Can services be the next growth escalator?

Ejaz Ghani, Arti Grover Goswami, Homi Kharas, 12 December 2011

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The world is experiencing a third industrial revolution with services trade being at the forefront of this revolution. Services are characterised by growing tradeability, increasing technological sophistication, and lower transport costs. Modern services can now be unbundled and splintered in a value chain just like goods and they can be electronically transported internationally through satellite and telecom networks. The number of services that can be transported digitally is constantly expanding – processing insurance claims; call centres; desktop publishing; compiling audits; completing tax returns; and transcribing medical records. In a not-too-distant future, patients at home will be able to speak with their doctors and students will access high-quality education via virtual classrooms. Labour matching is increasingly done online and platforms like Odesk can connect employers and employees across national boundaries.

Over the last three decades, services have contributed more to growth, in both developed and developing countries, than the goods sector (Figure 1). In both sectors, growth in developing countries has been faster than in developed countries, but catch-up has been faster in the goods sector.

 Although conventional wisdom has been that labour-intensive manufacturing creates the most jobs in developing countries, recent data suggest otherwise; employment growth has been most rapid in the services sector (Figure 1b). In developed and developing countries alike, labour is being shed from both agriculture and manufacturing.

In the goods sectors, technologies have matured and developing countries already have a large market share and have achieved significant scale economies. However, modern services appear to be steadily expanding, with catch-up opportunities continuing to rise. As broadband penetration in developing countries continues to grow and improve in speed and quality, it is easy to see greater possibilities for modern service exports from low- and middle-income countries. In fact, technological change in the services sector is now larger than in the goods sector, suggesting that services may be the next escalator for growth in developing countries.

Although India is the most famous case of services-based growth, it is not the only developing-country example. Armenia, Bangladesh, Kyrgyz Republic, Moldova, Mozambique, Pakistan, Philippines, Romania, Rwanda, and Sri Lanka are among a group of developing countries that have increased their revealed comparative advantage in modern services exports. As a group, lower middle–income and low-income countries have a higher RCA in modern services than in goods exports, and a higher RCA in modern services than high-income countries.

Figure 1. Sources of growth and job creation in developed and developing countries

Source: Authors’ calculations from World Development Indicators. Notes: Developing countries are defined as the low-income, lower-middle–income and upper-middle–income countries in the World Bank classification in 2008. Low-income countries have a per capita income of US$ $975 or less and lower-middle–income countries have a per capita income in the range of $976-$3,855 while upper-middle–income, $3,856-$11,905.

Figure 2.

Source: Authors’ calculations from World Development Indicators. Notes: Employment figures for developing countries are approximated by adding up the figures from countries which report their data to ILO. These may not necessarily be accurately representative of the developing-country group.

Economic growth can result from specialisation and trade, but the size of the growth dividend from specialisation depends on the technological sophistication of exports (Dalum et al 1999, Feenstra and Rose 2000). Empirically, an advanced export structure, higher productivity levels, and faster growth rates are linked.

Hausmann et al (2005) have introduced a method by which to gauge export sophistication in quantitative terms and have shown that their measure is positively correlated with economic growth across countries. This metric, called PRODY, is defined as a weighted average of the per capita incomes of all countries exporting a particular product, with the weights given by the RCA of the exporting country. PRODY is therefore an alternative to the engineering approach to technological sophistication (Lall 2000) which tries to assign each sector to a technological category based on its content.

Hausmann and others only focused on trade in goods, a significant omission considering that services are the fastest growing component of international trade and global growth, and modern services are the most important and possibly the most sophisticated products being traded today. Recently, Mishra et al (2010) have extended the analysis to cover services. Like earlier studies, their analysis also suggests that services export sophistication is strongly associated with growth in per capita income.

In a recent publication edited by Ejaz Ghani (2011), we go deeper into this analysis and show that:

  • Services are becoming more sophisticated over time;
  • Modern services are the most sophisticated component of trade; and
  • Developing countries now have higher revealed comparative advantage in modern services exports than do developed countries.

Measuring sophistication: PRODY

Our starting point is the PRODY measure of sophistication developed by Hausmann et al (2005). (For a formal definition, see Appendix 1).

By construction, products with high values of PRODY are those where high-income countries play a major role in world exports of that product. If we assume that high-income/high-wage countries primarily export products with significant know-how or technological content, the PRODY index is bound to be correlated with the unobservable degree of technological sophistication of the product. The intuition is simple: products like airplanes are highly sophisticated and so are only produced in rich countries. These countries also have a high degree of revealed comparative advantage in the export of airplanes, and so the PRODY for airplanes is high. Over time, the PRODY can grow because the income levels of the main exporting countries grow or because the revealed comparative advantage (the weights) of richer countries grows.

PRODYs across sectors and time

The database for services exports comes from the balance of payments (rather than customs data as is the case for goods) and is disaggregated by sector rather than product. We group these sectors into two aggregates: modern services and traditional services. Modern services are found in ICT, business and finance, and other commercial services. Traditional services typically require more face-to-face interaction: for example, government and community services, transport, trade, hotel, restaurant, beauty shops and barbers are included.

In 1990, modern services had a PRODY that was 10% higher than traditional services, but about 8% lower than that of goods. By 2007, the PRODY for modern services was 70% higher than for traditional services, and 40% higher than for goods (Figure 3). This is all the more striking when we consider that all sectors had increased the degree of technological sophistication over this period.

Figure 3. The growing sophistication of modern services, 1990–2007

Source: Authors’ Calculations from IMF Balance of Payments. Note: Modern services is calculated by taking out travel and transport services exports from commercial services exports.

What explains the rising PRODY in services?

To understand the forces behind the rise in PRODY, we undertake a simple decomposition exercise. Recall that the PRODY is calculated as the product of two variables, an exporting country income level, and the weight of that country as given by its RCA. Accordingly, the PRODY can change over time either because the weights shift for each exporting country (the revealed comparative advantage gets more marked) or because the income levels of the exporting country rise. (See Appendix 2 for the formula.)

We calculate the change in PRODY for three sectors, modern services, traditional services and goods, and compare the change between 1987–89 and 1997–99 with the change from 1997–99 to 2007–09.

Figure 4. PRODY change decomposition

Source: Authors’ calculations from IMF Balance of Payments.

The decomposition exercise shows the following trends.

  • First, all products have experienced a higher degree of sophistication over time as the per capita incomes of countries has grown.
  • Second, the revealed comparative advantage term is negative for five of the six calculations, implying that rich countries are losing their comparative advantage and developing countries are becoming more important exporters.
  • Third, the exception to this trend is for modern services exports in this century. Despite the tremendous growth in modern service exports from developing countries, exemplified by business process outsourcing, there has been even more rapid growth in modern service exports in developed countries (relative to their goods exports).

The PRODY decomposition assumes that the number of countries reporting/participating in a sector’s exports remains the same throughout all periods. Since this does not hold in our case, the decomposition is inexact. To check robustness, we applied the decomposition with a balanced panel and for a different time period (change in PRODY from 1995–97 to 2001–03 and from 2001–03 to 2007–09) with minimal change in results.

Conclusion

The range of modern services that can be digitised and traded globally is constantly expanding. India has been a pioneer, but many other poor countries are finding it easier to generate productivity growth in services than in industry. This does not happen automatically. Although the same set of general non-distortionary policies is as important for modern services as for goods, specific strategies for services matter. Services expansion provides an alternative growth escalator for developing countries.

The views expressed here are those of the authors and not the World Bank.

Appendix 1

Formally, the PRODY value for a product j is defined as                         

where  yi stands for the real per capita GDP of the i-th (i = 1, 2, ...,N) country exporting in sector j, while the weight

normalises country i’s Balassa index of revealed comparative advantage with respect to those of all the countries exporting in the same sector.

Appendix 2

The decomposition of the change over time of the PRODY is given by the following identity:

References

Dalum, B, K Laursen, and B Verspagen (1999), “Does specialization matter for growth? Industrial and Corporate Change”, 8(2):267-288

Ghani , E (2010) (ed.), The Service Revolution in South Asia, Oxford University Press.

Feenstra, RC and AK Rose (2000), “Putting Things in Order: Trade Dynamics and Product Cycles”, Review of Economics and Statistics, 82(3):369-382.

Hausmann, R, J Hwang, and D Rodrik (2005), “What you export matters”, NBER Working Paper No. 11905.

Lall, S (2000), “The technological structure and performance of developing country manufactured exports, 1985-98”, Oxford Development Studies, 28(3):337-369.

Mishra, S, S Lundstrom, and R Anand (2011), “Service Export Sophistication and Economic Growth”, Policy Research Working Paper 5606, World Bank.

Topics: Development, International trade, Productivity and Innovation
Tags: comparative advantage, PRODY, Services sector, Services trade, technological change

Ejaz Ghani
Lead Economist in Economic Policy and Debt, PREM Network, World Bank
Arti Grover
Consultant, International Trade Department, World Bank
Homi Kharas
Senior Fellow in Global Economy and Development, Brookings Institution

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