During his inspection tour in Beijing last week, China's top political adviser Jia Qinglin stressed the development of the services industry, echoing the head of the national economy planning body's announcement that the development of the sector lags behind the demand generated by China's fast economic growth. Zhang Ping, director of the National Development and Reform Commission, has vowed to implement more favorable policies aimed at boosting the services sector's development under the 12th Five Year Plan (2011-2015).

A well-developed services sector plays a major role in improving production efficiency and promoting technical progress and innovation. In developing economies, the adequate provision of services, especially transportation, telecommunications, logistics and financial services, is a prerequisite to ensure and sustain economic growth. In developed economies, services have become the primary source of output and employment, accounting for about 70 percent of GDP and 60 percent of total employment.

The services sector has expanded rapidly in China since economic reform was launched some three decades ago, particularly after China joined the World Trade Organization (WTO) in 2001, but their size appears to be smaller than expected based on China's income level.

The share of services and services-related employment in relation to GDP tends to rise with the level of income of an economy, because high-income elasticity of the demand for services increases faster than the demand for goods as real per capita income rises. Empirical evidence suggests that the share of services in middle-income countries accounts for about 55 percent of GDP and 54 percent of total employment. In 2009, the services sector in China accounted for 42.4 percent of GDP and 34.8 percent of total employment.

The relative underdevelopment of the services industry is a direct consequence of the economic development model adopted by China, which favors manufacturing with focus on manufactured exports. As a result, fiscal incentives have directed investment into the production and export of goods, discouraging investment in services.

Besides, while manufacturing greatly benefited from liberalization brought about by the successful opening-up policy, openness has been limited in the services sector. The restricted exposure of the services sector to overseas direct investment, and its implicit technological transfer, has limited the expansion of the sector and the quality of the services provided. It has constrained the potential of trading services, too, which explains the persistent deficit observed in the services account of the balance of payments.

Moreover, despite the ambitious services liberalization commitments that China agreed to when it joined the WTO, their implementation and enforcement remain weak. As a result, there is still a dominant presence of State-owned enterprises (SOEs) in the services industry, which constrains competitiveness. The high market concentration limits the entrance of new domestic and foreign players, thus reducing the benefits of enhanced competition and liberalization. Experiences of Organization for Economic Cooperation and Development member countries show that liberalization of services, including the provision of utilities, results in significant cost reduction and productivity gains.

In this connection, the inefficient allocation of financial resources enhances the dominance of SOEs in the provision of services. While significant progress in financial sector liberalization has been achieved, the current system remains biased toward large SOEs, which absorb about two-thirds of total lending. In contrast, private enterprises, which tend to be more efficient and innovative, receive only one fourth of the available credit. Notwithstanding their significantly smaller allocation, private firms generate about 50 percent of GDP and are the primary source of employment generation in China.

Against this background, wide-ranging reforms are needed to turn services into an efficient and competitive sector. That would strengthen domestic sources of growth and support government efforts to rebalance the economy. For instance, by reducing market concentration in the sector, the resulting liberalization and improved competitiveness would lower production costs and prices, and increase the quality of the services provided to consumers and producers both.

Recent efforts by the government to better enforce the Antitrust Law are steps in the right direction. More openness toward foreign participation in sectors, including banking, telecommunications and professional services, will foster liberalization efforts. In this regard, a reliable intellectual property rights regime, which is crucial for the development of services, where copyrights and trademarks are important, would help attract more overseas direct investment into the sector, and encourage domestic firms to innovate.

It is important, too, to deepen financial sector reform for the improvement of capital allocation to move toward an innovation-based economy and grant wider access to finance. Given the superior performance of private companies in China, more efficient capital allocation would translate into higher GDP growth. Furthermore, more sophisticated capital markets will bring benefits to self-employed entrepreneurs, and small- and medium-sized enterprises, which are critical players in a vibrant services sector-based economy.

On the demand side, accelerating urbanization will boost the development of the services sector. The scale and structure of the services demanded in an economy depend on the level of urbanization. At the same time, a certain critical mass is needed for the demand for services to increase.

Hence, expediting urbanization, which is a key force to drive future growth and development in China, will boost the development of the services industry. A larger services sector, underpinned by supportive policy measures, including investments in education and vocational training, will absorb surplus labor from manufacturing and agriculture sectors, foster employment generation, and make income distribution fairer. With urbanization featuring prominently in the government's reform agenda, and with a more flexible household registration system (hukou) already in place, the 12th Five-Year Plan holds the key to unlocking the enormous potential that the services sector entails in China.

The author is the head of the economics unit of the Asian Development Bank's office in China.

(China Daily 02/22/2011 page9)