The hidden key to growth: how local services stimulate economic expansion.

• Author: Baily, Martin

Having focused for many years on manufacturing-led growth, policymakers across the developing world now recognize the contribution that service exports can make. India leads the world in offshore IT services. Dubai has tourism as well as a growing financial services hub. Singapore is building hospitals to serve patients from across Asia. The Philippines is developing call centers. Yet these offshore service strategies overlook a far larger, if less well-understood, opportunity to boost wealth creation: stimulating domestic service sectors.

Higher productivity in services is the key to growth in any economy. Local services account for more than 60 percent of all jobs in middle income and developed economies, and virtually all of new job creation (Figure 1). Manufacturing is not going to be a sustainable long-term source of new jobs anywhere--even in China-given the rapid advances in technology and productivity that are reducing industry's labor needs.

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Why, then, do so many policymakers omit local services from their development plans? Part of the reason is that service work has a poor reputation. Low-skill, low-wage, ephemeral jobs in fast food joints and beauty parlors hardly seem the building blocks of a modern economy. But such jobs form the minority of service employment: even in the United States, widely thought to have too many of them, they represent only 22 percent of the huge range of total service employment. In fact, services comprise many activities critical to economic growth, like power supply, transport, and telecommunications, as well as numerous high-skill, high-wage occupations, such as accountants, researchers, and professionals in health and financial services.

After years of neglect and undue regulatory constraints, local service productivity in most emerging economies lags far behind productivity in sectors developed for export. This is a pity. Research by the McKinsey Global Institute suggests that, given the fight competitive environment, local services across the range can be a powerful source of wealth creation and jobs for middle-income economies, more powerful than offshore services could ever be.

FASTER GROWTH AND MORE GOOD JOBS

Once an economy reaches the middle income level of development, service industries become a more important source of job growth than manufacturing. And, contrary to popular belief, a substantial percentage of these jobs are high-skill and high-wage. The more dynamic and competitive an economy's service sector, the more jobs and GDP growth it will create.

More good jobs. Since 1997, employment has declined in the goods-producing sectors of most developed and many developing economies, leaving service industries responsible for all net job creation. Among middle- and high-income economies today, services generate 62 percent of all employment on average, and the higher a country's GDP per capita, the higher the share of service employment (Figure 2).

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Manufacturing employment is shrinking worldwide as a result of more efficient use of labor, automation, and new IT. Roughly 22 million manufacturing jobs disappeared worldwide between 1995 and 2002, despite policy efforts to preserve them. Even China, the world's "factory floor," lost 15 million manufacturing jobs, equivalent to 15 percent of total Chinese manufacturing and a higher proportion than the global average loss of 11 percent. New jobs created by the boom in foreign manufacturing investment were not enough to offset these losses, caused largely by restructuring in China's state-owned manufacturing plants.

Somewhat surprisingly, service industries actually create more high-skilled occupations than manufacturing. In the United States, more than 30 percent of service jobs are in the highest skill category of professional, technical, managerial, and administrative occupations. In contrast, only 12 percent of all manufacturing jobs are in this category, and the same pattern holds in other developed nations. There are also many well-paid "blue-collar" jobs in services, such as electricians, plumbers, and auto mechanics. In fact, the distribution of wages in the United States looks broadly similar in services and manufacturing. There are more low-wage jobs in services, but also many high-wage jobs, and the variance within each sector is actually greater than the variance between them. Moreover, the experience of some countries in Europe shows that trying to contain growth in low-skill service jobs by imposing high minimum wages and other labor market restrictions results in higher overall unemployment, not more high-skill jobs.

Low-skill consumer service jobs, just like low-skill manufacturing jobs, may not be the most attractive. But they are crucial to all economies in providing formal employment for new entrants to the workforce and also unskilled workers--a group whose only alternatives are informal (and therefore illegal) work or welfare. Even if consumer service workers learn few value-adding skills "on the job," having a formal position can help them or their dependents to study elsewhere, and so move up the occupational ladder.

Faster growth. Because of their sheer size, local service sectors like retail and construction are important drivers of overall GDP growth. And access to high-quality local...