Who’s thinking of services reform?

People tend to bring strong views, weak evidence and a parochial perspective to the debate on services reform all over the world. They are concerned most about consequences for the services sectors themselves. That reform has spurred services growth is widely accepted, but what of the impact on the rest of the economy? Can we assess its significance? Now, with new data and new techniques, we can. In particular, our research on India and a number of other countries reveals a vital but under-appreciated link between services reform and manufacturing productivity.

One element of India's rapid economic growth since the early 1990s has been the modest resurgence of Indian manufacturing. Conventional explanations have focused on policy reforms in manufacturing industries, notably trade liberalisation and the dismantling of the "licence raj". Few have recognised that a key factor lies outside of manufacturing itself, in the services sector.

The neglect of services is surprising because it should be obvious how much manufacturing firms depend on services, for credit and insurance, for transport and telecommunications. Moreover, reforms in the 1990s have visibly transformed these services sectors, with greater openness and improved regulation leading to a dramatic growth in domestic and foreign investment. Indian manufacturing firms are no longer at the mercy of inefficient public monopolies but can now source services from a wide range of domestic and foreign providers operating in an increasingly competitive environment. As a result, they have access to better, newer, more reliable and more diverse business services.

The telecommunications market, of course, exemplifies the transformative power of liberalisation, interacting with technological change. It is easy to forget that in the 1980s, the communications minister, C.M. Stephen, declared in Parliament that telephones were a luxury, not a right, and that anyone unsatisfied with their service was welcome to return their phone as there was an eight-year waiting list of people seeking telephone services. Today, India has the world's second-largest telecommunication network and the third-largest Internet user-base, with one of the lowest call tariffs. Indian businesses, which used to be severely handicapped in their ability to communicate with their customers and suppliers, are now enjoying world-class communications services.

Transport has seen an improvement but not yet a revolution. The average turn-around time for a container at major ports has declined from about eight days in 1990 to four today. This is still a long time by international standards, but for firms that compete in highly variable markets, such as textiles and electronics, where the ability to respond quickly to changes in demand is crucial, this improvement has made a difference.

Banking reforms seem to have helped too. Manufacturing firms in India saw an improvement in their access to and cost of finance as a result of the banking sector liberalisation. The two World Bank Investment Climate Surveys point to a positive trend: in 2002, 61 per cent of Indian firms reported that access to finance was an obstacle to their business, but in 2006 only 41 per cent had the same complaint.

These improvements have enhanced firms' ability to invest in new business opportunities and better production technology, to exploit economies of scale by concentrating production in fewer locations, to efficiently manage inventories and to make coordinated decisions with their suppliers and consumers.

In our research, we documented all the competition-enhancing policy changes affecting Indian services sectors. We then assessed the importance of these reforms for the performance of downstream manufacturing firms using data for about 4,000 firms operating in India. Our results suggest that even after taking into account other changes in openness, such as tariffs, the opening of services sectors to domestic and foreign entrants in banking, telecommunications, insurance and transportation boosted the productivity of manufacturing firms. How large were these effects? We find that even limited services liberalisation resulted in a productivity increase of 12 per cent for domestic firms. The additional effect of transport sector reforms was the greatest, followed by that of reforms in telecommunications and banking.

We do not take a rose-tinted view of India's services reform. Telecommunications has had its teething problems, particularly in the issuing of licences and in defining the role of the regulator. In air transport, some of yesterday's dynamic entrants are today struggling to survive. In banking and insurance, too, reform is still a work-in-progress. But our evidence suggests that even imperfect and incomplete reform has been better than no reform, at least from the perspective of manufacturing firms.

Nevertheless, we would not suggest that services liberalisation should proceed mechanically. It is evident that the gains are much greater if liberalisation is complemented by regulatory reform and the strengthening of regulatory institutions. The consequences of weak prudential regulation in financial services have been painfully demonstrated in a number of countries in the recent crisis. Stronger pro-competitive regulation is needed to prevent foreign and domestic oligopolies from appropriating the gains from liberalisation in telecommunication, transport and retail. Firms and workers may need time and assistance to adjust to more open regimes. And instruments like universal access funds would ensure that the gains from liberalisation are shared by the poor and remote. These complementary measures are not just desirable, they are necessary to ensure that reform is politically sustainable.

Beata Smarzynska Javorcik is professor of international economics at the University of Oxford, UK. Aaditya Mattoo is research manager of trade and international integration at the World Bank

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