Services as a growth escalator in low-income countries

Ejaz Ghani, Stephen O'Connell 15 June 2017

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It has long been argued that economic growth is driven by the manufacturing sector (Baumol 1967, McMillan and Rodrik 2011). The East Asian tigers are the classic success stories of how the conventional path to development goes hand-in-hand with industrialisation. However, this conventional path to development seems to have hit a road block in other regions.

Indeed, in most low-income countries in Africa and South Asia, manufacturing is declining as a share of GDP. The worry is that without a major transformation, the recent growth spurt in low-income countries may soon run out of steam. While these concerns are fair, the experience of low-income countries also suggests that manufacturing is not the only driver of growth. Services can also be a dynamic growth engine. Indeed, services are now contributing more than manufacturing to output growth, productivity growth and job growth in low-income countries (Ghani and Connell 2014, Enache et al. 2016).

Manufacturing, services, and growth

Technological changes have made manufacturing more capital- and skill-intensive. So, it is
creating fewer jobs. Some form of premature deindustrialisation seems to have set in. This might be because consumers and households in developed countries now spend a lot less on manufactured goods than they do on services. This can put a limit on how fast development latecomers can grow through industrialisation. But there is no such limit in services.

The Third Industrial Revolution – led by services – has upset five long-held tenets of economic development.

  • First, services have long been thought to be driven by domestic demand. They could not by themselves drive growth, but instead followed growth. Service trade was limited because it required close proximity and face-to-face interaction between the buyer and the seller. However, this is no longer the case, as technology allows services to be produced and traded just like goods.
  • Second, global trade in services has exploded, and it is growing much faster than trade in goods. The cost of trading services that can be digitised has fallen dramatically, as services do not have to confront customs and other logistical barriers.
  • Third, services were considered to have lower productivity than manufacturing and were concentrated in informal sectors. However, technology, trade, and supply chains have altered the characteristics of services. Innovations in communication and transportation have contributed to global supply chains being extended into services, just as they have been extended into manufactured goods.
  • Fourth, it was thought that good jobs were created only in the manufacturing sector. This is no longer the case, be it in high- or low-income countries.
  • Fifth, service-led growth is also greener and more gender-friendly.

Indeed, the globalisation of services is the tip of the iceberg. While jobs in the industrial sector are shrinking globally, jobs in services have continued to expand. There remains huge room to benefit from service sectors. This does not mean that development latecomers should give up on industrialisation. They could pursue both.

Services are now becoming an active component of the growth strategy of most developing countries. Local industry associations now give services a seat at the policy table. Policymakers are no longer thinking narrowly and focusing only on manufacturing-based growth. The key policy message is that low-income countries now need a broader growth agenda. They do not need to be a one-trick pony.

Growth strategies for low-income countries 

So, what kind of growth strategy is appropriate for development latecomers? It will be shaped by many factors, and it will be country specific. The growth landscape in low-income countries is still evolving. 

Low-income countries will benefit from a demographic dividend which is associated with increased supply of labour, more savings and investments, technological progress and growth, although these benefits are not automatic. The East Asian tigers had a much higher ratio of working-age to non-working-age population when their industrialisation took off. The demographic dividend has already matured in East Asia. It is still to materialise in low-income countries in Africa and South Asia.

A smart growth strategy is also associated with smart urbanisation that shifts people and resources from traditional to modern sectors, be they in manufacturing or in services. Cities generate the majority of new jobs, a process that could drive a several-fold increase in per capita incomes. Indeed, the world has experienced global convergence in urbanisation with low-income countries experiencing the highest urbanisation growth rates in the world.

But low-income countries also face many challenges. Any growth model needs to address three major constraints: infrastructure, entrepreneurship, and education and technical skills.

The physical infrastructure in low-income countries has lagged behind that in other developing regions, and the gap has widened over time. Moreover, because of their small scale and limited competition, infrastructure services in low-income countries are typically several times more expensive than those in other parts of the developing world. This is a big cost disadvantage and is one of the key obstacles to sustaining high growth in low-income countries. The infrastructure issue has been exacerbated by stabilisation efforts trying to reduce fiscal deficits. As it is much harder to reduce current expenditures than expenditure on infrastructure, the bulk of adjustment has been borne by the latter.

Physical infrastructure matters greatly for growth in developing countries. This is true for both manufacturing and services. The relationship between infrastructure and growth is much stronger in developing rather than developed economies.

The skill content of both the manufacturing and service sectors has increased over time. It is not as if manufacturing employs only unskilled labour while modern services employ only highly-skilled labour. Unless more investments are made in education, skill shortages are likely to become an increasingly important constraint to growth and jobs across sectors.

Finally, an entrepreneurial foundation is essential for promoting structural transformation and growth. Entrepreneurship and more start-ups are critical for reallocating resources, improving productivity and facilitating the transition from informal to formal jobs. They are also critical for job creation, as jobs are created by new and small enterprises in both developed and developing countries.

Conclusion

The promise of the service revolution is that development latecomers can shape their own development path. They do not need to wait for China to become uncompetitive; there is a new boat that the latecomers can take. Unlike in the manufacturing sector, where developing countries already have a large market share, making it difficult for new entrants to become large-scale exporters, services appear to be steadily expanding, with catch-up opportunities continuing to rise and entry possibilities for all. A service-led growth can be sustained because the current globalisation of services is only the tip of the iceberg, and services are the largest sector in the world, accounting for more than 70% of global output.

Authors’ note: The views expressed here are those of the authors and do not necessarily represent those of the institutions with which they are affiliated.

References

Baumol, W J (1967), “Macroeconomics of unbalanced growth: The anatomy of urban crisis”, American Economic Review 57(3): 415-26.

Enache, M, E Ghani and S O'Connell (2016), “Structural transformation in Africa: a historical view”, World Bank Policy Research Working Paper Series 7743.

Ghani, E and S O'Connell (2014). “"Can service be a growth escalator in low-income countries?”, World Bank Policy Research Working Paper Series  6971.

McMillan, M and D Rodrik (2011), “Globalization, structural change and productivity growth”, National Bureau of Economic Research Working Paper 17143.

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Topics:  Development Productivity and Innovation

Tags:  development, services, growth, productivity, Low-income countries

Lead Economist in Economic Policy and Debt, PREM Network, World Bank

PhD Candidate in the Department of Economics at The Graduate Center, City University of New York

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