How trustworthy are trade deficit figures?

With the Chinese currently exporting everything from consumer electronics to clothing around the world, most notably to the UK and the USA, it is currently seeing a massive trade surplus while most developed economies are experiencing massive trade deficits. For instance, the United Kingdom, the current account deficit was $35 billion in 2011. Much worse however, was the United States, experiencing a deficit of $360 billion in the same year. On the other hand, China had a current account surplus of $250 billion. While a debate will continue to rage about how to solve these deficits, I believe that there is a fundamental problem with these calculations that means Western economics will always be at a disadvantage.

Currently, trade balances are calculated by taking the whole value of a good when it leaves the country and is traded to another country, regardless of the work that has been completed there, or the value added by the country. This means that if the UK was to produce a table, designed in Italy, valued at £150, the full amount would be added to their balance. However, the value of the imported raw materials needed to produce that table was also valued £140, £150 would still be added to the trade balance, even though the country has only added £10 in value for the manufacturing. Applied to world-wide trade, this has big implications.

For example, Apple have recently reported that over 80 million iPads have been sold throughout the world since the first iPad was introduced in April 2010. Being designed in California by Apple, it is manufactured in China by Foxconn. Even so, none of the component parts are made in China, with the parts coming from a range of countries, including: South Korea; Japan; Taiwan; the United Kingdom; the European Union and the United States. Out of this, around 40% of the parts are provided by Samsung from South Korea. This means that it is a perfect example of how trade calculations are unreliable and hold too much weight in economic debates.

Under current calculations, for each iPad produced, $275, the total production cost, is added to the US trade deficit with China. With 80 million iPads produced so far, that is a total of $22 billion added to the deficit since 2010. However, the total value of the actual work provided by China accounts for only $10, due to the low labour costs, at around 2% of the selling cost of the device. This means that if we consider only the true value added by China, the deficit from the iPads alone will reduce by 96%, to around $800 million, a figure that is a lot different than the $22 billion using the current method.

The same misleading account is applied to all other products. So, if Carnival Cruises, an American company designs a new cruise ship, they could then contract the manufacturing to China. China would then need to buy steel, aluminium and other raw materials from places like Brazil. These parts would then be put together by the Chinese workers to build the cruise ship, which would then exported to the United States. This would lead to the total value of the ship to be counted as an export for China, and thus added to the trade deficit, despite the fact that they have only added the labour, with the raw materials and designs coming from elsewhere. Again, just like the iPad, this is unfair, with labour the only value added by the Chinese.

As a result of the accounting practices, the Chinese surplus of $250 billion is massively exaggerated. Since they provide the final assembly for most of the products they export, the full production value is added to their trade balance, implying that the Chinese is providing a lot more value than they actually are.

Pascal Lamy, the head of the World Trade Organisation, has suggested that if trade statistics were changed to reflect true domestic content, America’s deficit with China would be more than halved. Hal Varian, the Chief Economist at Google, has also suggested that trade deficits between countries are meaningless, adding to the argument suggesting that they need to be changed to reflect the true values added by each country.

So the next time you see news reports suggesting that the “UK trade deficit with China reaches a new record”, or any other country, be wary.