secondary school education (b st )
EDUT Return to tertiary education (b ut )
Data sources
Estimated using Quarterly General
Household Survey provided by the Hong
Kong Census and Statistics Department,
General Household Survey Section
Same as GAPTP
Hong Kong Monthly Digest of Statistics,
various issues, Hong Kong Census and
Statistics Department
Hong Kong Monthly Digest of Statistics,
various issues, Hong Kong Census and
statistics Department
Same as GAPTP
Same as GAPTP
Same as GAPTP

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