As countries navigate the path from poverty to prosperity, they typically experience a relative decline in their agricultural sectors, a shift towards manufacturing, and then a rise of their services sectors.  But what is striking in Asia is that although the region's leading economies of Hong Kong, Japan and Singapore all have dominant service sectors, Japan's service sector is not nearly as dynamic and competitive as the other two economies ...

Even if Tokyo were a city-state, it would still not compete with Hong Kong and Singapore in services.  For example, notwithstanding Japan's immense foreign exchange reserves, Tokyo only ranks as number 5, after London, New York, Hong Kong, and Singapore in The Global Financial Centres Index.  Both Hong Kong and Singapore are ranked above Japan in the World Economic Forum's financial development report.  And both also have many more foreign tourist arrivals than Japan.

What are the lessons for Asia's emerging economies which are still climbing the development ladder, and are seeking to avoid falling into a middle income trap of arrested development?

First things first, why is the service sector so important in our economies?

While some service sector jobs like flipping hamburgers at McDonalds are low-skilled, many service jobs require the highest of skills -- in sectors like finance, health, education, research, engineering, telecommunications, logistics, and so on.  That's why a large and dynamic services sector is the hallmark of an advanced economy for which services are also an important area for exports and foreign investment.

But the services sector does not just stand alone.  It is a backbone sector with very important linkages with the rest of the economy.  For example, many high-tech manufacturing activities and Asia's complex manufacturing supply chains and production networks could not function effectively without efficient logistics, transport, telecomunications, trade finance and business process services.

The services sector can now also be a fast track to development as countries can leap-frog towards a services economy.  International tourism has been a development driver for many Asian countries, like Thailand, Malaysia, Cambodia, and Singapore.  And thanks to information and communications technologies, electronically deliverable business processing activities are increasingly being offshored to lower middle income countries like India and the Philippines.  A number of Asian economies are also very active in the export of health and education services.

And while human services like health and education can strengthen the economy, they also contribute to "human development" and better lives, the ultimate goal of development.

How is the service sector doing in emerging Asia?

The services sector represents about three-quarters of the Singaporean economy, and more than half of the Philippine and Indian economies. It only accounts for around 40 per cent of the Thai, Malaysian, Chinese, Cambodian, Indonesian, Lao, and Vietnamese economies.

In Singapore, the Philippine, Malaysia, Indonesia and Brunei, the services sector was the fastest growing part of the economy over the 2000-2007 period.  In China and India, the services sector grew at about the same pace as manufacturing, while in Vietnam, Thailand, Laos and Cambodia the services sector growth was noticeably slower than manufacturing.  The only really surprising aspect of these two sets of data is the poor performance of Thailand.

Let's now take a quick look at Asia's international trade in services, which is one important sign of dynamism and competitiveness.  In China, services trade only represents 5% of GDP, and in India it is less than 15%, while in the South East Asian ASEAN countries it is above 25% -- this latter figure is however heavily influenced by Singapore.

It is hard to draw firm conclusions.  But these figures imply that emerging Asia is underperforming in services trade and thus overall services performance.  Why?  Analysis by the OECD and World Bank suggest that emerging Asia (excluding Hong Kong and Singapore ) has many policy barriers and restrictions on the development of the services sector.  These include things like regulations which raise the cost and difficulty of doing business, and barriers to the entry of new firms.

Overall, the services sector and services trade suffer from much greater restrictions in these emerging Asia economies than in the advanced OECD countries -- especially in areas like telecommunications, transport, distribution, logistics, and financial services.

This brings us back to the case of Japan which has many of the same restrictions holding back its services sector, and which demonstrates just how hard policy reform can be.  According to the OECD, the key to boosting Japan's growth potential is to enhance productivity growth in the service sector.  Japan's labor productivity is some 30% below the US level, and this is mainly due to slow service productivity growth in recent years, in contrast to the high and sustained growth of productivity in the manufacturing sector.

The OECD recommends: (i) strengthening competition through regulatory reform especially by lifting key regulations on entry and operations; (ii) upgrading competition policy by increasing administrative penalties, reducing the many explicit exemptions, scaling back the special treatment of SMEs and ensuring that the large number of trade associations do not limit competition; (iii) increasing international openness to foreign direct investment and imports -- the share of foreign affiliates in total service turnover and the proportion of services in the total turnover of foreign affiliates are the lowest of all OECD countries -- the import penetration rate for services in Japan is also the lowest among OECD countries; (iv) carrying out fully the privatisation of Japan Post to shift funds away from the public sector and towards the private sector; and finally (v) addressing regulatory problems in key service industries like the retail sector, energy sector, transport industry, business services and public services.

The experience of Japan provides salutary lessons for Asia's emerging economies, and the examples of Hong Kong and Singapore demonstrate the great benefits of developing a dynamic and competitive services sector.  But many emerging Asian economies are, like Japan, riddled with vested interests which block reform.  Witness India's recent difficulties trying to open up its grotesquely inefficient retail sector to Walmart.

As history and the analysis of the "middle income trap" show, the first stages of the path from poverty to prosperity are much easier than the later stages.

References:

OECD.  Economic Survey of Japan 2008: Enhancing the Productivity of the service sector in Japan

http://www.oecd.org/document/19/0,3343,en_2649_34833_40375123_1_1_1_1,00.html

Financial Centre Futures.  The Global Financial Centres Index 11, March 2012.

http://www.longfinance.net/Publications/GFCI%2011.pdf

World Economic Forum.  The Financial Development Report 2011.

http://www.weforum.org/reports/financial-development-report-2011

Shepherd, Ben, and Gloria Pasadilla, "Services as a new engine of growth for ASEAN, the People's Republic of China and India".  Asian Development Bank Institute Working Paper No. 349.

http://www.adbi.org/working-paper/2012/03/06/5017.services.new.engine.growth.asean.prc.india/