How trade really adds up
Inaccurate calculations create a distorted, damaging picture of trade flows, which do not reflect the true value of exports to countries
Forget calculus, algebra and simple arithmetic.
When it comes to calculating trade, you need a whole new understanding of value to make the mathematics work in a world where a notional US$425 export from China is, in fact, worth only US$21 to the country.
Fail to figure out how, and you end up with a badly distorted picture of trade realities.
The potential for increased political friction in the global trade arena means the need to spread the knowledge of how trade really adds up - largely the preserve of a select network of nerds until now - is becoming urgent.
It is not enough to know that trade boosts income and growth through specialisation, allows producers to benefit from economies of scale and provides consumers with more choice at lower prices.
Nor is it sufficient to understand that the diffusion of technology and knowledge that strengthens economic interdependency reduces the scope for conflict.
When jobs are at stake and the pall of protectionism casts its shadow, knowing where the value is created by trade - and how much is generated - is absolutely crucial. Not least because a country taking action to curb imports could easily damage its own exports.
That is why breaking down where the value is created in a US$425 export matters.
The Fung Global Institute, where I work, recently unpicked the seams of a high-end branded men's jacket that retailed in the United States for US$425. As it was labelled "Made in China", it entered US import statistics as a wholly Chinese product.
That could hardly be further from the truth.
The jacket was put together in China from parts (fabric, lining, trimming, stitching, buttons, labels and so on) that came from mainland China, Japan, Hong Kong and South Korea.
China also supplied the labour to create the finished garment and thereby earned the "Made in China" label, because that was where the jacket was assembled. It was the final place of shipment to the market of sale.
But where was the value added in each part of this process?
All of the US value was intangible, involving services such as design, intellectual property, branding, transport, insurance, advertising and retailing, as well as, of course, profit.
Manufacturing costs (parts, labour, overheads and so on) added up to US$38, or 9 per cent of the value, and China's individual contribution was US$21, or 5 per cent.
Yet that US$21 value addition earned China a spot in US trade statistics as an exporter of a jacket worth US$425.
Other researchers have undertaken similar studies on products such as an Apple iPhone, a Nokia 95 smartphone and an Apple iPad.
The message is very similar, with incorrectly defined trade flows telling the same misleading story about the sources of value.
The problem arises when trade is measured as gross flows rather than in terms of value addition.
Trade should be measured in the same way as we measure GDP, in value-added terms.
The distorted picture of trade we work with has far-reaching consequences for our perception of reality.
First, by thinking in terms of gross trade numbers, we cannot grasp the true nature of interdependency among countries through trade.
In a world where global value chains are ubiquitous, a large share of imports is contained in exports.
In countries like the Philippines, Malaysia, Singapore and Thailand, 60 per cent or more of the value of imports is contained in exports. Globally, the share of intermediate products in total imports exceeds two-thirds.
Second, gross trade numbers tell a false tale of the technology content of a nation's exports.
With the traditional measure of trade, it appears, for example, as if the mainland is entirely responsible for designing and making iPhones, whereas it does little more than assemble them.
Third, we end up with a false picture of bilateral trade balances. Economists attach little importance to bilateral balances, because it is a country's over- all trade balance that really matters, but the politics can get ugly.
If US-China trade flows had been measured correctly in 2008, for example, the mainland's trade surplus would have been 40 per cent lower than the figure at the centre of the acrimonious debate about unacceptably large bilateral trade balances that triggered ill-considered threats of retaliatory action.
The data requirements for measuring trade in value-added terms are far more demanding than our traditional approach of looking only at final product value, and for technical reasons the numbers are often far more aggregated.
But if the world fails to rise to the challenge of getting this right, we invite baseless trade tensions and demands for protection.
In our joined-up world, acting against imports can directly damage a country's own export industries, because its imports may be embedded in its exports.
This ironic consequence of outdated thinking about trade may occur more frequently than we realise.
Patrick Low is vice-president of research at the Fung Global Institute