Services Trade: A pathway to inclusive growth in Developing Economies

International trade in services plays an increasingly large role in the world economy and in everyday life. However, the full extent of this trade is not always understood by market participants. When a consumer purchases a smartphone or a car that was manufactured in a country other than their own, there is no doubt that international trade is involved. It is less common for consumers to realize that they are taking part in international trade when eating in a restaurant while traveling abroad, or when using a foreign car share service in their own country. The large number of services that go into the manufacture and distribution of consumer goods may be even less obvious to the users of these products.

Some mis-perceptions about the importance of international trade in services are due to their intrinsic characteristics of intangibility and non-storability. However, new technologies are contributing to increasing services tradability. There are many ways that services can be traded internationally, referred to as “modes of supply”. The WTO General Agreement on Trade in Services (GATS) categorizes services trade according to four modes of supply: Cross-border supply (mode 1), in which services are supplied from the territory of one member (i.e WTO member) into the territory of any other member, such as through the internet. Consumption abroad (mode 2), in which services are provided in the territory of one member to a consumer of any other member, such as tourism. Commercial presence (mode 3), in which services are delivered by a supplier of one member through commercial presence in the territory of any other member, such as establishing a controlled affiliate in a foreign country to serve the local market. Presence of natural persons (mode 4), in which a supplier of one member provides services through the presence of natural persons in the territory of another member, such as consultants.

The supply of services through cross-border trade is perhaps most easily recognized as international trade. Examples include consultancy services over the phone or legal services provided in one country to clients in other countries by e-mail or video. Spending by tourists in other economies and students studying abroad are two common examples of consumption abroad. Commercial presence is when a foreign owned retailer or bank supplies services to local consumers. Finally, an architect or engineer moving abroad temporarily in order to provide their services is an example of services supplied through the presence of natural persons. Statisticians face various challenges in categorizing and measuring international trade in services. In some cases, the distinction between goods and services trade is unclear. For example, the streaming of a film from a digital platform based in another country is counted as trade in services, but if the film is stored on an imported DVD, it is considered to be trade in goods.

Services can also enter manufacturing production processes, either as high-value inputs such as engineering services, or as lower-value inputs such as assembly that is, they are inputs in an international transaction of goods. Trade statistics in value added terms reveal the importance of services inputs in the international trade of goods and services.

Distribution services and financial services are the largest traded services globally, with US$ 2,634 billion and US$ 2,463 billion respectively, and they account for 19.9 per cent and 18.6 per cent of total services trade in 2017. Wholesalers and retailers have a crucial role in international trade, connecting producers and consumers worldwide, thus ensuring consumers access to a variety of goods at competitive prices. The financial sector is the backbone of the economy, and one of its key functions is to enable international transactions, facilitating the smooth exchange of goods and services between countries, while managing the risks associated with their flows. According to estimates, world trade in financial services and in distribution services takes place predominantly by means of the establishment of a commercial presence in other countries (mode 3). In 2017, around 77 per cent of financial services, or some US$ 1,941 billion, and over 70 per cent of distribution services, some US$ 1,852 billion, were traded worldwide through foreign affiliates.

However, increased digitalization, e-banking, mobile banking and online sales are reshaping the business models for the finance and distribution sectors. Although banks and other financial services institutions maintain affiliates abroad for operations, they are adapting to changes in consumers preferences by offering an increasing number of services online, from credit card transactions to finance management. Insurance companies are making it possible to underwrite and submit claims online. These are only a fraction of the online cross-border services that digitalization is expected to bring to the industry in the near future. As a result, the share of services exports through branches and subsidiaries established in other economies is declining in leading developed traders.

In distribution services, electronic payments, innovative software and evolving mobile technology are enabling consumers to order goods online from anywhere in the world. This has resulted in a boom of online cross-border sales with many wholesalers and retailers, especially in developed economies, closing physical stores and choosing to sell online, or blending physical presence with online ordering and delivery options. Distributors face fierce competition, especially on the web, and, in order to satisfy consumers’ expectations of fast delivery, they need to be able to rely on transport operators. Whether products are ordered online or through traditional means, the distribution of goods, including internationally, requires an efficient transport and logistics industry.

In 2017, one-third of global trade in transport, related directly to the cost of shipping goods across economies, mainly by sea or by air. Supporting transport services such as cargo handling, storage and warehousing made up an additional 16 per cent. Overall, around half of world trade in transport services is driven by trade in goods, including both goods that directly reach consumers and those that are used as inputs in production processes. This makes the transport sector vulnerable, as freight shipping rates are volatile and fluctuate according to global demand. Since 2005, the transport industry has faced challenges due to weak merchandise trade flows following the global financial crisis, stagnating economic conditions and overcapacity, with 2009, 2015 and 2016 as the worst years on record. Developed and developing economies were equally affected.

However, transport is vital not only for trading goods, it is essential to move people across the globe, for business or for leisure, enabling also other services to be traded internationally. In the last decade, the rise of low-cost airlines, coupled with the multiplication of direct routes, especially at the regional level, has not only changed the air transport industry, but has fostered impressive growth in international tourism.

Technology is permeating all services sectors and gradually transforming them. This is the result of the synergy between the telecommunications industry and its provision of high-speed connectivity such as 5G, the IT sector and its development of innovative industry-specific software, and robotics, thanks to a thriving R&D sector. For example, the construction sector is increasingly making use of advanced technology in its operations, such as drones for the aerial surveillance of building projects, replacing land surveillance, and construction through automated modular 3D printing, to cut costs and compensate for skilled labour shortages. In addition, with prefabricated construction taking place indoors in factories and just assembly work onsite, the definition of construction as a service is becoming blurred.

Digitalization is also transforming professional services. The number of virtual law firms and freelance management consultants on digital platforms is growing. With no physical offices to run, they have lower operating costs and clients can benefit from reduced fees. Artificial intelligence and machine-learning can be used in accounting and bookkeeping, and several companies, thanks to such technology, may look into relocating these services back to home offices rather than importing them from other countries. Although it might still be early to see it in the numbers, a shift is under way and is likely to affect trade.

Finally, a range of services is taking baby steps in international trade, such as educational, health or environmental services. At present, these services account for a negligible share of trade, but they are rising. Educational services are predominantly traded through consumption abroad (mode 2). However, online distance education is growing thanks to the thousands of educational platforms flourishing on the web, addressing a variety of educational needs from primary school students to graduates. Several leading universities offer online courses in subjects from sciences to the humanities, with online tutors available to assist students. Online distance learning represents a cheaper and more flexible alternative for students worldwide who, due to financial constraints or for other reasons, are unable to travel abroad to pursue higher education. New technologies are increasingly making it possible to integrate virtual reality into education and training, thereby making e-learning an ever more thorough experience for online students.

Trade in health services, from complex surgery to rejuvenation treatments. However, in the coming years, the ways in which health services will be traded may change vastly. New health services providers are emerging across all developing regions, from Asia to Latin America, offering treatment to foreign travellers such as dental work or aesthetic treatments at attractive prices, further increasing the relative importance of trade through consumption abroad. The numbers of medical travel agencies and facilitators are growing, as are those of insurance companies providing health coverage abroad to cut costs. In the meantime, 5G technology and robotics are transforming trade in health services, allowing distant diagnostics and even pioneering remote surgery and medical interventions in real time and without the physical presence of doctors.

From product manufacturing, assembly and design to the shipping and distribution of goods, services have traditionally been seen in a fundamental, yet supporting, role in trade, secondary to trade in goods. However, services not only facilitate trade in goods, they are themselves traded and are enablers of trade in services.

The participation of Developing Economies

Between 2005 and 2017, developing economies, excluding LDCs, gained over 10 percentage points in their share in global trade, reaching US$ 3.4 trillion in world services exports and US$ 4.5 trillion in global services imports. Such an impressive result is the outcome of a process of structural economic transformation and successful trade diversification from goods to services in several developing economies, in Asia in particular, and the emergence of new services traders and new ways to trade services.

By contrast, in the same period, LDCs increased their share in global services exports by 0.1 percentage point. In 2017, LDCs accounted for only 0.3 per cent of world services exports, or US$ 38.3 billion, and, in imports, their participation was at less than 1 per cent, with services imports totalling US$ 124.1 billion. Commercial services production in LDCs is, on average, 40 per cent of GDP, well below middle-income economies (over 50 per cent) and high-income economies (generally above 70 per cent). In fact, income plays a role. Three out of five leading developing services traders are high-income economies, while the rest are classified as upper middle-income and lower middle-income economies.

The participation of developing economies in services trade is not yet inclusive. A close look reveals that trade is very concentrated, with the same five economies ranking both as leading services exporters and importers, although in a different order. In 2017, China was the leading services trader, followed by Hong Kong (China), the Republic of Korea, Singapore and India.

These five Asian economies accounted for 56.7 per cent of developing economies’ exports and 58.1 per cent of imports. They are the main drivers of developing economies’ impressive trade performance, with services exports rising by over 12 per cent on annual average since 2005, almost three times faster than in developed economies. From R&D and IP-related services to ICT services, professional services and finance, these five economies are penetrating high value-added services trade.

After 2009, the five leading developing economies substantially modified the way they export services, in a manner which increasingly resembles that of developed economies, and which matches the way the world predominantly imports services, i.e through a commercial presence of another country.

In 2017, services exported by these five economies through branches and subsidiaries abroad made up, on average, 55.9 per cent of their services exports, a rise of 22 percentage points since 2005. In China and the Republic of Korea in particular, up to two-thirds of services were exported through foreign controlled affiliates, more than half in Hong Kong, China, and around half in Singapore, too. In India, cross-border trade remains the dominant mode, with only 20 per cent of services exported through foreign-controlled affiliates in other economies. Nevertheless, this is a 12-percentage-point increase compared with 2005.

For the five leading developing economy traders, construction, finance and distribution are the sectors that contribute most to the remarkable growth of their services exports through foreign-controlled affiliates. However, in a variety of other sectors, from professional and business services, to ICT and transport, a shift in the way services are exported has already occurred. In others, such as tourism or health services, a change is well under way. In China, the Belt and Road initiative has further accelerated this process, with Chinese services firms encouraged to “go global” and helped to expand rapidly in local markets (China Ministry of Commerce, 2017).

For these other developing economies, some 125 in number, spread across all regions,with relatively good levels of internet penetration, services trade digitalization can offer concrete opportunities to boost exports and gain a share of global services markets. In the meantime, exports through the consumption abroad of services, including health and educational services, can help diversify their service supply; such a trend has already started in several economies.

Turning to LDCs, since 2005, their services exports have been rising by almost 11 per cent on average per year, albeit from a very low base, with growth led by tourism. Boosted by intensified intra-regional arrivals in recent years, tourism represents an important source of revenue for LDCs and is the only services sector in which the group’s participation in global exports exceeds 1 per cent (at 1.3 per cent).

However, LDCs’ services exports are unbalanced. With tourism as the largest sector (34.4 per cent of services exports), the share of LDCs’ services exports through consumption abroad, estimated at 43.1 per cent in 2017, is at least twice as big as in most developing economies and five times bigger than in developed economies. Cross-border trade accounts almost entirely for the other half but is largely concentrated on transport and distribution services, while commercial presence, for example in construction, is in the initial stages. For LDCs, diversifying services exports in order to integrate into global services exports remains challenging due to infrastructural constraints, lack of skills, low financial resources and a digital gap.

Participation of Micro, Small and Medium-Sized Enterprises

There is a general consensus that micro, small and medium-sized enterprises (MSMEs) play a critical role in countries’ economies, offering employment to significant numbers of people across a diverse range of professions and trades. MSMEs are also widely viewed as holding the key to inclusive growth, which is so frequently spoken about but remains an elusive goal.

Yet it is worrying that a large proportion of MSMEs, despite their recognised potential, fail to become productive and sustainable sources of economic value. Among the factors holding MSMEs back are inadequate human and financial resources and a policy and regulatory environment that tends to be far better suited to large enterprises. In fact, MSMEs generally receive little attention at the official policy level. Where they do, it rarely translates into concrete and viable forms of support. Not surprisingly, these sorts of problems are more pronounced in developing countries than developed countries.

The exponential growth in global services trade could, however, be a game changer for MSME communities in developing countries, particularly as many services are more accessible to entrepreneurs and small firms than manufacturing, mining or agriculture, which generally require considerable investment. Information and communications technology (ICT), financial services, transport and hospitality are among the services sectors that hold particular potential for MSMEs, while also conveniently laying the foundation for a well-functioning society. That is not to say that services do not require investment in resources such as financial and human capital, but start-up costs are often relatively low, and trading across borders has become a more realistic option given the developments in e-commerce and the relative ease of communicating and transacting via digital platforms.

Advances in technology, which are having such a dramatic effect on how people live, work and interact, have been the key driver behind the global value chain (GVC) phenomenon. GVCs, which have blurred the lines between tangible goods and services trade, have created many opportunities for MSME service providers to act as links in the chain even on a modest scale, operating from their home base. In this way they gain access to an extended market which, had they had to face the costs and logistical hurdles of shipping goods across borders, might not have been possible.

MSMEs have much going for them in the services arena. With the right resources, they tend to be flexible and able to adapt quickly to changes in the marketplace, whereas in larger firms, decision-making is more cumbersome. This flexibility is often the product of an entrepreneurial spirit and/or a youthful fascination for things that are new and innovative. The need for flexibility will, of course, intensify as automation, artificial intelligence and other technological developments continue to transform the world of work and erode the pool of more traditional jobs. Many services are powered by digital technologies, thus putting tech-savvy MSME service providers in an excellent position to leverage the continuously unfolding opportunities. The rapid spread of mobile banking services in East and Southern Africa in recent years is an example of how advances in technology have helped to fan entrepreneurial ideas and create new, high growth industries that have international reach.

It has been argued that the development of the services sector in developing countries that are still agriculture or mining dependent can clear the way for the country to “leapfrog” manufacturing, which would be the next logical stage in the economic development process. This view appears to have some merit if the unprecedented growth in mobile phone usage and the growing popularity of online business and leisure services are anything to go by.

However, a services sector cannot thrive in a vacuum, devoid of a supportive policy environment and regulatory framework and well functioning infrastructure, notably in the telecommunications and energy spheres. MSMEs, in turn, need special types of attention and assistance, particularly if they are to make inroads into regional or international markets. MSMEs often lack market knowledge and international business skills, but as they are not well understood or properly catered for in developing countries, they are often confronted by the same rules, regulations and challenges as those faced by larger firms. The services sector is notoriously regulated and requires informed and skillful navigation. A lack of finance, compounded by weak creditworthiness, is another perennial problem. Faced with these challenges, many MSMEs simply retreat into the informal sector where their economic potential remains stunted.

MSMEs need to be given serious attention if developing countries are to make headway in their frequently expressed desire for inclusive growth and sustainable development. Although stories abound of small businesses in Africa, Asia and other developing regions that have made impressive strides in building a regional or global presence, these are more often than not “pockets of excellence” which do not realistically reflect the status quo. Left on their own, most MSMEs will be unable to grow and reach their full potential.

While opening doors to new sources of finance and building knowledge and skills are critical steps, creating a strong cohort of MSME service providers also depends on a country having an entrenched services culture, from which different services sectors and individual providers can take their nourishment. This implies that while there may be merit in “leapfrogging”, it does not include taking short cuts. MSMEs are not the exclusive preserve of young people, but in a world where jobs in large, established companies are becoming increasingly scarce, they constitute an important source of employment for young people with good ideas and a desire to succeed.

Clearly, developing countries (government, business and civil society) need to devote much more time and effort to researching, understanding and unleashing the potential of MSMEs in high-potential service sectors, failing which technology giants and other major economic players could crowd out smaller local entities and set an economy on a course that simply entrenches inequality.

Role of Services in Global Value Chains

The importance of services in GVCs goes beyond their large share of value added. Coordinating dispersed production blocks requires services linkages such as transportation, telecommunication, and various producer services like business and financial services. A well-functioning services sector therefore enables and facilitates fragmentation, leading to an increased reallocation of production stages across borders. However, despite its key role as an enabler or ‘glue’ that holds supply chains together, the role of services in GVCs is often underappreciated and poorly understood.

Measuring the role of services in global value chains is increasingly complex as manufacturing and services, including intellectual property, become intertwined components of any production process The line between these individual components becomes increasingly blurred, partly also because of the servitization that is the increasing bundling of goods and services by manufacturing firms. For example, ships or airplanes may be delivered with training packages for the crew, or machines may require services in order to be installed Other examples include firms such as IBM, which has completely changed its production characteristics and has transformed itself from a goods producer (of computer hardware) to a service supplier (of cloud computing and artificial intelligence). Another recent trend is the emergence of “factory-less” goods producers, whereby traditional manufacturing firms such as Apple or the British appliance firm Dyson outsource manufacturing activities to other firms and focus on services such as design, sales and coordination activities.

Technology is a key driver of these trends, forcing firms to innovate and change their business models in order to stay in the market. On-going digital transformations render the split between what is a service and what is a good increasingly blurry. Technological convergence is also leading to multi-functional devices, such as mobile phones which can act as cameras, e-readers, music libraries, games consoles, etc and new technologies, for example sensors which add functionalities to “non interactive” goods and make them digital (for example, car components or smart fridges).

These recent developments make the measurement of services in international trade even more complex. Trade in value-added statistics accounts for intermediate input linkages between sectors and measures the sectoral value-added in exports of goods and services.

To conclude: Services play a crucial role in the functioning of GVCs, and services liberalisation is in many ways different from goods liberalisation. Yet, we know little about the trade-effects of RTAs covering services. The new evidence that service trade agreements foster the GVC participation of developing countries has important policy implications. When the production of goods involves intermediate inputs crossing borders multiple times, developing countries that wish to take a more active part in GVCs have more options than just lowering tariffs or non-tariff barriers. Liberalising trade in services can provide new pathways for developing countries to utilise their comparative advantage in global supply chains. Furthermore, allowing the cross-border supply of services without local presence is crucial to increasing countries’ participation in manufacturing GVCs. This new finding warrants further investigation since it is likely to gain relevance as advanced communication technology enables more modern services to be supplied and consumed from a distance.