20100626 China needs a service revolution

China needs a service revolution

By Barry Eichengreen
Saturday, Jun 26, 2010, Page 8

China is getting its exchange-rate adjustment, whether it likes it or not. While Chinese officials continue to mull the right time to let the yuan rise, manufacturing workers are voting with their feet — and their picket lines.

Honda has offered its transmission-factory workers in China a 24 percent 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 percent. Shenzhen, to head off trouble, has announced a 16 percent increase in the minimum wage. Beijing’s municipal authorities have pre-emptively boosted the city’s minimum wage by 20 percent.

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 if Chinese officials had 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. All that, however, is water under the bridge.

With exports of manufactured goods becoming more expensive, China will have to grow by producing something else. It will have to move away from a strategy in which manufacturing is 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. However, 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 his 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.

However, 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 South 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 over the past decade. It is that service-sector productivity growth has run at barely half the rate of the US.

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 (R&D). In South Korea, less than 10 percent 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 South Korea and Japan, large firms’ entry into the service sector is impeded by restrictive regulation, for which small producers are an influential lobby group. 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 healthcare workers following this example.

The results would be devastating. Where value added in Chinese manufacturing has been growing by 8 percent a year, service sector productivity is unlikely to exceed 1 percent if China is unlucky or unwise enough to follow the example of South 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 being undemocratic.

Barry Eichengreen is professor of economics and political science at the University of California, Berkeley.