A fascinating case study based on the iPhone shows how the global economy really works and why exchange rates do not matter much for trade flows any more. Established views on world trade and globalization are severly questioned by this analysis.
Eight simple words are sufficient to describe globalization. Those eight words are also giving a concise summary of the daunting problems the world economy has been struggling with for years. On top of this, they are revealing the weaknesses of traditional trade theory. In tiny, silver letters they are printed on the back of every iPhone:
“Designed by Apple in California – Assembled in China”
In our global economy the invention of high-tech goods like the iPhone and the physical production of this stuff are happening in different places on the planet. This spatial separation has huge economic consequences as two economists with the Asian Development Bank and a think tank in Tokyo are pointing out in a fascinating research paper.
Yuqing Xing and Neal Detert have analyzed the supply chain of the iPhone and came to amazing conclusions for trade and currency policies. Their results are highly relevant for current trade and exchange rate negotiations Their paper shows that even a significant appreciation of the Chinese currency would not really help to reduce the U.S. trade deficit with China. The importance of exchange rates for the structure of world trade is massively overrated.
The paper entitled “How the iPhone widens the United States Trade Deficit with the People’s Republic of China?” highlights a strange paradox of globalization. On the one hand developed countries like the United States are world leaders in developing innovative IT products. On the other hand the physical devices are being produced in developing and emerging countries and shipped to the industrial world. According to the paper, this lead to the following consequence:
“Even high-tech products invented by US companies will not increase US exports, but to the contrary exacerbate the US trade deficit.”
According to their estimates the iPhone in 2009 had contributed 1.9 billion dollars to the U.S. trade deficit. The smart phone is thus responsible for almost one percent of the U.S. trade deficit with China. The huge hole in U.S. trade balance is the main ingredient of the global economic imbalances that many economists regard as a longterm threat to global economic stability.
Why current trade statistics are flawed
Traditional trade theory is not able to explain these trade patterns. As Xing and Detert assert:
By any definition, the iPhone belongs to the high-tech products category, where the US has an indisputable comparative advantage. In effect, the Peoples Republic of China [PRC] does not domestically produce any products that could compete with iPhones. The US also has an absolute advantage in the smart phone category. Ricardian theory and Hecksher-Olin theory would suggest the US should export iPhones to the PRC.
But the global economy does not match with those old-fashioned trade models any more. The character of world trade has completely changed in recent decades thanks to foreign direct investment, increasing global division of labor and global production networks. Nowadays high-tech products have not one but many countries of origin. Components and parts are sourced from all over the world and assembled in low-wage countries. The current trade statistics no longer reflect what’s really going on in the global trade. .
Xing and Detert illustrate this with the example of the iPhone, using data from the market research firm iSuppli. According to those figures the total production cost of the iPhone was $178.96 in 2009. In the U.S., Apple sold the equipment for $500 – the profit margin stood at 64 percent.
All parts of the iPhone are brought from other countries to China, assembled and then re-exported. The most important supplier is Toshiba – the Japanese company supplies parts worth $60, including the Flash memory and the touch screen. Germany’s Infineon supplies components’ are worth 29 dollars and parts by Samsung from Korea are worth $23. Components from U.S. companies cost eleven dollars. Overall, the material costs add up to $172.46. Assembly of the individual parts in China costs only $6.50 – just 3.6 percent of manufacturing costs.
Since the current trade statistics are based on the total value of the goods and services, each iPhone bought by American consumes resembles an import from China of $178.98 . In 2009 Apple sold 11.3 million iPhones in the USA. All in all those iPhones added up to almost $2 bn of Chinese imports to the US. However, the actual value added by China was $73.5 million dollars ($6.80 per phone). From a value added perspective the U.S. even had a small trade surplus of $ 48 million with China because American companies provided iPhone components worth 121.5 million dollars. The authors conclude:
Bilateral trade imbalances between a country used as a final assembler and its destination markets are greatly inflated by trade in intermediate products. These statistics provide a distorted picture about bilateral trade imbalances.
A more general description of the flaws of the current trade statistics has been compiled by Andreas Maurer and Christoph Dagain, two Economists with the World Trade Organization. In their paper entitled “Globalization and trade flows: what you see is not what you get!” they are coming to the following conclusion:
The international fragmentation of industrial production blurs the concept of country of origin and calls for the production of new statistics on the domestic content of exports, with a view of estimating trade in value added.
Exchange rates don’t really matter
Those biased statistics lead to wrong policy recommendations, especially regarding the exchange rate policy. The U.S. has for years put pressure on China and has called for a revaluation of the Yuan. According to American criticism Beijing keeps the exchange rate artificially low and benefits from unfair competitive advantages.
However Xing and Detert provide compelling evidence that even a drastic Yuan appreciation would be almost meaningless for trade flows. If China’s currency appreciates by 20 percent the assembly costs for the iPhone would increase only by 1.30 dollar. This is merely 0.7 percent of the total manufacturing expenditures. The economists assert:
Even a 50% appreciation of yuan against the dollar would not bring a significant change in total manufacturing costs, as the assembling cost contribution of PRC workers to a ready to use iPhone is very little—only 3.6%. Therefore, it is unlikely that a yuan appreciation would lower many components of the trade deficit, in this case the portion due to iPhone trade.
Rolf Langhammer, foreign trade expert at the Kiel Institute for World Economics, agrees. “Today exchange rates are much less important for global trade flows than in the past.” However, the example of the iPhone exaggerates the phenomenon. According to Langhammer , the value added to Chinese exports in China on average is 73 % rather than 3.6% .
Nonetheless the U.S. economy apparently has a structural weakness with regard to China. In a recent paper entitled “Rising Import Demand in China: Cui Bono and Why? Langhammer comes to the conclusion that U.S. exports did not significantly benefit from economic growth in China.
Given the profit margin Apple enjoys with the iPhone, the company could easily produce the phones in the U.S. – even though labor costs are ten times higher there, say Xing and Detert. The total costs of production would increase by about $60 to 240 dollars per iPhone. The profit margin would decline from 64 to 50%. The economists assert:
In this hypothetical scenario, iPhones … would contribute to US exports and the reduction of the US trade deficit, not only with the PRC, but also with the rest of the world. More importantly, Apple created jobs for US low skilled workers; those who could not be the software engineers needed by Apple. Giving up a small portion of profits and sharing them with low skilled US workers by Apple would be a more effective way to reduce the US trade deficit and create jobs in the US.
Note: This blog post is an English version of my article “Die Logik der iPhone-Ökonomie” which has been published in Germany’s Handelsblatt. The English text is partly based on a translation by Karen Gallagher with Asian Development Bank. Many thanks to Karen!
Update: Tim Harford kindly drew my attention to the paper “Who Captures Value in a Global Innovation System? The case of Apple’s iPod” by Greg Linden, Kenneth L. Kraemer and Jason Dedrick which makes the same point than the ADBI paper.