A Comparative Study of the Role of the Service Sector in the Economic Development of China and India(Revised report)
June 19, 2006
By
Deunden Nikomborirak
Thailand Development Research Institute
Introduction
As tariffs have fallen to very low levels in many economies, trade in services has become the focus of interests for the studies of both trade and development in lieu of trade in goods. Experiences show that an economy – regardless of the level of development -- cannot maintain its competitiveness in the long run without an efficient service sector.
China and India, the two largest emerging economies undergoing rapid economic transformation and growth, too, have been witnessing an increasing role of their service sector. The sector contributes to bout two fifthsof China’s GDP and roughly a half of that of India as can be seen in figure 1.1.
Figure 1.1Service Sector GDP share (1995 – 2004)
Source: 1/ India' data from World Development Report 2005. China's revised GDPdata from Quarterly Update, February 2006, World Bank Office, Beijing
2/ IMD World Competitiveness Yearbook
The drivers of the service sector growth in the two countries differ, however. . China has a solid domestic manufacturing base from which services grow, while India’s economy appears to leap directly from agriculture to services, driven by external demands for IT related services. Looking into the future, China’s broad and deep WTO accession commitments will have significant implications to the country’s service sector development. India’s unilateral liberalization, on the contrary, is likely to be much more gradual due to political sensitivities of certain service sub-sectors. What are the implications of this policy divergence to the future role of the service sector to the economies of India and China?
This study shall review and compare the role of the service sector in China and India in the context of the development of the domestic economy and integration with the global economy. At the same time, it also seeks to make rough predictions with regard to likely future trends given the current policy environment.
The organization of the paper is as follows. The first chapter provides an overview of service sector’s contribution to national income and employment in both countries. The second chapter looks at services in the context of international trade and investment in order to gauge the extent to which foreign markets and capital played a role in the development of both countries’ service industry. The third chapter examines and compares the two countries’ policies with regard to service sector liberalization in order to be able to speculate future trends and patterns of their respective service sector growth. The final chapter concludes on the findings of a comparative study of China’s and India’s service sector development.
1. Service Sector’s Contribution to Economic Development
Empirical studies in development economics reveal that most developing countries undergo a similar economic structural shift through the course of economic development with shrinking agricultural sector and expanding manufacturing and service sector. For example, Chenery and Taylor (1968) found that a country’s industrial GDP and employment shares tend to rise as it becomes richer at the expense of agricultural sector’s share, except for economies that rely heavily on exports of primary products. At higher income level, income and employment shift to services. These findings are based on empirical tests that employed large cross-country data sets[1].
The reason for such a structural shift can be explained from both the supply and the demand side. From the supply side, growth in manufacturing and services may outpace that in agriculture because of the employment of technology and capital in these sectors can overcome the law of diminishing return faced by the agricultural sector that relies on fixed factor, namely land. As the industrial sector grows, demand for particular services, such as transportation, housing and construction naturally increases, giving further stimulus to the service sector.
On the demand side, the expanding share of manufacturing and service sectors is believed to be contributed by higher income demand elasticity for manufacturing products, and even higher for services products. That is, as income rises, the population demands proportionately more of manufacturing and service products and proportionately less of agricultural products.
Available secondary macroeconomic data collected in this study reveals that the development of the service sector in China seems to closely follow the historical pattern experienced by both developed and developing countries, while India’s shift out of agriculture directly into services appears to diverge from the common path.
1.1 Contribution of the Service Sector to GDP
As can be seen in figure 1.2, during the past 10 years, China’s service sector’s GDP contribution increased significantly. In the year 1995, service sector contributed to just 3 per cent of China’s GDP. The figure changed to 40.2 per cent in 2004, an increase of 7.2 percentage points. Manufacturing sector’s share, however, decreased marginally by2 per cent from 48 to 46 per cent during that time.
The expanding service sector GDP share came mainly at the expense of the agricultural sector share, which declined from 0 per cent to 13 per cent as shown in figure 1.2. It is therefore clear that, during the last decade, the manufacturing sector boom in China has led to an even higher growth in the tertiary sector and that service sector growth has been facilitated by the release of resourcesfrom the least dynamic sector, the agricultural sector.
In contrast, India's service sector growth has clearly been the engine of growth of India’s economy during the last decade. Service sector contribution to the national GDP increased from 42 per cent in 1995 to 49 per cent in 2003, before declining to 45 per cent in 2004 can be seen in figure 1.3. India’s manufacturing sector’s GDP contribution seemed to have fallen over time from 28 per cent in 1995 to 27 per cent in 2004. Unlike China, however, India's manufacturing has never experienced double digit growth. Mitra, Devashish (2006)[2], found that rigid labor market due to state labour rules and regulations[3] and lack of infrastructure development are the two key factors hindering labor productivity improvements, employment and capital accumulation that would spur progress in India's manufacturing sector.
It is interesting to note that, while India’s sectoral GDP share appears to indicate a declining agricultural share, the annual figures appear rather unstable as can be seen in figure 1.4 below. This is due mainly to the inherent volatility of India’s agricultural output due to its heavy dependence on the monsoon. Consequently, service sector’s GDP share also appears to vacillate. For example, the marked decline l in the service sector GDP share in the year 2004 resulted from a particularly good agricultural year. According to the Centre for Monitoring Indian Economy (CMIE)[4], agriculture sector grew by 9.3% in 2003-2004, against 8.9 % for services. However, the sector’s growth, as unpredictable as it has been, is likely to be less than 1 per cent in 2005-2006.
Another interesting point about India’s sectoral development is the rising prominence of the manufacturing sector. Figure 1.4 illustrates how industrial sector’s growth is catching up with that of the service sector. According to the CMIE, during the first 5 months of the year 2005, manufacturing GDP growth reached a record of 10.5% against 8.1% during the same period a year earlier.
The rising prominence of the manufacturing sector is also underscored by the sudden surge of FDI into the industrial sector in 2004 as will be discussed in chapter 2. Industries that are major recipients of FDI include automobile and components, pharmaceutical, electronic devices and industrial equipments. While it may be somewhat too soon to conclude, these figures signal that India’s manufacturing may finally be emerging out of its long dormancy, following a series of economic reforms that have gradually taken place in India over the last decade.
Figure 1.2 Percentage of GDP by Sector, China
Source: World Bank Office, Beijing (2006), Quarterly Update: February 2006
Figure 1.3 Percentage of GDP by Sector, India
Note: Data year 1999 from WDI, Data other years from IMD
Source: 1. IMD World Competitiveness Yearbook
2. World Development Indicators (WDI) database
Figure 1.4: India’s Annual GDP Growth by Sector
Source: Center for Monitoring Indian Economy (CMIE)
Coming back to India’s service sector, looking at growth figures of various service sub-sectors reveals the following:
(1)the sector’s growth has been concentrated in a few service sub-sectors, namely, business services, communications, banking and hotel and restaurant services.
(2)service sectors experienced highest growth rates are those most open to FDI, perhaps with the exception of banking that still maintains certain restrictions concerning foreign ownership of local banks. The high correlation between market openness to foreign investment and growth in India’s service sector was evidential in a report published by the World Bank[5]. This may be the case because of India’s particularly heavy reliance on foreign investment given the limited pool of domestic savings[6].
(3)legal services, real estate and transport services that are very much closed to foreign investment experienced lower growth.
(4)With the exception of banking, these fast-growing service sub-sectors are relatively small in size compared to other services such as trade, community services, public administration, real estates and transport. Hence, despite all the hypes about India’s service-sector led growth, growth potentials of the country’s service sector are barely realized. Should these major service sectors become more open to domestic or foreign competition, service sector growth could be much higher than witnessed in the past.
Table 1 Average Annual Growth Rate and GDP shares of Service Sub-sectors
1980s / 1990sService Sub-sectors / Growth (%) / GDP share (%) / Growth (%) / GDP share (%)
Business Services / 13.5
( / 0.3 / 19.8 / 1.1
Communications / 6.1 / 1.0 / 13.6 / 2.0
Banking / 11.9 / 3.4 / 12.7 / 6.3
Hotels and Restaurant / 6.5 / 0.7 / 9.3 / 1.0
Community services / 6.5 / 4.3 / 8.4 / 5.5
Trade (Wholesale and retail trade) / 5.9 / 11.9 / 7.3 / 13.7
Other services / 5.3 / 1.0 / 7.1 / 1.7
Transport / 6.3 / 3.8 / 6.9 / 4.3
Insurance / 10.9 / 0.8 / 6.7 / 0.7
Public Administration, defense / 7 / 6.0 / 6 / 6.1
Legal services / 8.6 / 0.0 / 5.8 / 0.0
Dwelling, Real estates / 7.7 / 4.8 / 5 / 4.5
Personal services / 2.4 / 1.1 / 5 / 1.1
Railways / 4.5 / 1.4 / 3.6 / 1.1
Storage / 2.7 / 0.1 / 2 / 0.1
Source: Reproduced from Gordon and Gupta (2004).
1.2 Employment in the Service Sector
Stylized facts reveal that GDP and employment shares are usually closely related. Mobility of labour ensures that productivity levels across different sectors of the economy are equalized. However, in practice, labour is not perfectly mobile across sectors due to many obstacles such as skill requirements, relocation of labour, etc. This is often the case for countries that are in a transitional period in economic restructuring.
Once again, on the employment front, China seems to follow the common pattern experienced by most other developed and developing countries, while India stands out as a unique case.
As can be seen in figure 1.6, since 1995China’s service sector’s employment share has been on the rise continuously, roughly in keeping with the sector’s GDP contribution. In the year 1995, service sector contributed to 33 per cent of the country’s GDP and 28.2 per cent of employment. Seven years later in the year 2002, the figures were 41.7 and 33.5 respectively. That is, an increase in service sector value added share by 8.7 percentage points was accompanied by an increase in labour share by 5.3 percentage points. China's service sector employment elasticity during this period is calculated to be 1.6.
Such has not been the case in India. In 1995, service sector contributed to 42 per cent of the country’s GDP and 67 per cent of its total employment. This would indicate a relatively low labour productivity in the service sector. The figures in 2002 were 49 and 69 respectively. That is, while service sector’s GDP contribution rose by 7 per cent, its contribution to employment merely increased by only 2 per cent. This implies that the employment elasticity of India’s service sector is roughly 0.3, which is extremely low compared with China’s figure of 1.64.
Looking into each country’s sectoral employment data shown in figure 1.7, it became obvious that the increase in China’s service sector employment was made possible by the inter-sectoral shift of labour supply mainly from the manufacturing sector, and, to a lesser extent, the agricultural sector. The decline in employment against rapid output growth in China’s manufacturing sector indicates a marked productivity gains.
Figure 1.6 Service sector contribution to Employment
Source: Service sector employment share calculated from data appeared in tables 1.7 and 1.8 below
Figure 1.7 Employed Persons in China
Source: China Statistical Yearbook 2004
Turning to India, a striking feature of the employment data during 1993-2003 shown in figure 1.8 is that the number of persons employed in agriculture, manufacturing and services barely changed in a decade. The absence of a fall in employment in the agricultural sector is contradictory to most countries’ experience.
India’s jobless service sector growth stems from the fact that the sector’s growth has been driven largely by only a few service sub-sectors – i.e., banking, telecommunications and IT-enabled services. Additional employment generated by these sectors was not able to offset the rapidly falling labour demand elasticity faced by other service sub-sectors as productivity level rises from extremely low levels as discussed earlier.
The study by Banga (2005[7]) reveals that in the nineties India experienced a sharp fall in the employment elasticity in certain large, fast growing service sub-sectors, namely government and banking services. For example, the employment elasticity of government services fell from 0.5 during 1983-84 – 1993-94 to 0.07 during 1993-93 – 1999-2000, while that for financial services fell from 0.92 to 0.73. This is because of major improvements in technology employed by new entrants to the market as well incumbents helped cut down labour input and boost productivity.
A report by McKinsey and Co (2001)[8] confirmed large productivity gains contributed to the unspectacular employment record of India service-sector led growth. The report estimated labour productivity in 6 service sectors, namely, energy distribution, housing construction, retail distribution, retail banking, software and telecommunications. It found that India’s software services that experienced the most rapid growth have the highest productivity levels, followed by telecommunications, banking and construction. On the contrary, retail distribution, energy distribution and hosing construction that are closed to foreign investment experienced significantly lower productivity level.
Figure 1.8 Employed Persons in India
Source: Economic Survey 2005-2006. Ministry of Finance, India.
Looking closer at the sub-sector level in table 2, one finds that the only two service sub-sectors that experienced high employment growth in the nineties are telecommunications and computer-related business.
Again, these three services represent “islands” in the large sea of the service sector that remain highly protected. It is also noteworthy that the banking sector, which has experienced relatively healthy growth, did not contribute much to employment. This is due to the displacement of workers from inefficient public sector banks as the country gradually liberalized its banking sector after a spade of nationalization of banks in 1969 and 1980. In light of the banking sector experience, the opening of the India’s other service sub-sectors occupied by state-owned enterprises saddled with excessive employment is likely to have a small impact on employment prospects.
Table 2India’s Service Sector Output and Employment Growth at a Disaggregate Level
Service Sub-sectors / Value-added Growth in 1990s (%)* / Employment Growth between 1993/1994 & 1999/2000**Business Services / 19.8 / Computer related services – 20.6 %
Other business services – 11.6%
Communications / 13.6 / Telecommunications - 33 %
Postal – 6%
Courier – 6.2%
Banking / 12.7 / 4.3
Hotels and Restaurant / 9.3 / 7.3
Community services / 8.4 / NA
Trade (Wholesale and retail trade) / 7.3 / Wholesale – 6.4%
Retail – 7.1%
Other services / 7.1 / NA
Transport / 6.9 / Air transport – 6.2%
Water transport – 2.6%
Road transport – 6.5%
Insurance / 6.7 / 3.8
Public Administration, defense / 6 / NA
Legal services / 5.8 / 6.2
Dwelling, Real estates / 5 / 6.2
Personal services / 5 / NA
Railways / 3.6 / 3.2
Storage / 2 / NA
Source: * from table 1;
** from The World Bank (2004), Sustaining India’s Services Revolution: Access to Foreign Markets, Domestic Reforms and International Negotiations. Available at
1.4 Summary
The role of the service sector in the economic development in China and India during the last decade has been markedly different as follows. First, the role of the service sector in China has been mainly to facilitate domestic production and trade ingoods, while growth in service sector in India was triggered by external demand for software and IT-related services. It should be noted, however, that while China's initial demand for services was largely derived demand from rapidly expanding manufacturing sector whose average annual growth during 1978-2005 was a spectacular 17%[9], higher income levels among its population eventually spurred growth in other consumers-oriented services such as tourism.
Second, China’s service sector growth is highly employment elastic, while that in India, employment contributions fell far behind that of income. This has been the case because the sector's growth engine, which concentrates narrowly on a few export-oriented sub-sectors, was not able to generate sufficient employment to offset the sharp fall in employment elasticity experienced in other service sub-sectors resulting from productivity improvements.
It is probable that the rising prominence of India's service sector preceding that of the industrial sector is nothing more than a temporary blip in the country's development path. The long overdue industrial reform that has been holding back the manufacturing sector growth is finally producing some visible results with recent statistics showing impressive industrial sector growth coupled with strong FDI figures.