Terms-of-trade Effects and GDP

OK, this may sound wonkish, but I'm posting it because I think it has real-world effects that can lead to misinterpretation of data.

In one of my last posts, I pointed out that China's Q1 trade surplus had risen by 50 %, even though exports were down 20 %, because imports had dropped even faster. That got me thinking about why trade balances change, and what the implications are.

Let's look at a simple example:

A country produces 100 $ worth of "stuff", exports 50 $ of stuff abroad, and imports 50 $ of oil for domestic consumption.

GDP = 50 $ consumption of stuff + 50 $ consumption of oil + zero trade position = 100 $

Now let's assume oil prices collapse by half. As the oil-producing country finds it harder to afford "stuff" (the price of which doesn't change), it cuts its imports by 20 %.

What happens to our country? Let's see:

- Domestic consumption stays at 50 $ of stuff. Oil consumption stays constant in real terms, but decreases 50 % in nominal terms. In other words: Total nominal consumption drops 25 % to 75 $, but real consumption is unchanged.

- There is now a trade surplus: Exports of 40 $, imports of 25 $, i.e. a 15 $ surplus.

- Domestic production is down 10 %: 50 $ local consumption + 40 $ exports = 90 $, as opposed to 100 $ last year (that's both nominal and real, as we are assuming that the price of stuff didn't change)

- GDP is 90 $ in nominal terms (75 $ domestic consumption + 15 $ net exports), i.e. down 10 %. But is up sharply in real terms: Domestic consumption is unchanged, and the trade surplus went from 0 to 15 $. In today's prices, that's a GDP increase of 20 % (15/75). In last year's prices, the increase is 15 % (15/100).

Isn't that amazing and rather counterintuitive?

Domestic production is down 10 %. Domestic consumption is unchanged. But real GDP is up sharply. All because imported commodities became cheaper, and export prices didn't budge (and even though export volumes went down significantly).

The headline GDP number sounds great (strong growth). But people on the ground won't feel it, because production (read: jobs) is down sharply. While their purchasing power is up (because imports have become so much cheaper), they will more likely focus on bad job prospects, hold on to their money, and worry about the future...