THE WORLD BANK

China: Services Sector Development andCompetitiveness

DECEMBER 15, 2000

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World Bank Note December 15, 2000

China: Services Sector Development and Competitiveness

Issue: The relative underdevelopment of consumer and producer services in China is a constrainton employment, growth, and competitiveness.

Findings: (a) Despite major problems with the statistics, it is evident that the level of services islow in relation to (i) comparable countries, (ii) recent increases in domestic demand, and (iii)promoting economic efficiency and technical progress in the context of globalization.

(b) Many services are unavailable, except at prohibitive cost, and there is limited choice. Thequality of services is variable, with sharp regional disparities in social services, urban-ruraldivergence in services consumed by households, and in the quality of producer services availableto different economic activities in the country. High cost services are a tax on consumers andproducers, and impair the economic and technical efficiency of specific regions within thecountry as well as China's external competitiveness.

(c) The underdevelopment of the services sector is due to an out-dated government policyregime. The protection of monopolies, price and other forms of intrusive regulation, and aninadequate framework for promoting the smaller and more-agile non-state enterprises thatnormally form the backbone of the services sector are the main constraints. In addition, low skillsand limited access to world-class technologies act as a brake on the provision of services of thekinds demanded by consumers and producers.

(d) Services development creates employment directly; while agriculture shed over 30 millionworkers, services created nearly 73 million jobs over the past decade, and have even greaterpotential. Equally important, better and more services are needed to expand the domestic marketas an engine of growth, revive agricultural and industrial investment, facilitate industrialrestructuring, accelerate human resource development, and compete in the global economy.

(e) This note addresses producer services, specifically logistics, telecoms, business services, ande-commerce. The major thrust of policies in these sub-sectors should be directed atfundamentally reforming the role of the government. Specific and detailed proposals are madefor each of the four areas. Quantitative analysis suggests that GDP would be 4 percentage pointshigher and private consumption 9 percentage points higher in 2010 with reforms, than undercurrent policies.

Next Steps: Local experts helped conduct the background work for this note. This collaborationshowed that there is an urgent need to establish coordination mechanisms among agencies toimprove the policy focus on services sector development. Some new work on services isunderway in government agencies and through World Bank studies on post-WTO economicissues, but this should be expanded. In sub-sectors where the knowledge of issues and solutionsis advanced (e.g., health care, social insurance), the relevant agencies urgently need to taptechnical support to reformn policies and institutions. In some areas (e.g., the development oflogistics), there is also a need for projects and advanced project management technologies..

* Questions on this note may be addressed to Ms. Li Li, External Affairs Officer, World Bank Office,Beij ing.Email: LLi2@worldbank.org

CHINA: SERVICES SECTOR DEVELOPMENT AND COMPETITIVENESS

INTRODUCTION

1. This note is a collaborative effort between leading Chinese experts in governmentagencies and research and academic institutions and World Bank staff. The purpose ofthe note is to draw the Government's attention to the negative effects an underdevelopedservices sector could have on medium-term growth and international competitiveness.The note recommends that the government adopt appropriate measures in the Tenth Five-Year Plan to stimulate growth in the services sector in step with the needs of a growingeconomy.' It presents some general recommendations based on earlier World Bankstudies and recent work completed by domestic and foreign experts.2 Then, to illustratethe general points with specific recommendations, it focuses on a set of producer servicesthat is judged to be critical at this stage of China's development-logistics, businessservices, e-commerce, and telecommunications. This note is neither exhaustive withrespect to consumer and producer services in the Chinese economy, nor comprehensivewith respect to all of the issues associated with the development of the four producerservices described. It is intended to be a survey of some of the broad policy issues thatneed to be considered, and to point the direction to a more thorough and purposefulservices sector development strategy.

THE ISSUE

2. China has achieved a striking record of growth and poverty-reduction since thecountry launched economic reforms and opened the economy to external trade sometwenty years ago. Consequently, it is on the way to becoming one of the world's largestmarket economies, if not the largest, some time in the 21st century. Despite thisremarkable progress, today the Chinese economy faces unprecedented challenges,probably no less than twenty years ago. Domestically, there is the big challenge of anunfinished reform agenda that is far more difficult to resolve than the previous one.Internationally, there is an equally large challenge of harnessing the positive forces ofglobalization and technological revolution to benefit the Chinese economy, whileminimizing their risks. Success or failure can best be measured in terms of China'sability to achieve sustainable growth over the medium- and long-term. This is becausepoverty alleviation and completing the reform agenda (which will displace a large part ofthe non-productive workforce in the State sector) requires sustained and high economicgrowth.

1 Examples of the kinds of economic activities that normally fall within the services category are: finance,accounting, auditing, legal services, insurance and real estate; education; tourism; health care; transport,storage and communications; trade (for example, importing, exporting, domestic wholesaling andretailing); business services (for example, advertising, marketing, sales, consultancy, informationprocessing, research and development); restaurants and hotels; community and personal services (forexample, entertainment), and government services. Broadly speaking, these activities produce eitherconsumer or producer services, that is, output intended for final consumption or as intermediate inputs intoproduction processes and goods.2See Annex 2 for a list of background papers prepared to support the findings of this note, and relatedWorld Bank publications on specific services sub-sectors in China.

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Measuring Services 3. The relative underdevelopment ofChina's services sector is a drag on morerapid increases in employment, medium-

In all countries, statistical offices find it difficult term growth prospects and sustainedto measure the share of services in national international competitiveness. In 1992,output. The problems with quantifying and cometitiveness.eInd1992,pricing outputs and inputs, tracking quality the Government gave unprecedentedchanges, and attributing to the service sector, policy attention to the development of therather than to agricultural or industrial goods, the services sector, by issuing a strategyvalue of services inputs are believed to result in document.3 Subsequently, real servicesserious under-estimates of the contribution of sector output, as measured in China'sservices to national economies. In China, theproblems are compounded by the transitional nattonal accounts, rose by 8.8 percent pernature of the national statistical system, which year, compared to 10 percent for thehas only partially covered the distance from the economy as a whole. Employmentolder Soviet-based accounting methods to those increased by an average of 8.6 million perthat are recommended in modern market year, at a time when industry created 2.9economies. Annex I discusses the issues million jobs and agriculture shed 4.3detail.

million jobs. Even casual observationThus, although the share of the services sector in suggests that the range and quality oftotal output is estimated to be about 33 percent, many services increased greatly, and thisand employment in the sector is 190 million, the applies to both consumer and producertrue numbers are likely to be larger.Nevertheless, even after reasonable adjustments, services. However, a comparson withChina's services sector lags behind that of some of China's neighbors, or even withcomparable countries in terms of its size. countries elsewhere at comparable levels

of per capita income shows that theMore important, however, are the high cost, services sector is relativelyuncertain availability, and highly variable qualityof services. Unfortunately, information on these underdeveloped.parameters is only available through case studiesand micro-surveys. Nevertheless, the frequency 4. This note suggests that awith which they surface suggests that there is an fundamental reason for the under-

development of China's services sector iseconomic: a highly restrictive policy regime for services delivery that does not allow it torespond effectively to the growing demand for services. Most services are tightlymanaged and controlled by the Government, therefore the providers are able to operatewith great market power (for example, banking, insurance, telecommunications,passenger air transport, and railways). In other areas such as housing, health care, urbantransport, and education, there is a strong emphasis on social welfare dimensions. Thisoften results in high policy-induced barriers to entry and price regulation that seldompromote resource use efficiency, product innovation or improvements in quality, andoften undermine desirable social welfare outcomes (for example, in the areas of credit,

3The document is titled: The Determination of the State Council and the Central Committee of the ChineseCommunist Party to Promote the Development of Tertiary Industry, June 1992. Since the issue of policydocuments related to the reforms of 1978, this was the first time that a sectoral development strategydocument was issued by the Party. Aiming to achieve a services sector growth rate above that ofagriculture and industry, it presented general objectives for promoting domestic and foreign investment inthe sector, reforming state owned institutions involved in services output provision, financing the sector,and liberalizing prices for most services sector output.

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insurance or health care).4 It is especially important to note that, with very fewexceptions, the gap between China and comparator countries is larger in the newerservices or those requiring higher skills, than in traditional services. Equally important,the growing deficit on the services account of the balance of payments is a possibleindication of bottlenecks in the provision of services from domestic sources. 5 In additionto the policy regime, other factors that account for the slower growth of services are thelow rate of urbanization, inadequate labor market skills and imperfect labor mobilitywithin China. The development of Hong Kong SAR as a major provider of services toMainland China firms (mostly non-competing or internationally benchmarked forquality) is another element that explains, in particular, the underdevelopment of producerservices in China.

TOWARD A SERVICES-DRIVEN GROWTH STRATEGY

5. The historical experience of developed and developing countries provides a firmbasis for stating that, as aggregate incomes rise, they lead to an increase in the share ofservices in an economy. Consumer services expand as people move from the necessities(food, clothing and shelter) to better-quality necessities and an expanded array of goodsand services. In general, individuals tend to have a higher income elasticity of demandfor services than for goods.6 Producer services grow as they become more vital to theproduction of the kinds of new goods and consumer services demanded by society.Valuation issues aside, China's recent experience suggests that this trend is firmlyunderway. The strategic questions at this point are: Should the services sector be thegrowth-engine of the Chinese economy? Can it? How?

6. The potential contribution of the services sector to employment, medium termgrowth, and international competitiveness argues for a services-driven growth strategyfor China.

* Employment-In 1970, services employed 31 million people, compared to 35million in industry (manufacturing, utilities and construction). By 1994 it hadovertaken industry, and in 1999 nearly 190 million people were employed in thesector, compared to 162 million in industry. Clearly, as the share of agricultureshrinks in the economy, and the need for urban jobs escalates, both industry andservices will have to shoulder the burden of job-creation.

4 While labor productivity (measured as real output per worker) is lower in services than in manufacturing,profitability and average wages (except in wholesale/retail trade and catering services) are higher. Seebelow.5The deficit on the non-factor services account rose from US$0.2 billion in 1992 to US$7.5 billion in 1999.The change in the factor services balance is even larger. starting from a surplus of US$0.3 billion in 1992 toa deficit of US$18 billion in 1999. However, caution is needed in interpreting this as an indicator ofChina's declining competitiveness in services, as many services are bundled in the value of merchandiseexports.6 It should be noted that both poverty and income inequality have profound effects on the bundle of goodsand services consumed in a society. In China, decreasing, but still high, levels of poverty and increasinginequality may have generated opposite effects on the demand for services.

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* Growth-However, industry in China is both more capital-using and less labor-intensive. Fixed capital investment per worker in manufacturing is higher than inmost services activities, as is fixed capital investment for each new worker.7 Theamount of employment generated per unit of gross output is also higher inservices than in industry, more than three times as much, according to estimatesderived from the 1997 Input-Output tables for China. More significant, however,is the fact that producer services, rather than manufacturing, are increasingly thedrivers of growth and productivity. In an economy where the share of industry inGDP has already eroded, and the profitability of manufacturing is under severepressure, adding services to products is one way of sustaining growth.8 Mostimportant, the introduction of low-cost and high-quality producer servicesnormally results in an economy-wide transformation of production, businessorganization, distribution and consumption patterns, rather than simply resultingin the accelerated development of one or more "leading sectors".9

* International Competitiveness-The concept of international competitivenesslies at the heart of achieving a sustained increase in China's standard of living.' 0

It is a significantly broader idea than "external competitiveness", which can bemaintained by exchange rates and subsidies, if necessary, to generate a risingshare of world export markets and, although not in a sustained way, an increase inthe domestic standard of living."' In a globalizing world, benchmarking to bestpractices is imperative. In this regard, it is useful to note that worldwidecomparisons conducted by reputable organizations identify China's servicessector weakness as a bottleneck to improved international competitiveness. 2

These findings are confirmed by a recent survey of private firms by the WorldBank Group. Labor and management skills, technology, market information, andfinancial services emerged as the main constraints on growth.'3

7 Manufacturing, rather than industry as a whole, is the relevant comparator. Several sub-sectors withinindustry (e.g., energy) and services (e.g., transportation) involve massive infrastructure investment.8 See Financial Times, "The Eclipse of Manufacturing", December 15, 1998 for a useful survey of suchtrends. Numerous examples are available from recent Chinese experience-the effect of improved coldstorage and handling on seasonal fruit and vegetable availability; the success of Legend in a highlycompetitive domestic market for personal computers; etc. Many of these are documented in World Bankstudies of specific services sub-sectors (see Annex 2).9 See also Stephen S. Cohen, J. Bradford DeLong and John Zysman, Tools for Thought: What is New andImportant About the "E-Economy", BRIE Working Paper #138, February 22, 2000 for a view on economictransformations, as distinct from leading sector development.'° One definition of international competitiveness, used by OECD is: "the degree to which [a country] can,under free and fair market conditions, produce goods and services which meet the test of internationalmarkets, while simultaneously maintaining and expanding the real incomes of its people over time". SeeAddrea Boltho, "The Assessment: International Competitiveness", Oxford Review of Economic Policy, vol.12, no. 3, p. 3, 1996." The recent experience of the Japanese economy, which remains externally competitive but has beenunable to protect standards of living, is relevant.12 The Global Competitiveness Report of the World Economic Forum, and the World CompetitivenessYearbook of the International Institute for Management Development come to virtually the sameconclusions. They identify education/labor skills, management, business and infrastructure services asspecial weaknesses.13 China: Private Enterprise Study, International Finance Corporation, Beijing, November 2000.

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7. The next question is-can the services sector be a growth engine in China? A partof the response depends on learning from the positive experience of countries such as theUS and Singapore, or of Hong Kong SAR. In this group, massive capital investmentsand human capital inputs were required over long periods of time before the payoff fromimproved services boosted overall productivity and growth. But counter-arguments canbe mustered from the examples of the spurts in productivity, growth and the standard ofliving in countries that have recently "opened" to more rapid development of the servicessector (for example, India).

8. Recent experience with regulatory reform in OECD countries shows thatliberalization in services industries and utilities resulted in significant gains in sectoralproductivity, cost reductions and growth of output. For instance, total factor productivityin the telecommunications and electricity industries in Germany, France and Spain rose40 percent on average as a result of recent regulatory reforms. Given the starting point forChina's services scctor, conccivably reforms should secure even bigger productivitygains than for OECD economies.

9. An economy-wide model was used to estimate the potential effect of services sectordevelopment on the economy over the next decade.' 4 Productivity gains are assumed tocome from three sources: (i) more efficient use of resources (for instance, capital)through financial sector reform; (ii) more competition, resulting in greater innovation andproductivity increases; and (iii) higher foreign direct investment through reduced entryrestrictions. Under modest assumptions of productivity gains (0.5 percentage pointshigher per year, limited exclusively to the services sector) and higher capital inflows (10percent higher by 2010), the model simulation yielded the following conclusions:

* Services sector liberalization could produce substantial benefits for China in termsof economic growth and consumer welfare. As expected, growth will beanchored more on the domestic than external market and, correspondingly, moreon services than the goods-producing sector. Real GDP would be 4 percenthigher and private consumption 9 percent higher in 2010 with just these reforms,compared to a status quo scenario. Using the current national accounts statistics,the share of services sector in GDP would rise from 32.8 percent with no reform,to 36.8 percent with reforms.

* A comprehensive reform strategy is more effective than a partial one becauseproduction activities and various components of the economy interact. Withoutfinancial liberalization that improves efficiency in the allocation of capital, the

14 The model was developed by the Development Research Center of the State Council. It is a 5 factor(land, capital and 3 types of labor), 52 production sub-sector, 2 representative households, recursivedynamic computable general equilibrium model (CGE). There are 12 services sub-sectors in the model,eight of which are characterized by imperfect competition. The model is calibrated to the 1997 socialaccounting matrix developed from the Input-Output table for that year. It was assumed that reforms wouldbe phased in over 10 years, starting in 2001.

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potential payoffs from services sector reforms are capped at significantly lowerlevels.

* Labor mobility is essential for the success of the services reforms. Somereallocations of labor and a contraction of employment in certain sectors may takeplace. This calls attention to the need for labor market transition programs, suchas re-training and portable social insurance systems.

10. These results depend on a number of assumptions about the model and data. Theyare not intended to provide precise measurements of the effects of services sector reformon the economy. But they should indicate the kind of benefits that can be derived fromeven a partial program of services sector reform. The following sections suggest apossible approach to reaping such benefits.

POLICY RECOMMENDATIONS

11. The policy recommendations of this note are framed by the followingconsiderations.

* The services sector in China has expanded over the last decade, and will continueto do so in the future. There are structural forces at work that will underpin futuregrowth.

> As aggregate incomes expand, given the high elasticity of demand for mostconsumer services, people will demand a wider range of better qualityconsumption opportunities. Many of these will be services, while the otherswill be goods with high services content. Evidence suggests that there ispent-up urban demand for consumer services in China, and this is showingup in the higher prices they are willing to pay. With increased urbanization,this demand will grow.

> The demand for producer services will grow as China's corporate sectormakes more intensive use of such inputs to reactivate and reorient industrialcapacities in order to complete the industrial transition that began in themid-1 990s. In addition, there is a global trend towards the fragmentation ofproduction processes, where the value added chain is broken up intoincreasingly fine components. Improvements in transport andcommunications are a major driver of this trend. Outsourcing, cspecially ofservices, is a noticeable and increasing phenomenon among the largerChinese firms, especially state-owned enterprises.' 5

15 Interestingly, for firms producing to international benchmarks of quality, price and product design, themain beneficiaries of such outsourcing seem to be Hong Kong SAR services providers. This is not justlimited to foreign funded enterprises, or the massive numbers of Hong Kong manufacturing firms thatrelocated to Guangdong and adjoining provinces in the 1980s and 1990s. The human capital endowment ofHong Kong in producer services is several multiples of the availability of such skills on the Mainland. Seethe report by Yue-Chim Richard Wong, Zhigang Tao, and Chi-Shing Chan, An Economic Study of HongKong's Producer Service Sector and Its Role in Supporting Manufacturing, Hong Kong Institute ofEconomics and Business Strategy/APEC Study Centre, May 15, 2000.

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a As recognized widely, private provision of services has expanded, and can onlyincrease. Large segments of the social insurance system, education and healthcare, tourism and hotels, road transport, and business services already contain asignificant number of private sector actors, albeit in a stunted form. Theflexibility, interaction with consumers, and ceaseless pursuit of cost-savingsrequired to succeed in services provision make this an ideal sector for the growthof private firms.

* Special efforts are needed to increase the knowledge content of economic activityin China. As documented extensively in debates on economic development, astrategy based mainly on the use of more factors of production-labor andcapital-is self-limiting. Agricultural and industrial productivity in China are lowby international benchmarks. 6 Moreover, there are signs of flagging productivityin the economy. But several national and international trends are forcing the drivefor improved knowledge content.

> In industries characterized as low or medium technology, the increase intechnical knowledge and associated organizational changes increasinglyprovide an edge in productivity and enable product differentiation,significantly shaping competitiveness and value added. Even traditionalindustries, such as textiles, cement and steel are using new technicalknowledge and information systems to improve the design and quality ofproducts, of production processes, and the efficiency of marketing anddistribution.

> Likewise, in agriculture, better understanding of plant reproduction andgrowth, advances in genetic engineering, and better techniques forharvesting, storing, transporting and distribution are affecting the value andcompetitiveness of different types of plant and animal products.

> In addition services such as transportation, distribution, finance, insurance,health and education themselves are becoming increasingly sophisticatedand more knowledge and information intensive.

> In this context what matters more than the creation of high technology is theeffective use of it and other knowledge throughout the economy, especiallyits application for improving and upgrading all sorts of goods and services.As the acquisition, dissemination and assimilation of knowledge is a

16 Estimates by the World Bank show that manufacturing value added per worker in China is only 3.5percent of the level in the US, 7.1 percent of the level in Korea, and 92.5 percent of India. Agriculturalvalue added is 0.7 percent as high as in the US, 2.6 percent of the Korea level, and 75.6 percent the level ofIndia.

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services activity, rapid development of this sector is becoming essential toChina's goal of transforming itself into a global economic power.17

Finally, the forces of globalization, which have been influencing China'sproduction and consumption structures in a piecemeal fashion until now, willhave an accelerated and broader impact as a result of China's accession to theWorld Trade Organization (WTO). Based on what is known of the agreementsunderlying China's accession, widespread commitments have been made to opencritical parts of the services sector to international competition. These includeproducer services such as finance, distribution, and telecoms, each of which haslinkages with all parts of the Chinese economy. More, better quality and cheapercost services in these sub-sectors will have strong growth effects. However,Annex 4 of the draft WTO protocol allows China to regulate prices in servicesincluding transport, posts and telecoms, professional services, residentialapartments (but not houses) and education services. The fact that these areallowed does not necessarily mean that they should continue; the economicrationale for continued price regulation in many sub-sectors is weak. Moreeffectively, consideration may need to be given to drawing full benefits fromliberalization, while evolving transitional strategies for domestic providers. Theirability to survive in a more competitive environment is a legitimate objective forservices sector development strategy, but the economic costs of the transitionneed to be evaluated rigorously.

GENERAL RECOMMENDATIONS

12. A large body of work by the World Bank has focused on aspects of services sectordevelopment in China. Past reports that are relevant to today's challenges are listed inAnnex 2.

13. From these studies, it is clear that the central priority in terms of policy actions isto separate the State from the provision of most consumer and producer services,strengthen and modernize its regulatory role and the implementation of relevantstandards, and make the establishment of competition in services provision an over-arching objective of the development strategy.

14. In terms of sub-sectoral priorities, the most important ones are education and thecreation of an effective knowledge and innovation system. Improved services in theseareas have both a level effect (increasing productivity in other sectors) and a growtheffect (increasing the economy's ability to absorb new knowledge from the rest of theworld and to develop new knowledge). The recommended strategies in these areas arecontained in Strategic Goals for Chinese Education in the 21Js Century (World Bank,1999) and China's Development Strategy: The Knowledge and Innovation Perspective(World Bank, 2000). In addition, World Bank reports have also stressed the importance

" See the recent World Bank report, China's Development Strategy: The Knowledge and InnovationPerspective, November 2000, for a detailed discussion of these issues and concrete recommendations forservices sector development to raise the knowledge content of economic activity.

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of labor market mobility in facilitating the massive resource reallocations needed tocapitalize on a better services sector. Clearly, two essential ingredients to promote labormarket mobility, in addition to improved re-training and labor market informationservices, are reforms in housing and social insurance, both of which have been the subjectof recent studies by the World Bank. 18

SPECIFIC RECOMMENDATIONS

15. To illustrate the nature of reforms in specific sub-sectors, the remainder of thisnote focuses on four classes of services that are essential to raising productivity andgrowth in the Chinese economy. The analysis and recommendations provided belowfocus on logistics, business services, e-commerce, and telecommunications. Logisticsaccounted for 42.4 percent of services GDP in 1997, and are the largest group.'9 Civil andsocial services are the next largest group in the national accounts, with a 38.4 percentshare. Financial, insurance, and real estate services, with a share of 16.8 percent takethird place, followed by business services which have a miniscule share of less than 1.0percent.2 0

16. Logistics are an area that has traditionally been the focus of the governmentinvestment programs in the context of infrastructure development where the country has agreat need. However, logistics in terms of management services and coordination haslargely been ignored, resulting in high costs. Business services, a fast growing sub-sectorin OECD countries remain largely ignored in China and have received the least attentionin policy. This is reflected in the paucity of useable statistics for analytical purposes. Butbusiness services also hold the greater potential for growth, mainly because theprevalence of globalization and the technological revolution will drive their demand.

17. Telecommunications and e-commerce drive the New Economy-a new source ofeconomic growth. One unifying theme in all of these services is that the government hastraditionally played a significant role in them as noted earlier. Reforming the role of thegovernment thus holds the key to improving the efficiency in the provision of services.As discussed earlier in paras. 9-10, a program of services sector liberalization launched inthe 10th Five-Year Plan period could bring significantly higher economic growth in thenext decade than without liberalization.

Logistics

19. China's logistics costs are estimated to be about 18 percent of GDP, high incomparison with the United States, 9.5 percent in the mid-I 990s, but about the average of

18 See the World Bank reports, China. Pension System Reform (#15121-CHA, August, 1996), Old AgeSecurity: Pension Reform in China (1997), and proceedings of the workshop on China's UrbanizationStrategy: Opportunities, Issues and Policy Options (May, 2000).19 This category includes storage, inventory financing, packaging, transport and administration, systemmanagement and information control.20 The contribution of business services to the economy may have been under-estimated because they tendto be emerging businesses not yet fully captured by the statistical system.

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a transition economy. The long time and high cost required to complete transactions, highinterest charges and inefficient transport systems all contribute to China's high logisticscosts. In developed economies, transport costs account for about a quarter of the totallogistics cost, while in China it is closer to half. A reduction of logistics cost to 15 percentof GDP (3 percent of GDP), a feasible target for the period of Tenth Five-Year Plan,would save more than US$30 billion annually. But indirect saving for the economycould be much higher because a high logistics cost represents a barrier to the growth ofboth domestic and international trade. The opportunity to hasten the development oflogistics in China is brighter now than ever before because the prospect of China's ofjoining the World Trade Organization intensifies pressures for firms to looks for ways tocut logistics costs. Correspondingly, the State should also adjust its roles in three areas inrelation to logistics-regulator, facilitator, and catalyst.

Regulatory function

20. The regulatory role of the state has been reduced during the last decade, but it stillneeds to be much less intrusive, and act more efficiently where it does still need tointervene, i.e., its actions should be less affirmative and more remedial. Specificrecommendations are:

* Follow international best practices in the implementation of international traderegulations, particularly those related to customs, taxes, and health and quarantinerequirements. One of the most time consuming activities is customs examination.Here a change in Chinese practice toward international norms, which wouldrequire halving the sampling rate, would significantly reduce storage costswithout prejudicing national security.

* Create a permanent coordination council for logistics development in trade. Thisshould have specific and time-bound objectives to shorten the time involved in thebureaucratic processes of moving export containers from their inland origin totheir overseas destination. Logistics costs could be reduced by about 15 percentwith a better-coordinated inspection system, particularly one that did not requirethe unloading of already loaded and sealed containers in their port of exportation.

* Let operators determine tariff rates on a commercial basis for rail transport(remaining controls on road transport tariffs are largely ignored) and especiallyfor containers where application of market principles would result in significantlylower tariffs and more effective competition with road transport. Liberalize airtransport charges.

* Relax the regulations of business licenses so that vertical integration of logisticsfunctions is easier. This would help companies at all stages of logisticsdevelopment -- those just starting on their own in-house logistics activities--tothose at the forefront of value-added logistics activities.

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Facilitation function

* Consider consolidating logistics related functions into a single Ministry-theMinistry of Transport in due time. More efficient coordination of transportactivities to facilitate multi-modal transport will be essential to the developmentof logistics and the facilitation of foreign direct investment in inland provinces.Experience in other East Asian economies shows that some governmentintervention in a facilitation role can greatly accelerate the process when mostresponsibilities for the development of logistics activities (transport andwarehousing) are within one ministry (typically a single Ministry of Transport)and when the ministries responsible for trading activities have a strong incentiveto cooperate with each other and the transport ministry.

* Encourage the development of Chinese trade associations of logistics providers tostimulate the growth and development of logistics activities. One way of doingthis is to give the associations the right to apply and enforce international logisticsstandards, such as in the cases of associations of manufacturers in Europe andUnited States.

* Encourage business faculties to set up Logistics Institutes, in which academic andbusiness interests can come together to find new ways of applying theoreticalconcepts to logistics activities. These can be powerful stimulants to thedevelopment of logistics activities as happened in other countries.

Catalyst function

* Encourage the formation of new logistics companies through regulation andsimple and flexible registration of new domestic and foreign logistics companiesthat applies equally to inter-provincial trade in order to stimulate morecompetition in the market that have been dominated by several large players.

* Clarify the role of central and local governments in regulating inter-state trade.While it is generally clear that regulation of China's international trade is aresponsibility of the national government, responsibility for inter-provincial tradeis still unclear in some areas such as application of sanitary regulations and healthchecks(for goods that are sold in the market). Some Chinese provinces stillattempt to impose their own regulations of inter-provincial trade. Further progresson deregulating inter-provincial trade will depend on a clearer understanding ofthe roles of the respective levels of government with respect to trade, so thatreduced regulation at one level is not frustrated by increased regulation at another.

* Accelerate the pace of the experimentation of pilot projects in logistics. Theworld of trade and logistics is changing too fast to make slow experimentationmeasures in a number of years tenable.

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* Organize regional seminars and workshops that are focussed on specific logisticstopics, such as development of information systems, increasing market knowledgeand awareness of the changes in logistics practices in developed countries that arethe recipients of Chinese exports, and replicating and expanding the experience ofShandong and Guangdong in the application of logistics functions in industry.

Business Services

21. One of the areas where the globalization and the technological revolution will havethe largest impact is business service. Already, business services are the fastest growingsegment of OECD economies and hold the key to their long-term growth. OECD usesthe term strategic services to describe the nature of business services as being strategic tothe competitiveness of a business. Competition will drive the need for business servicesand efficient provision of business businesses, in turn, enhances businesscompetitiveness. As the need for business services will rise significantly over time, Chinawould need to create a favorable environment to stimulate the development of businessservices, lest her competitiveness should suffer. This implies China needs to reformpolicy environment that appears too restrictive to permit a sound development of abusiness services sector that will meet the demand for tomorrow.

22. China's business services sector can be defined to include the five categoriesdeemed to be strategic businesses in the context of OECD economies. These are:computer software and information services, R&D and technical testing services,marketing services and business organization (comprising management consultancy andlabor recruiting services), and human resource development services (training programand on-the-job training), plus professional services that include legal, accountancy andauditing services.

23. In China, business services are a newly emerging sector that have grown fast froma very low base as a result of three forces: (1) a rapid growth in the use of computertechnology; (2) growing outsourcing of technical services; and (3) market-orientedeconomic reforms. The last factor has proved to be the most significant factor, sharplydriving up the demand for professional services in financial markets, legal, auditing andaccounting fields. Due to the paucity of data in this area, an accurate estimate of thecontribution of business services to the economy is not available but it is likely to beminuscule. 21 Thus, even adjusting for the stage of economic development, thedevelopment of business services in China is probably inadequate to meet the growingdemand.

24. The factors that have influenced the growth of business services are complex. Butit is also clear that the current policy environment is inadequate for promoting the growthin this sector. What is needed most is to redefine the role of the government in this sector.At present, many segments of business services have not benefited from market-oriented

21 For instance, the contribution of strategic services was estimated to be 0.022 percent of GDP in 1991,compared with 3.6 percent of GDP in the UK in the mid- 1 990s.

12

economic reforms in China. The government retains tight control over theirdevelopment. State-owned enterprises are favored at the expense of non-state domesticand foreign firms. Tight control of business licenses induces rent-seeking behavior. Thepolicy environment facing accounting, legal and advertising/marketing services based onthe survey results to be discussed below, is most representative of these characteristics.On the other hand, computer software and information services have been growing fastand do not seem to share these problems. Human resources seem to be the majorconstraint on their future growth. R&D, technical consulting services and the wholeknowledge delivery and dissimulation system is discussed in the World Bank reportChina 's Development Strategy. The Knowledge and Innovation Perspective.

25. Accounting services. As recently as 1998, the Ministry of Finance and its localgovernment counterparts controlled almost all of the accountant offices in China, directlyor indirectly. This almost ensures that the accounting profession's main job is to satisfythe needs of the government, i.e., performing auditing on state-owned enterprises fromwhich accounting firms derive the bulk of their revenue. Thus, domestic accounting firmshave not yet evolved into providing strategic consulting services. Furthermore, since thegovernment is directly or indirectly engaging in accounting business through the firms itcontrols, it's granting of business licenses to accounting firms creates room for conflict ofinterests.

26. Legal services. In China, legal services are the subject of numerous domesticregulation and government control at both national and sub-national level. Some of theseare sensible, and reflect practices elsewhere in the world. For example, the setting ofqualifications and experience standards in the legal profession. Most of the law officesare state-owned with fees largely set administratively by the government. The legalservices market was opened to foreign law offices in 1992 but their services are limited toforeign companies in China. The result is that the legal services profession saw littlegrowth in the 1990s.

27. Advertising services/marketing. This is a business that has seen a rapidliberalization as non-state-owned advertising firms captured 14 percent of the market in1997 previously entirely dominated by state firms. Nevertheless, the State still enjoys amonopoly position as the State controlled carrier (news media) still retains 50 percent ofthe market share for advertisement. False advertising appears to be a problem.

28. More broadly, the single most severe restriction of business services developmentin China is not so much with barrier of technology or capital. Most business servicescompanies are small-and-medium companies. Instead, government monopoly proves tobe the most significant entry barrier. However, reform and liberalizing of markets areslowly taking place. In April 1999, accounting offices began to sever their ties withvarious tiers of the government. Foreign accounting and legal firms have also began tooperate in China. With China's entry to WTO, further opening of professional services toforeign and domestic firms are expected. Over the long haul, it is the knowledge base ofthe economy that dictates the pace of growth in business services because business

13

services are knowledge-intensive activities. But the government can accelerate thedevelopment of the business services market by undertaking the following steps:

* Transform its role from being a services provider to the market regulator. This isalready underway, as seen in the merging of professional associations and theirlegal separation from "sponsoring" government agencies.

* Abandon attempts to regulate the price of legal business services (for example,legal services), focusing instead on increasing competition.

* Further deregulate the business services market by allowing greater entry offoreign firms with advanced know-how and domestic firms.

* Establish rigorous professional certification and clear quality standards.

* Support the development of small and medium enterprises.

* Support education and training of skilled professional services staff.

* Collect adequate statistics on business services.

E-Commerce

29. The Internet is said to be the driving force of the New Economy of the UnitedStates in the 1990s. The use of the Internet in China has also grown rapidly since itsadoption three years ago. What is the potentialfor the Internet to be a new driving forceof growth for China? What are the obstacles for its assimilation in the Chinese economy?

30. China's Internet population has soared from 2.1 million at the end of 1998 to 17million by now. The number of dot.coms (services and content providers) has grownfrom 100 at the end of 1998 to 500 this year, increasing at a rate of two per day. Themarket of e-commerce has also grown significantly. By some estimate, it is expected toreach US$40 million this year and climb to nearly US$4 billion by 2003, a ten-foldincrease in just three years. The growth of the Internet, like elsewhere, has also played arole in driving the growth of the information technology industry (IT) that is rapidlyemerging as a new "growth pole" in the economy. State Information Center estimates thatChina's information technology (IT) industry saw a seven-fold expansion during theperiod 1992-1998. Though its share in GDP is still small, at 4.8 percent of GDP in 1998,the IT sector already contributed significantly more to nominal GDP growth due to thisrapid expansion.

31. Indeed, the Internet could have a large sustained simulating effect on economicgrowth in China, even matching or superceding that in the United States. Potentially, asexperience in the US and elsewhere has shown, the Internet could be a powerful tool forreducing costs and raising the efficiency of enterprises, thereby improving theircompetitiveness. For a large economy like China, in which the exchange of commodityand information flows between geographical regions and are still being inhibited by

14

natural or artificial barriers, the Internet provides a powerful tool to connect markets andbreakdown barriers to trade and exchange. The Internet thus has the potential to allowChina to reap the large country advantage. The recent success of the ShanghaiPharmaceutical in the use of the Internet to tap the vast interior markets far away from itsShanghai base indicates that the potential can be turned into a reality. Another areawhere the Internet can help break the traditional barrier is in the supply chain or logisticsmanagement, whose development has been inhibited by the lack of the necessarycoordination between suppliers and distributors. The Internet now makes the coordinationrequired for supply chain management feasible. Furthermore, c-learning has a vastpotential to be tapped into as a powerful educational tool to upgrade China's humanresource skills, being in the high-tech area where there is tremendous shortage for skilledmanpower or in the low-tech area where general upgrading of knowledge for the futureis also in great demand.

32. Notwithstanding the large potential benefits of the Internet to the Chineseeconomy, success is not necessarily assured because the development of the Internet inChina is handicapped by several factors. Foremost, China's e-commerce today can becharacterized as one with an "e" but largely without "commerce". Yes, growth in "e" hasbeen rapid as witnessed by the rapid growth in the electronic and IT industry. But muchof China's dot.coms are still devoid of commercially viable "content". To the extent theyhave commercial content, they are predominately operating with Business-to-Customer(B-to-C) models. The Internet has not yet been widely used as an intermediary or as abroker for business transactions as typically characterized by a B-to-B model. Until thishappens, the role of the Internet as a means to spur productivity growth in the Chineseeconomy, as experienced by the US economy, will be limited. The US experience showsthat the spread of e-commerce has sharply driven the demand for IT investment and hasimproved efficiency in telecommunications services. It is "commerce" that drives "e". Incomparison, foreign demand for IT products provides an increasingly powerful stimulusto growth in the IT industry in China. (IT and electronic exports now account for 40percent of total exports of China.). Nevertheless, the US experience also suggests thatabout 90 percent of the dot.com start-ups are failing, and hardly any are making profits.The contribution they are likely to make to the profitability of firms over the foreseeablefuture will be very small. Consequently, an appropriate public policy model forpromoting such ventures should be focused on private sector development, withoutmassive government investment or credit exposure, and with focus on an enablingenvironment that promotes low cost entry, exit and operation.

33. Likewise, due to a lack of commercially viable content, the long-term survival ofChinese dot.coms could also be in jeopardy. This is because of the commercial use ofinformation technology that is at the heart of e-commerce. In addition, many of the key-supporting infrastructures essential to Internet development are inadequate. These includeefficient electronic payment system, efficient logistics services, efficienttelecommunications services, good net security protection, and a legal frameworkconducive to e-commerce. Finally, but not the least is that the government's censorshipexercise over web contents, rooted in security concerns that, if not judicially carried out,may slowdown the development of e-commerce in China.

15

34. To hasten the development of e-commerce as a contributor to efficiency andgrowth in the Chinese economy, the government has a significant role to play. Thecentral government needs to take the leadership role in coordinating with localgovernments to create an environment favorable to the sound development of e-commerce. As the July 1997 Global e-commerce Framework of the United Statesgovernment states, the role of government in e-commerce is to ensure clarity andconsistency of the laws and regulations promulgated for unleashing the market forces andinnovations that are fundamental to the development of c-commerce. More broadly, thegovernment could act on several areas, some through public/private collaboration such asin areas of education and training as follow:

* Adopt proper measures and safeguards to enhance security in e-commercetransactions to avoid fraud and raise its credibility.

* The government needs to carefully balance its national security concerns with theneed for Internet development.

* Establish a transparent legal and regulatory framework that is supportive of e-commerce's business registration and operation.

* Hasten the development and efficiency of telecommunications infrastructureservices.

* Improve the efficiency of logistics services as suggested earlier.

* Support educational and research programs that promote digital literacy such astechnical education and skills-building programs to reduce shortages in ITprofessionals.

* Foster Internet-based application and offer support to Internet contentdevelopment to facilitate the creation and the use of socially and economicallyvaluable local-language sites such as transport logistics and a nation-widepayment system.

* Stimulate IT use in government services-particularly procurement (e-procurement), education, health and environment.

Telecommunications

35. The telecommunications industry has been one of the fastest growing sectors in theChinese economy. With the current speed of growth, China will become the largesttelecom market in the world. However, even with this enviable performance, the level ofdevelopment of China's telecom industry has just reached a comparable internationalnorm, but not much above it, if at all. Thus, much of this growth represents a big catch-up. Even this is fortunate since telecom investment has been found to have a large effect

16

on economic growth. Going forward, China's telecom performance will be an even morecritical factor for growth performance, for it determines the quality and the speed withwhich the whole China is connected to the global Information Society, not the leastthrough the use of the Internet.

36. China's telecom sector faces a number of issues to successfully overcome, whichwould drastically improve the efficiency of the telecom services and increaseconnectivity. These have to do with the lack of (a) a basic telecom law that deters entryby potential entrants and investors in China's telecom markets, (b) the lack of competitionthat denies China, a powerful force, from raising efficiency for telecom services as inmany countries, (c) the lack of an independent regulator that often invites a conflict ofinterest between the regulator and its subordinate entity, (d) sub-optimal allocation ofresources, (e) unfair interconnection rules, (f) a distorted tariff structure, and (g) lowaccessibility of telecom services in poor and backward regions in China.

37. These issues create an immediate urgency for reforming China's telecom sector.Some of the regulatory reforms and entry barrier issues will already have been dealt within the context of China's commitments made under WTO accession. But the governmentneeds to follow through with effective implementation. In addition, governmentintervention in two areas is recommended: policy reforms and improving connectivity.

38. Policy reforms. Among the major policy reforms are:

* Liberalizing the market: Besides potential foreign entrants, potential domesticentrants include cable companies, the Ministry of Railway, which is able todevelop its own long-distance fiber optic network.

* Continuing reform efforts in the regulatory field, in particular:

3> Unbundling competitive services from segments with natural monopolyelements. This would make regulation of these segments easier, and reduce theroom for implicit cross subsidization;

z Re-balancing tariff to reduce the need for cross-subsidization; this wouldprevent arbitrage opportunity for new entrants to cream-skim profitable segmentsand regions;

> Putting price-cap to limit the price increase for incumbent operators and atthe same time to give operators incentives to save costs;

- vApplying successful license-allocation schemes: Emphasis should bebalanced on network rollout targets, rural coverage plans, as well as bid prices,depending on the main objectives;

>Ž Designing interconnection charges to assure a 'level playing field' for newentrants: The interconnections fees need to be sufficiently low for the non-

17

facility-based competition to be possible, and at the same time, sufficiently highthat the incumbent operators have incentives to expand the network;

> Allowing number portability to encourage competition by giving usersflexibility of changing services providers without changing numbers.

* Reforming the institutional environment to generate a warmer investment climate:

> Passing a telecom law that is consistent with the WTO's regulatory whitepaper (BTA-Basic Telecom Agreement) requirements as soon as possible;

> Improvingjudicial capacity for enforcement: Without such capacity, foreigninvestors may find it less attractive to invest; and when investing, they may scaledown to reduce the risk of expropriation;

) Avoiding standards and practices in China which are incompatible with ordifficult to adapt to the international environment.

39. Improving connectivity. The main steps to be taken here are:

* Assistance for infrastructure development in marginal areas, which can be mostefficiently achieved by promoting a careful mix of policy development, privatefinance and public funding. This should also include support for internationalconnectivity to help boost limited capacity through a coordinated program ofinternational connectivity upgrades that could result in significant benefitswithout massive public sector funding;

; Universal Access Fuind could be used to support expansion in high-costareas. Market forces could be used to reduce the cost of universal services.Allocating universal services obligations fairly among competitors, includingforeign ones;

* Creation of multi-use rural telecenters, linking sparse and poor rural population togovernment services and educational opportunities, giving access to the Internet,and making available to the rural poor specialized resources to make theireconomic activities more productive.

18

Annex I

UNDERSTANDING SERVICES AND MEASURING THE SIZE OF CHINA'SSERVICES SECTOR

What are services?

1. In high-income countries, on average, services contribute nearly two-thirds of totalvalue added. Among low- and middle-income countries, they account for a smallershare-54 percent-but still the majority of output. In East Asia, the services sector in arepresentative country has an even smaller share, but at 41 percent of Gross DomesticProduct (GDP) it is approximately equal to the size of the industrial sector. Given thesemagnitudes, it is surprising that policymakers in many countries give so little attention tounderstanding services, or to formulating strategic policies for their development.

2. A part of the problem in understanding this sector stems from the classical viewthat services represent unproductive labor, as they are consumed at the instance that theyare produced, therefore incapable of increasing the stock of material wealth. In China,the exclusion of the sector from the national income accounts, which conformed to thesystem adopted from the Soviet Union and other socialist countries, perpetuated thisview. Biases against the development of the services sector derive from a lack ofunderstanding of their role in improving production efficiency and promoting technicalprogress, in addition to directly satisfying consumer needs. Lower productivity growth inthe services sector than in manufacturing may have also contributed to the widely heldview that its development ("de-industrialization", according to some) was inimical tolong-term growth prospects. Very little of this is based on fully credible evidence.22 Infact, the reverse is true; increasing, and increasingly efficient, services are essential forraising standards of living in a sustainable manler.

3. Three chief characteristics distinguish services from most tangible (for example,bread, books) and intangible (for example, musical compositions, software designs)goods. They (i) involve simultaneous interaction between the provider and user; (ii)therefore they are non-storable; and, (iii) unlike goods, ownership of a services is nottransferred when it is provided.2 3 Clearly, the provision of services takes place underconstraints that do not usually exist for the production of goods. This may help explainsome of the slower measured growth of productivity in the services sector, as opposed tomanufacturing. It is also the reason why promotional policies for the sector require atleast as much careful attention, if not more, than industrial development policies.

22 For example, errors in valuing the services associated with producing a good can be a significantdeterminant of under-valuation when measuring productivity. Even today, such errors are a significantsource of concern in the national income statistics of the OECD countries.23 For two recent attempts to define services, see Sherry M. Stephenson, Approaches to LiberalizingServices, World Bank Policy Research Working Paper #2107, Washington DC, May 1999; and Peter Hill,"Tangibles, intangibles and services: a new taxonomy for the classification of output" in Canadian Journalof Economics, volume 32, No. 2, April 1999, pp. 426-446.

19

Annex ]

What activities are included in the services sector?

4. Two broad classes of services may be distinguished. Consumer services areprovided to individuals and households for final consumption. Examples of such servicesare haircuts, medical treatment, entertainment, and security. However, producer servicesare an equally important category. They are intermediate inputs, and become embodiedin the production of other goods and services. Examples of such services are those thatgo into advertising, marketing, transporting, wholesaling and retailing a soft drink ormotorcycle. Sometimes, the provision of such services requires the use of high skills andnew technologies. In such cases, the growth of producer services represents capitaldeepening, as important to economic growth as buying new machine tools and buildingmodem factories. In fact, the increasing importance of information technology,automation, knowledge, and their combination in economic activity worldwide, isblurring the distinction between manufacturing and services.

5. Two problems that arise in identifying and measuring the output of services undercurrent statistical systems are worth highlighting. First, the production-based method ofnational accounts identifies sectors as "goods producing" (for example, agriculture andfisheries, or manufacturing, or construction) or "services producing" (for example,wholesale/retail trade or transportlstorage/communications). However, a sizeable part ofvalue added that is attributed to the former sectors consists of services. For example, aleading white consumer goods exporter in China-Haier--does much of its own salesand marketing activity. Only a portion of such services-specifically just the part out-sourced to specialized firms-is attributed to the services sector. There is, therefore, asystematic under-valuation bias against services sector output. This is true, especially,for producer services.

6. Second, it is often difficult to distinguish between consumer and producer services,which adds to the under-valuation bias in measuring the latter. The output of "servicesproducing" sectors may be used both for final consumption and as an intermediate inputinto a production process. This is easy to see for such sub-sectors as finance, insurance,transport, and real estate. However, it is also true of other services producing sub-sectors,such as restaurants and a wide range of services delivered by the Government. Detailedinput-output tables, as exist for China, are useful in making the distinction betweenconsumer and producer services. However, they do little to correct the under-valuationbias against the services sector as a whole.

What is the size of the services sector in China?

7. Measuring the output of China's services sector represents several additional and,for the purposes of this report, insurmountable challenges. There has been a lot ofprogress in improving the quality and coverage of statistics for this sector. Despite this,neither the levels nor trends in services sector output, prices, and employment can bedetermined accurately enough to inform decision-makers. NBS is aware of the

20

Annex 1

shortcomings of these data, as well as the vital role services can play in the economy. Itis taking concrete steps to improve the use of deflators and the coverage of sub-sectors.Broader measures to improve these data depend on a radical overhaul of the nationalstatistical effort.

8. Four main reasons explain why the statistical system vastly under-estimates the sizeof the services sector in China.

9. First, as is well known, state-owned enterprises (SOEs) traditionally provide"cradle to life" services to their employees, ranging from kindergartens to funeralservices. Such a high degree of vertical integration between production and servicesunits naturally lowers their demand for external services. However, in the past, thenational accounts did not accurately impute the value of such services provided by SOEs,nor did they attribute this output to the services sector. More recently, because ofdifficult financial and operating environments, many SOEs have shed the extended socialwelfare burdens. The Government, at national as well as sub-national levels, has assumedsome SOE-based welfare activities, or privatized them. The National Bureau of Statistics(NBS) has now begun to estimate the value of services still provided by SOEs, and toattribute them to the services sector. Thus, the significance of this source ofunderestimation is bound to decline over time, although it will continue to undermine theidentification of past trends and levels.

10. Second, the nominal value of agriculture and industrial output is over-estimated,resulting in under-estimation of the share of services in the national economy. The grossindustrial output of the township and village enterprises (TVEs), in particular, is over-estimated despite routine efforts by NBS to squeeze the "water" out of the statistics. Thevalue of industrial output of the TVEs tends to be lower in the industrial census yearsthan in other years. For example, the share of TVEs in total industrial output in 1995-acensus year-was 33.7 percent. This is far lower than in the years immediately beforeand after: 43.8 percent in 1994, 44.2 percent in 1996, and 45.8 percent in 1997. Inaddition, the national agricultural census suggests an over-estimation of meat productionby 20 percent or so in most years.

11. Third, agricultural and industrial output is relatively under-deflated compared withservices output, which results in an upward bias in measuring the real value ofagricultural and industrial output, compounding the problems created by over-estimatesof their nominal values. As expected, the use of base-year prices (bubian jiage) for thedeflation exercise (1990 for the most recent data series), can seriously distort measures ofreal output, especially in the kind of high inflation environment that existed during theearly-1990s. Specific valuation problems affect the TVE output data, where theunavailability of appropriate base-year prices resulted in the substitution of nominalvalues for real. However, this was true for some TVEs and not others, so it is difficult togauge the size of the miscalculation.

12. Finally, for a long time the statistical system ignored services, using insteadstandard socialist planned economy accounting methodologies adopted from the Soviet

21

Annex I

model. The first services sector census did not take place until 1993-1995. It correctedsome of the statistical bias against services, but the statistical system is still far fromperfect. It has taken little account of some rapidly emerging sub-sectors, such as legal,financial, accounting, and private transport services.

13. Given such serious qualifications about the accuracy of the statistics, it is difficultto make too strong a case for services sector development based on the level and trenddata alone. Unfortunately, most of the arguments that have emerged in the internaldebates on services sector development have focused on the need to "catch-up" with thelevel of services shares that are seen in comparator countries. Relatively little attention isgiven to the composition of such services, a shortcoming that this note seeks to correct.Nevertheless, what can we tease out of the aggregate statistics to confirm the generalimpression that services are under-developed in China?

Figure 1: Services Sector in the 1990s

450.0 ----- ----

400.0-

3500.

300.0 - - -+Real output

250.0 ,,- +Services prices

200.0 - - -. Services employment2000v .- -_--- Labor productivity

' 150.0 -K Services prices (CPI)

100.0 - .\---. -

50.0 - _ __ _ _ _-

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

14. Using the available national accounts data, while keeping in mind thequalifications required in their interpretation, it is useful to examine Figure 1. The trendsin employment, output and productivity in the services sector would suggest that itsgrowth has been driven by improved efficiency in resource use. If this is true also of theshare of services wrongly attributed to the manufacturing sector, it can be assumedreasonably that a portion of the rapid gains in productivity seen in manufactures are owedto services outputs.2 4

24 The effect of producer services inputs on raising manufacturing output and productivity is a separatecontribution. Such effects are well documented for many countries. In China, there is only a limitedamount of recent analysis on this subject, so it is not possible to document this credibly and evaluate thesize of such contributions for the manufacturing sector as a whole.

22

Annex 1

15. The divergence between the two price indices for services output is alsonoteworthy. The problems with the slowly-growing national accounts deflators werepointed out earlier (see para. 11). By contrast, the services component of the CPI rose byan average annual rate of 16.4 percent, more than double the rate of the overall CPI. Thisreflected adjustments in the prices of many services that are administratively fixed-forexample, schooling, medical and housing services. However, it also reflects increaseddemand for more and better-quality services that parallel increases in household andbusiness incomes (for example, restaurants and entertainment), as well as producerservices to meet changing market conditions (for example, business services such asadvertising, marketing, communication, and consulting). Prices of services even rose byabout 10 percent per year during 1998-1999, when overall consumer prices declined as aresult of weak aggregate demand.

16. The information presented in Figure 2 is central to an evaluation of the current andpotential contribution of services sector growth to the Chinese economy. On average, thesector contributed 2.4 million new jobs per year during the 1970s, rising to 6.3 millionjobs during the 1980s, and 8 million during the 1990s. By contrast, agriculture shed 3.4million jobs per year in the 1990s, while industry absorbed just 2.9 million persons eachyear. If adjustments are made for the share of services attributed to other sectors, it isevident that the services sector is the engine for employment creation in the Chineseeconomy today.

Figure 2: Enployment Trends

180.0

160.0 -

140.0 __

120.0I pO * _ : _ = +GDP

~~ 1000 -- .1 - ---u-~~~~~~~~~~~Agriculture

80.0 -- - - Industry

60.0 / -/--- -x--Services

40.0

20.0

00 T ---- ---7--__ --

1970 1980 1985 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

23

Annex 1

17. Figures 3, 4 and 5 contrast services sector performance with that of the overalleconomy, and with agriculture and industry. The picture that emerges is that productivityincreases may have enabled the services sector to retain its growth potential in theeconomy, despite a clear increase in the price of services output relative to that ofagriculture and industry.

Figure 3: Real Output Trends in the 1990s

400.0

350.0

3000 -- - - - --- - - -

° 250 0; - -- - - ----- - - - --- , / : +--- =~~~~ Agriculturei

200.0 ~~~~~~~~~~~~~~~~~~~~~~Industry-- Manufacturing I

10.0 0 Services

50.0 -- -----, ------- -

0.0 -- --- - 7 -- ----- --- - -.- -- -_ _

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Figure 4: Price Deflators in the 1990s

250 0

2000 -.

- 1500 /---150.0 - -. -- -~~~~~~ ~~--- - ~~~ -U-- Agriculture

QN~~~~~~~~.-' .- ~~~~~~~~~~~~~~~~~Industry

~ - - -0 t. __ __________ _ _____ _ -(-- Manufacturing

C )K Services

50.0 r - --- -

0 .0 7-- _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ -_ __-_ _-

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

24

Annex I

Fgure 5: Average Labor Productivity in the 1990s

300.0

250.0

200.0 --- o EconomyAide

---- Agricwture150.0

- | | XF- -- ~~~~~~~~~~~~~~~~~~~~Industry-X---- Services

100.0

50.0 - -

0.0 -O _ , - - -- -

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

18. In nominal terms, the share of services value added in GDP rose only slightly overthe past decade, from 31.3 percent in 1990 to 33 percent in 1999. In real terms (constant1990 prices), it actually fell to 28.4 percent in 1999 (Figure 6). The decline in services-use intensity in the economy is also reflected by the fall in services inputs per unit ofoutput in most industries. On the other hand, the contribution of industry to GDP grewvigorously from 37 percent of GDP in 1990, to 42.7 percent in 1999. It is unclear howmuch industrial output should be attributed to the services sector (see para. 5). Anextreme case-which is not plausible-is to attribute to the services sector all of theincrease in the industry-to-GDP ratio during 1990-1999 (that is, 5.7 percentage points).Even so, the adjusted share of services in the Chinese economy would rise to only 38.7percent of GDP, well below that of comparator countries.

19. Thus, in late 1990s, the contribution of services to the Chinese economy appears tobe smaller than the contribution of services to countries with similar per-capita incomesas China's (US$3,220 measured at purchasing power parity in 1998 according to theWorld Bank's methodology). For instance, in 1998, in Jordan (per capita PPP income ofUS$3,130) the share of services in GDP was 50 percent; Jamaica (US$3,210) had a shareof 58 percent; Morocco (US$3,120) had a share of 54 percent; the Philippines(US$3,540) had a share of 52 percent; Indonesia (US$2,790) a share of 41 percent; andIndia (US$1,700) a share of 45%. As mentioned earlier the divergence between Chinaand the developed countries, especially in the OECD group, is even larger. Services arefrequently the largest segment of developed economies. For instance, in the UnitedStates, services contribute over 70 percent of GDP (Figure 7).

25

Annex I

Figure 6: Services Rose While Services Output Share Declined

o 120

' 115

a.O 110 19 19

105 1996 95 1993

10> 100 19 8 19 1989

° 95 88

2 90 1980

o 85 [984

X 80 1982 1983

> 75

70

22 24 26 28 30 32 34

Share of Service Output in GDP (percent)

Figure 7: The Size of China's Service Sector is below theInternational Norm

90

a> 8 0

70

C -WS+**6..

CC 50

4 0

30W ~~~~China

o 20

0

0 5000 10000 15000 20000 25000 30000 35000

GDP per capita at PPP (dollars)

26

Annex 2

Background Papers

Christine Zhen-Wei Qiang and Lixin Colin Xu, Reforming China Telecom.

E.C. Hwa, China: Services and Competitiveness.

Liu He, Qin Hai, and Lu Yanrong, E-Commerce in China.

Ping Xinqiao, Business Services in China.

Robin Carruthers, Logistics Development during the Tenth Five-Year Plan.

Xu Lin, The Main Reason for the Lagged Development of Tertiary Industry in China.

Xu Xianchun, An Analysis of the Reason for the Relative Lagged Development of theServices Sector in the 90 's in China.

Zhai Fan, The Macroeconomic Effects of Services Sector Liberalization in China.

Related World Bank Studies on China

China's Development Strategy: The Knowledge and Innovation and Perspective, 2000

Container Transport Services and Trade: Framework for an Efficient ContainerTransport System, October 10, 1996

Old Age Security: Pension System Reform in China, 1997

China: Higher Education Reform, 1996

Strategic Goals for Chinese Education in the 21st Century, 1999

China 2020: Financing Health Care: Issues and Options in China, 1997

China: Urban Environmental Service Management, 1995

China 2020: Clear Water, Blue Skies: China's Environment in the New Century, 1997

China: The Emerging Capital MVlarket (in two volumes), 1995

China: jMfanaging Public Expenditures for Better Results: Country EconomicMemorandum, 2000

China: Agro-industrial Crop Marketing, 1994

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Annex 2

China: Fruit and Vegetable Marketing Performance, 1996

China: Investment Strategies for China 's Coal and Electricity Delivery System, 1995

China's Railway Strategy, 1993

China: Southeast Coastal Region: Strategic Issues in Ports and Shipping Development,1993

China: Strategies for Road Freight Development, 1995

China: Forward with One Spirit: a Strategy for the Transport Sector, 1998

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