International trade theory has its roots in the 18th-century writings of Adam Smith. He argued that nations could increase their combined output if each specializes in producing goods at which it is most efficient, and then each engages in trade. Every country will be better off, he astutely claimed, in terms of the quantity of goods available for consumption, resources expended and additional output obtained through specialization.

According to David Ricardo, a prominent classical economist, even if a nation does not possess an absolute advantage in the production of a commodity, it still will benefit by producing and exporting those products in which it has a comparative advantage. Put another way, the less efficient nation should specialize in and export the goods and services in which it has the least disadvantage. This personal contemporary example explains the point: if you can type letters faster than your assistant, who is paid considerably less than you, should you put aside your more sophisticated and profitable projects so you can type? No. You are better off delegating the typing to your assistant even though you are more proficient at it.

Although this 18th century trade theory still holds true, conventional trade metrics used to measure global activity do not.

From Trade in Goods to Trade in Tasks

New economic realities—including more sophisticated supply chains, complicated co-production practices, and shifting trade patterns—have replaced the paradigm of trade in goods to trade in tasks. Not surprisingly, this is not well understood. One reason: the value generated is not accurately captured or reflected in conventional trade statistics. As a result, what’s not revealed—factors that often benefit the United States—have instead led to misinformation, trade distortions, bad policy recommendations, and trade friction.

The Value of Value-Added Data

Today, instead of flowing directly to America, much of Asia’s exports first go to China for assembly, processing and manufacturing, and then to the U.S., inflating the U.S.-China trade deficit. Unfortunately, conventional trade statistics don’t capture this changing trade pattern or the benefits it derives. To grasp a more accurate picture of what’s occurring, it’s important to identify how much value is added when a country manufactures, processes or assembles goods.

According to the U.S. International Trade Commission (ITC), Chinese value-added, as a component of Chinese exports, is about 50 percent. Stanford Professor Lawrence Lau puts this figure at 37 percent. And based on additional ITC analysis, this figure drops to 35 percent of the value of goods produced in Chinese export zones. As a result, one-half to two-thirds of the value of Chinese exports are of non-Chinese origin.

China is not unique. According to the World Trade Organization, the domestic values of exports from South Korea and Malaysia are 56 percent and 50 percent, respectively.

The Apple iPod manufacturing process is very telling. On the back of each iPod is the statement, “Designed by Apple in California and assembled in China.” However, conventional trade statistics don’t disclose this. What’s more, the U.S. import cost from China of an iPod, according to the University of California, is $150. Yet, only about $4 of this is Chinese value-added derived from Chinese labor and components; the remaining $146 represents the value of components produced in the United States, Japan, Singapore, Taiwan, and Korea.

In addition, the U.S. retail price, at $299, handsomely compensates U.S. retailers, distributors, logistic companies, marketers, researchers and Apple shareholders. Yet, based on conventional metrics, the $150 iPod import figure is applied to the U.S.-China trade deficit and perceived as having a negative effect on the U.S. economy.

The bottom line: since increasing numbers of products are co-produced across borders, origin labels—and the distorted trade pictures they perpetuate—mask what’s really happening. Even the Airbus 380 European label could be contested, says WTO Deputy Director-General Alejandro Jara. The engines are from the United States and Airbus Industrie has more than 1,500 suppliers in 27 countries.

Currency Assumptions are Outdated

The value of the renminbi (RMB), also known as the yuan, is undervalued by 25 percent on a trade weighted basis (JPMorgan says 10 percent), and 40 percent against the dollar, says Fred Bergsten of the Washington, D.C.-based Peterson Institute of International Economics. The assumption goes: if China raises the value of the RMB—which it began to slowly do on June 21—Chinese exports to the U.S. will become more expensive. In turn, fewer Chinese products will be purchased by Americans—bringing down the U.S. trade deficit. But due to today’s complex variables, including pass-through rates, the availability of domestically produced substitutes, and the change in cost of imported inputs, assumptions based on old textbook theories don’t always hold true.

For example, if an importer’s national currency falls by 10 percent and the cost of imports rises by 10 percent, the pass-through rate would be 100 percent. In turn, the weaker currency would reduce import demand. But today, many types of imports, especially consumer goods, have not become more expensive as the value of the dollar has come down. Why? Exporters to the U.S. often reduce their prices and accept smaller profit margins in order to maintain U.S. marketshare. As a result, real pass-through rates are significantly less than 100 percent.

A deeper look reveals this fact: between July 2005-July 2008, the RMB appreciated 21 percent against the dollar. Yet, the U.S. trade deficit with China rose by 33 percent. Likewise, from 2002-2005, despite considerable dollar appreciation against the Canadian dollar, euro, Japanese yen, Korean won, and Brazilian real, the U.S. trade deficit with each country rose. Thus, surprising to many policymakers, although the Chinese RMB is undervalued causing various problems, boosting its value is unlikely to have a significant impact on the U.S. deficit, noted former Federal Reserve Chairman Alan Greenspan.

Even if the pass-through rate were 100 percent and the price of Chinese goods rose enough to discourage imports, U.S. buyers would still seek lower-cost imports from other developing countries. Instead of focusing on the RMB—which is anticipated to gradually rise—policymakers would be wise to concentrate on other factors to correct U.S.-China and other global imbalances.

This article appeared in Impact Analysis, July-August 2010.

John Manzella
About The Author John Manzella [Full Bio]
John Manzella, founder of the Manzella Report, is a world-recognized speaker, author of several books, and an international columnist on global business, trade policy, labor, and the latest economic trends. His valuable insight, analysis and strategic direction have been vital to many of the world's largest corporations, associations and universities preparing for the business, economic and political challenges ahead.

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