Services Development and Comparative Advantage in Manufacturing
I. Introduction
On the face of it, services play a relatively small role in international trade. Conventional trade statistics show that services trade accounts for only one-fifth of cross-border trade. However, a significant part of goods trade includes trade in embodied services. In the United States, for example, more than a quarter of intermediate inputs purchased by manufacturers were from the services sector. For certain manufacturing sectors, such as computers and electronic products, this percentage - a measure of "services intensity" - is as high as 47.6 percent. Drawing on the Trade in Value Added Database, Miroudot and Cadestin show that services inputs account for about 37 percent of the value of manufacturing exports in the sample of countries covered. The development of the domestic services sector, as well as access to imported services inputs, can, therefore, be expected to influence comparative advantage in manufacturing trade. This paper seeks to understand this indirect role of services development drawing upon new data and new techniques.
The impact of services development is interesting because it is not straightforward. Since services are used as inputs in the production of manufactured goods, services development can help to increase manufacturing production. But since services and manufacturing compete for resources, the development of the former can be at the expense of the latter. For example, it is evident that the development of the services sector has drawn resources away from manufacturing not just in industrial countries like the United States and the United Kingdom, but also in developing countries like India.
We focus on two key services sectors: financial services and business services. Both have emerged as skill-intensive, dynamic, internationally traded services. These two services sectors are often regarded as the pillars of modern economies, and their value added shares in GDP have a strong positive correlation with countries' income levels (see Figure 1). These are also the two sectors which represent the tension we discussed above in the sharpest form. On the one hand, manufacturing performance is critically dependent on the domestic availability of these services.
On the other, these are the sectors that often provoke "de-industrialization" concerns – financial services in industrial countries like the United States and the United Kingdom, and business services in developing countries like India and the Philippines.
Well-functioning financial sectors are critical in mobilizing resources, stimulating investment, and at the same time helping firms (and households) better manage their risks. As shown in Appendix 3C, the business services sector covers a variety of critical of services activities, ranging from software consulting and data processing to management consultancy, engineering and R&D services. Intensive use of these modern services can help manufacturing firms increase productivity, reduce the cost of doing business, expand their choices within a longer geographic distance, differentiate their products from those of their competitors, strengthen their after-sale customer services, etc. USITC shows that business services accounted for nearly half of all services purchased by manufacturing sectors in the U.S. in 2008.
Our first hypothesis is that, while the overall effect of services development on the performance of manufacturing sectors can be ambiguous, its effect is more likely to be positive for manufacturing sectors that use services inputs more intensively. Furthermore, we distinguish embodied domestic services inputs from embodied foreign services inputs. When domestic firms have access to foreign services, they may at least partially bypass their own inefficient services provision by relying more on imported services inputs. As our second hypothesis, we expect to see a more positive effect of access to foreign services inputs on manufacturing export performance in countries with lower levels of domestic services development.
We develop a methodology to quantify the indirect role of services in international trade in goods using a method developed by Koopman, Wang, and Wei and Wang, Wei, and Zhu that generalizes the vertical specialization measures proposed by Hummels, Ishii and Yi. We use revealed comparative advantage (RCA) to measure the competitiveness of manufacturing sectors. Following Koopman, Wang, and Wei and Wang, Wei, and Zhu, we improve on the traditional Balassa RCA and construct new measures of RCA based on domestic value added in gross exports by taking into account both domestic production sharing and international production sharing.
In our econometric analysis of the impact of services development on RCA of manufacturing sectors, the key explanatory variable is the interaction between a measure of the development of financial (or business) services and the financial (or business) services-intensity of each manufacturing sector. We find that domestic services development has a mixed effect on manufacturing export RCA: in manufacturing sectors with low embodied services, services development reduces manufacturing export RCA; however, in sectors with a high degree of embodied services, services development increases manufacturing RCA. Figure 2 provides a visual illustration of this relationship in the case of financial services. We see a negative association between manufacturing RCA and a measure of financial development for a sector with low embodied financial services, but a positive association for a sector with high embodied financial services.
In the second hypothesis, we consider the role of services imports in helping overcome the limitations of domestic services markets. We begin by showing that a country's access to foreign services markets measured by the share of foreign embodied services is negatively correlated to countries' services trade barriers. Using the World Bank Services Trade Restriction Indexes (STRI), Figure 3 shows a negative relationship between financial services trade barriers and the share of embodied foreign financial services among embodied domestic and foreign financial services for the textile sector of 40 countries in 2000, using data from the World Input-Output Database (WIOD). A similar pattern holds for other manufacturing sectors and years. We then find that in countries with lower levels of services development, manufacturing exports benefit more from access to foreign services inputs. Our result suggests that lower services trade barriers may help developing countries to bypass their inefficient domestic services provision and promote their manufacturing exports through inter-sectoral linkages.
The rest of the paper is organized as follows. We review the relevant literature in Section II. In Section III, we present our hypotheses and carry out the empirical analysis. We conclude in Section IV.