Benefit of Liberalizing Trade in Services: Impact on Growth and

EmploymentYan Wang

Senior Economist, World BankYwang2@worldbank.Org

Prepared for the Training of Trainers course on “Trade Policy and WTO Accession”

Hanoi, VietnamMay 8-16, 2005

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OutlinePrevious session looked at impact of trade in goods,

here we examine trade in services• Theories regarding the gains from trade• Why are Services so important?• Benefits of opening services trade: deepening

division of labor, higher productivity in goods sector, learning by doing, etc

• Empirical evidence on services trade and growth• Impact of China’s service liberalization-CGE

analysis, based on Li, Wang and Zhai (2003)• Summary

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I. International Trade Theory: a Review

• Well-known trade models:– Ricardo (comparative advantage based on

differences in productivity levels)– Heckscher-Ohlin (comparative advantage based

differences in factor endowments)– Krugman-Helpman (trade driven by economies

of scale and consumers’ love of variety; explains intra-industry trade)

– The new trade models and new growth theory based on creative destruction [see below]

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Growth models• Neoclassical growth theory (Robert Solow)

– Diminishing returns to the accumulation of capital and labor

– Sustained growth requires continuous technological progress (exogenous to the model)

• Endogenous growth theory (Paul Romer)– Technological progress within the system– Models incorporate research, development and

technology diffusion

• New models of Creative Destruction (Aghionand Howitt 1992)

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The role of Entry and Exit• Schumpeter’s idea of Creative Destruction (1942) stresses

innovation /new products & new services• New endogenous growth model stress vertical innovations

generated by research (Aghion and Howitt 1992)– Monopoly rents provide the payoff /incentives for research– Better products/ services render previous ones obsolete.

• New entrants with better products /services drive the old firms out--good for productivity.

• Implications for trade: Competition / entry and exit are good for productivity growth– process encourages innovation and reallocation of resources from

inefficient ones to efficient one.

See also Melitz 2003, Hummels and Klenow 2005.

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Creative Destruction: Entry, Exit &competition raise productivity growth

New EntrantsWith new tech

Firms with obsolete tech

Exit

Manufacturing firmsBecome more productive

Spin-offServices

DeeperDivision of Labor

Reallocation

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Competition forced spin-offs and out-sourcing and led to deeper division of

labor

Accounting

Marketingdistribution Other business services

Legal services

Transport and logistic services

Manufacturer

Deeper DivisionOf Labor / Specialization

Expansion of Services

Productivity growth

CompetitivePressure

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Global Local

Basic R&D

ComponentManufacturing

Product design

Marketing

Assembly

Global Sourcing is possible:Local vs. global along the value chain

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II. Why services matter• Services account for large shares of production and

employment in most economies around the world. These ratios are higher for industrial countries

• The share of services in world trade and investment has been increasing. They have been among the fastest growing components of world trade over the last 15 years. Today, more than half of annual world FDI flows are in services, and the value of sales abroad by foreign affiliates of US service firms is estimated to be 3.5 times greater than their cross border exports.

• Some services are low-skilled labor intensive such as tourism and personal services. Thus the expansion of these services are conducive to job creation and poverty reduction.

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China (2004) new data

data: NBSChina 2004 Service Source: WDI 2005,

Saudi Arabia

Trend Line

Norway

Vietnam

Thailand

Sweden

Spain

SingaporeRussia

Poland

Nepal

Mongolia

Mexico

Malaysia

Lao PDR

Korea

Jordan

Italy

Iran

Indonesia

India

GreeceGermany

France

Finland

Egypt

U.K.Denmark

Czech Republic

ChinaCambodia

Brazil

Belgium

Azerbaijan

Austria

Argentina

20

30

40

50

60

70

80

0 5000 10000 15000 20000 25000 30000 35000GDP per capita, PPP (constant 2000 international $)

Serv

ice

Valu

e A

dded

( %

of G

DP)

Service Sector as a Percentage of GDP (Year 2003)

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The role of services as input to the good sector

• Many services are key input to the production of other goods and services, and thus crucial for the competitiveness of the goods-export sector.

• Inefficient provision of services acts like a tax on other producers in the economy

• For exporters in agriculture and manufacturing, inefficient provision of services can lead to negative rates of effective protection

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Why open the service sector• Services as engine of growth: since deeper division of

labor and specialization contribute to competitiveness and higher productivity

• Services trade / entry [foreign or domestic] and exit are conducive to productivity growth

• Liberalization in service may generate sizable gains– A) Standard gains from trade and specialization;– B) Services as intermediate input—better services

for the goods sector; – C) Gains from FDI as a means for trade --learning-

by-doing.– D) Entry and exit /Competition are good for

productivity growth due to resource reallocation, etc

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III. Empirical evidence on Services Trade and Growth

• In the US, Service-producing industries account for – three-fourths of post-1995 growth in aggregate

labor productivity. and– all of the acceleration in labor productivity and

Multi-factor Productivity (MFP) relative to 1987-95.

• Large contribution of IT-producing sectors to MFP is offset by declines in other goods-producing industries (Bosworth and Triplett 2004)

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Evidence in Transition Economies• Exports of services (BOP basis) up from 2

to 8% of GDP, 1990-2004– EU-15 average = 8%– Southern/Eastern Europe = 11%; CIS = 5%

• Services FDI now accounts for 60% of global stock; but some 80% in Baltics

• Business services = 40% of total inward FDI stock in DCs, vs. 20% in OECD

• Transport/telecoms = 25% in transition economies vs. 10% elsewhere

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In transition Economies• Controlling for change in investment/GDP, inflation,

crises, addition of services policy variables statistically significant > 1% level (Eschenbach & Hoekman 2005)

• Using firm data from 350 firms from Czech Republic, Mattoo et al found that– There is a positive relationship between services

sector reform and the performance of domestic manufacturing firms relying on services inputs

– Allowing foreign entry is the key channel through which services liberalization may affect performance of downstream manufacturing sectors

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Services liberalization and growth

Source: Mattoo, Rathindran, and Subramamian (2001)

Linear prediction

1 8.5 -.024

.059

ITA

NZL

SLV

PAN

PRT

FIN

ISL

ARG

CHE

ESP

BELNLD

NORUSACANSGP

EGY

FRA

SWE

GRC

GUY

AUS

GBR

AUT

CYPJAM

BOL

DNK

MLT

MWI

CRI

ZAF

TUR

MOZ

KEN

IND

MAR

VEN

MEX

PHL

NIC CHL

URYKOR

PER

MYS

ECU

AGO

THA

HND

COL

TUN LKA

BRA

IDN

DOM

Composite services liberalization index

Growth rate (adjusted for other factors)

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IV. China lags behind in service sector development

• Underdeveloped and inefficient: in China, Services accounted for 34% of GDP in 2004 (which was adjusted upward to 40.7% by NBS), lagging behind other industrial and developing countries. Why?

1. Under-reporting /data issue2. It is a part of “Imbalances” existing in the Economy

– Inadequate education and health services in rural areas– Inadequate access to financial services by SMEs

Overinvestment in physical capital and underinvestment in human and natural capital

3. State monopoly, lack of competition in some sectors;• How to correct this imbalance?

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However, China’s service sector share in GDP had been stagnant or falling.

China Service Sector's Share in GDP

20

22

24

26

28

30

32

34

36

1981

1983

1987

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

Year

% Current Price1990 Price

Source: China Statistics Yearbook(2002) and China Statistics Abstract (2003)

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Factors for China’s lagging Services• Under-reporting (as informal sector is large)• Lack of competition— entry barriers in many sectors

such as banking, telecom, civil aviation, and railways, and restrictions on non-state capital and foreign capital investment

• Low level of marketization (government-led growth)• Low level of urbanization• Inadequate human resources in many services: legal,

accounting, financing, multimode distribution, E-commerce, computer software, R & D, market service, corporate management service, etc.

• Therefore, reform and liberalization is needed for the development of the service sector.

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V. Macro impact of liberalizing the service sector—CGE analysis

A Computable General Equilibrium (CGE) model (based on Li, Wang and Zhai 2003)

• 52 production sector and 2 households: urban and rural

• Factors of Production– agricultural land, capital, labor by rural / urban and skill levels

• Monopolistic Competition – Transportation, communication, finance, insurance, real estate,

social service, education, health and cultural service

Source: Li, Shantong; Yan Wang; and Fan Zhai 2003. “Impact of Service Sector Liberalization on Employment and Output: A CGE Analysis”. Paper presented in NDRC-WBI seminar, September.

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Simulations Design

• Base case projection for 2000-2010• Service liberalization case – incorporated four

aspects of policy or institutional changes.– Promote competition in service sector – Increased foreign investment resulted from reduction of

barriers– Increased productivity induced by service liberalization– Halving the barriers to services trade

• All policy changes will be phased in over the period from 2003-2010

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Economic efficiency gains

Percentage change of GDP relative to base case, 2010

-1 0 1 2 3 4

Combine (1)(2)(3)(4)

(1) Perfect competition

(2) More FDI

(3) Productivity promoption

(4) Reduction trade barrier

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Sectoral adjustment

Percentage change of output relative to base case

-1 0 1 2 3 4 5 6 7 8 9

Agricultural

Industry

Service

(4) Reduction trade barrier(3) Productivity promoption(2) More FDI(1) Perfect competitionCombine (1)(2)(3)(4)

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Change of output in service sector

Percentage change of output relative to base case

-1 1 3 5 7 9 11 13 15

Infrastructure

Commerce

Finance

Oth. Serv

(4) Reduction trade barrier(3) Productivity promoption(2) More FDI(1) Perfect competitionCombine (1)(2)(3)(4)

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Change of employment in service sector

Percentage change of output relative to base case

-6 -4 -2 0 2 4 6 8

Infrastructure

Commerce

Finance

Oth. Serv

(4) Reduction trade barrier(3) Productivity promoption(2) More FDI(1) Perfect competitionCombine (1)(2)(3)(4)

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Effects on sectoral output and employment, 2010

Output Employment Output EmploymentAgriculture 0.8 0.5 0.2 0.2Industry 1.1 0.3 0.3 0.3Construction 4 3.1 0.7 0.7Service 9 -2.2 0.8 0.5

Transportation 11.3 1.2 1.2 1Post 8.1 -1.8 0.3 0.3Tele-communication 16.5 6 0.4 0.4Commerce 4.7 -5.3 0.3 0.2Restaurant 5.8 -4.2 0.7 0.7Finance 15.2 3.4 0.5 0.5Insurance 12.7 1.5 0.5 0.5Real Estate 24 11.9 0.4 0.4Tourism 64.4 48.6 23.3 23.1Civil Service 9.8 0.1 0.8 0.7Education, health etc. 5 -4.2 0.3 0.2Public Administration 0.8 -0.3 0.1 0

Source: Li, Wang and Zhai 2003. Authors' model simulation results

Liberalization (% change with baseline)

Tourism boom (% change with

liberalization case)

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Effects of service liberalization• Service liberalization will boost economic

efficiency and have shared benefits• Annual GDP growth rates will increase by 0.5

percentage point in 2003-2010• Welfare gains amount to 827 bn yuan or 4.2% of

GDP in 2010• Real consumption rises by 6.8 % and real

investment by 3.8 %• Employment will rise only if construction is

included, and wages for skilled and unskilled labor will rise by 3-6%, benefiting both rural and urban HHs.

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Sectoral and Employment Results• Output will expand in all service sectors,

especially in highly regulated subsectors such as telecom, insurance, and banking

• Tourism and real estate will experience big output booms and significant increases in their employment

• Employment in the service sector will increase, if construction is included.

• In the case of a foreign tourism boom, both employment and output will increase significantly by 0.8 and 0.5 percent over the baseline.

Note: WTO/GATS definition includes construction in services.

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Conclusions• Trade in services brings efficiency gains from deeper

division of labor, specialization, services as intermediate input to the goods sector, and “learning by doing” in new types of services.

• Entry and exit are crucial for productivity growth, as new ideas, technologies and processes are often embodied in new entrants to the market

• Empirical evidence links services trade with productivity growth, in the US and Transition economies, and China.

• Our CGE analysis shows that opening service trade plus a tourism boom may lead to a rise in both output and employment

• Complementary measures are needed to reduce strains for the rural poor.

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References• Aghion, Philippe, and Peter Howitt, 1992. “A model of growth through creative

destruction”, Econometrica, 60:2 (March 1992) 323-351.• Grossman, G. M. and E. Helpman, 1991. “Quality Ladders in the Theory of

Growth”, Review of Economic Studies, 58, 43-61.• Hummels, David and Peter J. Klenow, 2005, AER, 95(3): 704-723• Melitz, Marc J. 2003. “The impact of trade on intra-industry reallocations and

aggregate industry productivity” Econometrica, 71 (6): 1695-1725.• Noguer, Marta and Marc Siscart. 2005. “Trade raises income: a precise and

robust result” Journal of International Economics, 65 (2005) 447-460.• Schumpeter, J. A. 1942: Capitalism, Socialism, and Democracy. New York:

Harper and Brothers. p.83.On services trade• Eschenbach & Hoekman 2005• Bosworth and Triplett 2004• Arnold,Jens, Beata Javorcik and Aaditya Mattoo 2006• Li, Shantong; Yan Wang; and Fan Zhai 2003. “Impact of Service Sector

Liberalization on Employment and Output: A CGE Analysis”.• WANG, Yan and Nihal Bayraktar. 2006. “Banking Sector Openness and

Economic Growth,”, working paper. March 2006.• Wang, Yan and Nihal Bayraktar, 2004. “Foreign Bank Entry and Performance of

Domestic Banks”, WB Policy Research Working paper no 3416, 2004.