Asia's Service Sector Imperative

Marcus Noland (PIIE), Donghyun Park (Asian Development Bank) and Gemma B. Estrada (Asian Development Bank)

Op-ed in the APEC Currents Newsletter

December 1, 2012

For decades Asia's labor-intensive, export-oriented, and manufacturing-based growth paradigm has delivered growth with jobs. But as the manufacturing sector matures in many parts of Asia, its capacity to generate employment is waning. Energizing service industries is therefore vital to maintain employment growth in the region.

Strengthening the service sector also has a diplomatic rationale. While the global financial crisis did not originate in Asia, the region has not been immune to its effects. The postcrisis growth slowdown in the advanced economies means that domestic demand—and hence services that cater largely to domestic demand—must contribute more to Asia's future growth.

Domestic political considerations also reinforce the imperative to strengthen the service sector. Populations in many Asian countries are rapidly aging. The elderly typically consume fewer manufactures and more services than younger demographic groups. To the extent that the public sector either provides or underwrites these services, improvements in service sector efficiency could have a salutary impact on public finances.

The case for raising productivity in the service sector is therefore overwhelming. But achieving these gains is difficult. Can Asia successfully address its service sector imperative? The region has witnessed rapid improvement of financial services in the last two decades. In response to the Asian financial crisis, regional economies strengthened prudential standards over financial service providers. The global financial crisis has intensified the ongoing regulatory reform process in the region, with calls from the Financial Stability Board leading international standard-setting bodies to propose specific regulatory requirements.

Also, Asia has some well-known success stories, such as India's emergence as the world's leading information and communications technology-business process outsourcing (ICT-BPO) exporter. The Philippines is also a major ICT-BPO hub. However, even in these countries, success appears to be limited, concentrated in a few internationally tradable service industries rather than the service sector as a whole. In much of Asia the weak service sector badly lags both international best practices and the efficiency of the local manufacturing sector. Even where there are strong service sectors, there are concerns that they are effectively enclaves. While export-oriented industrialization transformed Asia into the factory of the world, the region's record in the service sector has been much less impressive.

Low Productivity of Asia's Service Sector

Global cross-border trade in services has risen steadily as a share of world income for the past quarter-century. Services clearly play an increasingly prominent role in many economies around the world, but in Asia, the steady expansion of cross-border trade in services is less evident. Traditional services such as wholesale and retail trade, hotels and restaurants, real estate, transportation, personal services, and public administration predominate. But modern services—such as include information and communication, finance, and professional business services­—account for only about 8 to 12 percent of the economy in China, India, Indonesia, Thailand, and Taiwan compared with about 17 to 25 percent of national income in Organization for Economic Cooperation and Development (OECD) economies such France, Japan, and the United States. Modern services tend to have higher productivity and pay better wages than traditional services. They are considered tradable internationally, offering opportunity for countries to diversify their foreign trade.

A huge gap separates Asia's productivity in services from that of the OECD countries. Labor services productivity in most Asian economies is less than 10 percent that of the OECD countries, but some economies have already caught up with the OECD—Hong Kong in as early as 1990 and Singapore in 2000. Taiwan is also close behind. But crude estimates based on average productivity growth in developing Asia, at 4 percent in 2000–09, indicate that it might take about 15 to 30 years for most economies to reach even about one-fifth of the OECD's current labor services productivity. China's and India's historical growth in services productivity indicates it will take them about 10 years; their rates of productivity growth, at around 8 percent, are much higher than in other countries.

Meanwhile, service sector efficiency has barely improved over the past decade in some countries. For example, while Korea's productivity level is already 40 percent that of the OECD, labor productivity growth is only less than 1 percent, and according to some estimates, total factor productivity growth—which takes into account the contributions to output of both labor and capital inputs—is actually negative! Similarly, labor productivity in the Thai service sector has been stagnant. In economies with relatively large service sectors, such as Pakistan, the Philippines, and Sri Lanka, labor productivity improvements have been positive but only around 2 to 3 percent per year.

As in services, there is a significant gap between industrial productivity levels in Asian developing economies and OECD countries. Still, in most Asian economies, the gap between local and OECD productivity levels is more dramatic in the service sector than in the industrial sector. Service sectors in some South Asian countries, particularly India, Maldives, Pakistan, and Sri Lanka have less catching up to do with the OECD's productivity level compared with their industrial sectors, but overall, most Asian economies face the daunting task of closing the productivity gap.

The wide gap in service sector efficiency between OECD countries and developing Asia suggests that much remains to be done to transform the region's service sector. On a positive note, there is plenty of room for productivity growth in services and thus for services to contribute to Asia's future economic growth. While the service sector has grown in size in most Asian economies, its composition has remained mostly unchanged. Judging by the pace at which the mix of service activities has evolved, the process of achieving a more sophisticated and modern service sector is more likely to be long. Asian economies can either wait for the process to take hold or initiate bold steps to hasten the process. While moving toward modern, high-productivity services is a desirable path for economies trapped in traditional, low-productivity services, for the poor economies services should be a direct instrument in bringing about more inclusive growth.

Slow productivity growth in the service sector can retard economywide productivity growth. Conversely, productivity advances in the service sector can generate positive spillovers for manufacturing and the rest of the economy. For example, efficient ICT and transportation can promote productivity across the entire economy. A strong modern service sector, in particular business services such as design, prototyping, and marketing, can help middle-income Asian countries move up the value chain and thus escape the much-feared middle-income trap. Internationally, the growing tradability of services and consequent emergence of global supply chains in services, for example in health care, present new growth opportunities for a region that is heavily involved in the global supply chain in manufacturing.

Governments can help lay the foundation for a vibrant service sector through both policy reform and investments in physical infrastructure and human capital. As evident in the rise of India's ICT-BPO sector due to lack of regulation and China's stunted service sector due to a promanufacturing policy bias, removing policy distortions can help. The experience of both India and China shows that policy distortions can stunt the growth of the service sector. At the same time, the government can take active measures to create a more conducive environment for the service sector—e.g., investing in physical infrastructure such as telecom and education/human capital. Good infrastructure and an adequate supply of human capital are especially important for modern service industries such as ICT-BPO.

Concluding Observations

For employment, international relations, and internal stability reasons, Asia faces an imperative to strengthen its service sector. Traditional services account for much of the service sectors in lower-income Asian countries, whereas modern services play a bigger role in higher-income countries. Such diversity means that each country faces different priorities in service sector development, but strengthening modern services remains a common regionwide challenge.

The intangible nature of services does not take anything away from their very real economic effects, especially in employment but also for broader economic dynamism. For example, efficient energy, transportation, and distribution networks boost the productivity of the manufacturing sector. A strong modern service sector, in particular business services such as design, prototyping, and marketing, can move middle-income Asian countries up the value chain toward higher value-added activities and thus help them escape the middle-income trap.

To close the yawning productivity gap between Asian countries and OECD economies, a wide range of structural and policy impediments must be removed for Asia to fully unleash the potential of the service sector as an engine of growth and jobs. Internally, these include the strengthening of labor and capital markets, reform of tax regimes, and elimination of burdensome regulations that protect incumbent firms and thus stifle competition and innovation. International historical experience shows that regulatory reforms often deliver significant economic benefits such as higher labor productivity and lower prices.

Barriers to trade in services also impede competition in domestic service markets. Liberalizing trade and foreign direct investment in services can promote productivity and efficiency as in goods trade. Reducing such barriers also contributes directly to exports and growth—e.g., India's well-known success as an ICT-BPO exporter. The overall guiding principle for Asian policymakers must be to create a more competitive environment for their service industries.