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China Needs a Service-Sector Revolution

BEIJING – China is getting its exchange-rate adjustment whether it likes it or not. While Chinese officials have announced their intention of letting the exchange rate move, only time will tell whether their talk is accompanied by deeds. In the meantime, manufacturing workers are voting with their feet – and their picket lines.

Honda has offered its transmission-factory workers in China a 24% wage increase to head off a crippling strike. Foxconn, the Taiwanese contract manufacturer for Apple and Dell, has announced wage increases of as much as 70%. Shenzhen, to head off trouble, has announced a 16% increase in the minimum wage. Beijing’s municipal authorities have preemptively boosted the city’s minimum wage by 20%.

The result will be to raise the prices of China’s exports and fuel demand for imports. The effect will be much the same as a currency appreciation.

China should count these wage increases as a measure of its success. Higher incomes are an entirely normal corollary of economic growth.

The only difference in China is that the adjustment has been suppressed, so it is now coming abruptly. It would have been better had Chinese officials encouraged earlier and more gradual adjustment, and if adjustment had come through currency appreciation, which would have enhanced workers’ command over imports, rather than inflation, which will make no one happy. But that is water under the bridge.

With exports of manufactures becoming more expensive, China will have to grow by producing something else. It will have to move away from a strategy in which manufactures are the engine of growth toward the model of a more mature economy, in which employment is increasingly concentrated in the service sector.

China will never rival India as an exporter of high-tech and business services, because it lacks that country’s large population of native English speakers. But it has ample scope for expanding the supply of personal and business services for a desperately underserved, increasingly prosperous domestic market. This is a point that Morgan Stanley’s chief economist Stephen Roach makes in recent new book, The Next Asia.

The good news, as Roach observes, is that the service sector places less burden on natural resources and creates more employment than manufacturing. The former is good news for China’s carbon footprint, the latter for its social stability.

But the bad news is that the transition now being asked of China – to shift toward services without experiencing a significant decline in economy-wide productivity growth – is unprecedented in Asia. Every high-growth, manufacturing-intensive Asian economy that has attempted it has suffered a massive slowdown.

The problem is more than just the tendency of productivity to grow more slowly in services than manufacturing. Service-sector productivity growth in formerly manufacturing-heavy Asian economies has been dismal by international standards.

In both Korea and Japan, to cite two key examples, the problem is not simply that productivity in services has grown barely a quarter as fast as it has in manufacturing for a decade. It is that service-sector productivity growth has run at barely half the rate of the United States.

Why is this? In countries that have traditionally emphasized manufacturing, the underdeveloped service sector is dominated by small enterprises – mom and pop stores. These lack the scale to be efficient, the ability to exploit modern information technology, and the capacity to undertake research and development. In Korea, less than 10% of economy-wide R&D has been directed at the service sector in the last decade. This stands in sharp contrast to the US, where half of all R&D is associated with services. Enough said.

In both Korea and Japan, large firms’ entry into the service sector is impeded by restrictive regulation, for which small producers are an influential lobby. Regulation prevents wholesalers from branching downstream into retailing, and vice versa. Foreign firms that are carriers of innovative organizational knowledge and technology are barred from coming in. Accountants, architects, attorneys, and engineers all then jump on the bandwagon, using restrictive licensing requirements to limit supply, competition, and foreign entry.

One can well imagine Chinese shopkeepers, butchers, and health-care workers following this example. The results would be devastating. Where value added in Chinese manufacturing has been growing by 8% a year, service-sector productivity is unlikely to exceed 1% if China is unlucky or unwise enough to follow the example of Korea and Japan.

Employing workers in sectors where their productivity is stagnant would not be a recipe for social stability. China needs to avoid the pattern by which past neglect of the service sector creates a class of incumbents who use political means to maintain their position. Perhaps China will succeed in avoiding this fate. Here at least may be one not-so-grim advantage to not being a democracy.