Asian manufacturing slows, but services have been slow to fill the gap

The euro-zone crisis has dominated discussions among policymakers over the past few years, but the economic slowdown in Asia's two giants - [People's Republic of] China and India - has become a source of growing public concern as well. How worried should we be about an additional drag on the global economy?

After years of double-digit gross domestic product growth, China's economy is decelerating. We predict its growth will slow to 7.7 per cent this year, from 9.3 per cent in 2011. Its population is ageing, real wages are rising and growth is moderating towards more sustainable rates.

India, too, has massive potential to grow fast and reap a demographic dividend, but it has been struggling with structural reform. We expect that India's expansion will slow to 5.6 per cent in 2012, from 6.5 per cent last year.

Weak external demand is partly responsible for the slower growth, but internal factors - namely, slowing investment and stagnating consumption - are also holding back expansion. Maintaining growth in a global slowdown requires rethinking the future of "factory Asia".

Asia's boom was driven largely by intraregional manufacturing linkages. But, with budget-tightening around the world, demand for Asia's exports is expected to continue to falter. So where should Asia look for new sources of growth?

Upgrading the service sector - for example, business processing, tourism and health care - could play a critical role in future growth. Asia's service sector is already large; services accounted for nearly half of developing Asia's gross domestic product in 2010, while service workers comprise more than one-third of the total workforce.

If these countries follow the same path as the advanced economies, agriculture's dominance will give way to industry, which in turn will be supplanted by services, further broadening their role.

Making Asia's service sector more dynamic is essential. But it is still dominated by traditional services such as restaurants, taxis and barbers. Modern services - such as internet connectivity technology, or financial, legal and other professional business services - account for less than 10 per cent of Asia's service economy, well below the 20-25 per cent in advanced economies.

Labour productivity is also quite low: for most economies in the region, service-sector productivity is less than 20 per cent of the OECD average.

A vibrant service sector could have broad economic benefits. Synergies between services and industry could improve overall productivity. Modern services are becoming increasingly tradeable, providing new export opportunities.

Skills gaps and a lack of infrastructure are frequently cited as factors that hinder service-sector dynamism in Asia. But burdensome regulations are the biggest barrier. Excessive regulation that protects incumbent firms and other vested interests undermines market competitiveness and limits prospects for improved efficiency.

Many service firms in Asia are owned by the public sector, so governments have less incentive to deregulate services. But the same authorities have already opened their manufacturing and agriculture sectors for the common good.

Why, then, do they maintain policies that protect the special-interest groups that dominate the service sector?

Many argue that regulations protect small domestic firms against undue competition from large foreign players. But the truth is that the regulations are stifling even for domestic competition.

Asian policymakers must remember how they successfully developed their manufacturing sector - through competition. The same logic should be applied to services.

Upgrading the service sector is low-hanging fruit for Asia, because investment is not required. And yet service-sector reform remains just out of reach, owing to the absence of the political will needed to dismantle the vested interests that keep it there.