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A Decade of Economic Reforms - Review by RBI
[Source: RBI Report on Currency and Finance 2001-2002 dated March 31, 2003]
Module: 1 - Real Economy - Growth, Saving and Investment
(The article analyses sustainability of the services sector in view of its
increasing significance in the overall growth process.)
Sustainability of Services Growth
Reforms bring Growth Momentum to Services Sector
Since the 1980s, growth process in India has been marked by a robust performance of services sector. While this is partially in line with the experience of developed countries, the Indian experience is somewhat unique in the sense that the sectoral shift in favour of services sector accompanied almost stagnant share of industry and reduced share of agriculture. The momentum continued during the 1990s; in fact, it was the growth performance of the services sector that provided a modicum of resilience to the overall growth of the economy, particularly in times of adverse agricultural shocks and industrial slowdown
The set of economic reform measures initiated since 1991 also impacted on the performance of the services sector. First, reforms in the domestic industrial environment which resulted in rising manufacturing growth provided synergies to the services sector in the form of increased demand for producer services. Second, the liberalisation of the financial sector provided an environment for faster growth of the financial services. Third, reforms in certain segments of infrastructure services also contributed to the growth of services. Consequently, the services sector posted a much higher growth during the reform period as compared with the pre-reform period with its share touching nearly the 50 per cent mark. Finally, the rapid growth in services sector appears to have benefited from external demand; the typical example of which is the software industry and call centres. Interestingly, the decelerating trend in manufacturing and overall GDP seems to have been much less pronounced in case of services. Nevertheless, there are apprehensions about its sustainability in view of the contribution of "public administration and defence" to growth in services.
Against the above backdrop, the present article broadly looks into the following two issues: First, the performance of the services sector and second, the sustainability of services growth. After analysing the relative performance of the services sector in the reform period, the supply-side sources of services growth are examined followed by a discussion on the decomposition of services into three segments, viz., producer services, consumer services and Government services.
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Performance of the Services Sector
Since the 1980s, services sector has come to occupy a position of dominance in the composition of GDP. The average share of services sector increased to 45.4 per cent during the reform period as against 38.9 per cent in the pre-reform period. In terms of growth, services sector posted a higher growth of 7.8 per cent during the reform period as against 6.7 per cent during the preceding period. However, services sector is actually an amorphous entity; on the one hand, it includes sectors like 'public administration and defence', largely independent of the level of economic activity, and on the other, it has sectors like 'trade, hotels and restaurants'. At the sub-sector level, 'trade, hotels and restaurants' continued to be the major segment in terms of its share in services. The growth performance improved for all segments during the reform period barring 'financing, insurance, real estate and business services'. However, the 'financing, insurance, real estate and business services' improved its share during the reform period when all other segments witnessed shrinkage in their respective shares, which seems to be the result of the financial sector reforms that led to emergence of new participants, instruments and markets. The poor performance of the non-banking sector, among others, has been the cause for the deceleration in growth of this sector. Nevertheless, the relative contribution of this sub-sector to the services growth has been maintained across the periods.
Factors underlying the Services Growth
Growth of services stemming from capital productivity/total factor productivity could be seen as an encouraging development in a capital scarce economy like India. The gross value added from services registered a higher growth in the reform period even though the trend growth of Gross Capital Formation (GCF) in services decelerated to 5.7 per cent from 5.9 per cent in the pre-reform period. This could imply an improvement in capital productivity and/ or total factor productivity in services. There is a broad consensus that the recent surge in services has been contributed, among others, by the skill-intensive and high productivity activities such as Information Technology (IT) services, which have emerged as one of the fastest growing segments in the 1990s. The labour productivity in software services is estimated to be twice that of the manufacturing sector (Arora and Athreye, 2001). The ascendancy of services can also be seen as an outcome of the economic liberalisation and encouragement of private investment in industry and infrastructure (Government of India, 2002c). Besides, increased expenditure on public administration and defence, social services and rural extension services has had a positive impact on the services growth in the 1990s.
Given the inter-sectoral linkages of services sector with other sectors, particularly industry,performance of the commodity producing sectors has implications for the growth performance of services sector. To explore such inter-linkages, a demand function for services sector has been estimated using GDP from industry, exports of services and prices of services as explanatory variables. The estimates reveal a significant positive impact from the industrial sector as is evident from its elasticity at 0.11. Export of services also has a positive effect on the services demand with its elasticity at 0.02 while the impact of services prices turns out to be negative, as expected.
Composition of Growth in the Services Sector
Intermediate versus Final Consumption of Services
For a meaningful analysis, the issue of absorption of services as intermediate vis-à-vis final consumption is examined by classifying them into producer, consumer and Government services. Their relative roles can provide insights as regards the sustainability of services growth. Activities like 'trade, 'transport, storage and communication', 'financing, insurance, real estate and business services', which are more of intermediate nature, are taken as producer services. Activities like 'hotels and restaurants' and 'other services', having the nature of final consumption, are classified as consumer services whereas 'public administration and defence' (PAD) are treated as Government services.
The stylised facts on intermediate versus final consumption of services along with Government services during the pre-reform and reform period are presented in Table 3.28. While producer and consumer services have recorded a higher growth in the reform period, the Government services have witnessed a marginal decline. This has implications for growth dynamics, not only for services sector but also for the overall growth process. Producer Services
The increased share of producer services in total services in the reform period can be explained by, inter alia , the phenomenon of increasing relevance of outsourcing by the Indian industry. Peripheral service-oriented activities, which were carried out earlier in-house, are being contracted out to the outside agencies in order to focus on core competencies in an increasingly competitive environment in the reform period. Furthermore, the increasing share of producer services reflects the growing complementarity between services and manufacturing (RBI, 2002). The expansionary potential of services can be viewed from the fact that 50 per cent of the industries are directly or indirectly services-intensive (Bhowmik, 2000). The major demand for producer services emanates from the manufacturing sector as well as exports. The estimates of demand function for the producer services show that a rise in manufacturing output drives up the demand for producer services (elasticity 0.18). The export growth also leads to a rise in demand for producer services (elasticity 0.06). Increase in the price of producer services expectedly has a negative impact on demand (elasticity -0.24)17.However, as some of the producer services such as 'transport, storage and communication' are used as input for industrial production, a bi-directional relationship between industry and services sector cannot be ruled out.
Consumer Services and Private Final Consumption Expenditure
An upward trend was observed in consumer services, which recorded a growth of 8.0 per cent in the reform period as compared with 5.8 per cent in the preceding period. The increased growth in consumer services in the reform period has been accompanied by a similar growth pattern in private final consumption expenditure (PFCE) on services. The share of services in PFCE has moved up to 24.9 per cent in the reform period from 18.0 per cent in the preceding period. A disaggregated analysis of PFCE on services shows that medical care and hotels have recorded significant increases in growth during the reform period while growth in transport and communication has slowed down over the same period. Government Services
Government services, comprising PAD is often singled out for the high growth in services since increased expenditure of the Government in the form of wage bill gets directly reflected in its value added even without any addition to services. An examination of the issue of faster growth of this sub sector in the 1980s showed that the tertiary sector growth was not solely due to increase in the growth of GDP originating from PAD (Nagaraj, 1990; Kumar, 1992). The steep wage hike in 1990s in line with the Fifth Pay Commission's recommendations brought back the issue into focus once again (Acharya, 2002). It is also observed that one percentage point of growth of 5.0 per cent in GDP for 1997-98 is attributed to the 20 per cent increase in real value added in the PAD sub sector arising chiefly from pay increases to Government servants (Government of India, 1999).
The growth in PAD, during the period 1997-98 through 1999-2000, has been far higher than growth in services excluding PAD and therefore PAD undoubtedly contributed to the overall growth of services. During the reform period as a whole, an assessment of services excluding PAD, however, contradicts the perception that PAD alone is responsible for higher services growth. Although the Fifth Pay Commission related pay increases might have distorted estimates of GDP originating from services for a few years, they do not affect the trend growth which remains at 8.2 per cent during the reform-period even if Government administration is excluded altogether. The log-linear trend growth of services with and without PAD has been broadly the same during the reform period (Table 3.29). On the whole, the services sector growth appears to have accelerated in the reform period, with the impetus coming from sources other than PAD
External Demand for Services
The growing role of tradable services in international trade and exchange has come to be recognised with the General Agreement on Trade in Services (GATS). India's share in world exports of commercial services has doubled from 0.6 per cent in 1990 to 1.2 per cent in 2000, while the share in world merchandise exports has gone up marginally from 0.5 per cent to 0.7 per cent during the same period. Interestingly, there has been a consistent surplus on account of trade in services. The compositional shifts in foreign trade in favour of services in the reform period has helped in the emergence of new sources of earnings in India's balance of payments. Earnings from software exports have increased from negligible levels in early 1990s to a level of US $ 7.5 billion in 2001-02. These are likely to surge by 30 per cent during 2002-03 as per the NASSCOM estimates. Thus, while the 1980s was dominated by tourism earnings, the second half of 1990s witnessed an unprecedented jump in India's earnings from new economy activities like software services exports and other information technology related skill intensive exports. The services exports thus, provided some element of stability to the external balance of the country and also positively impacted on the overall demand in the services sector.
Summing Up
The services sector has exhibited a strong trend component that has provided an element of stability to the growth process. The sector seems to have grown in the reform period, sustained by an increasing demand for producer and consumer services coupled with the external demand. The role of public administration and defence appears to have been limited in the growth process. The emergence of producer services as an important source of services growth reflects strong inter-linkage with commodity producing sectors of the economy. Apart from providing inputs, services contribute to the outward shift of the industrial sector's production frontier by enhancing productivity growth. Conversely, services growth could be sustained provided adequate demand impulses are generated in industry or agriculture. Given India's comparative advantage in information technology, services growth momentum can be sustained by exploiting new opportunities in international trade in services, particularly, in the area of communication and information services, technology transfer and software.
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