Dec 14, 2012

Service sector of India and the Rybczynski effect on manufacturing

The theory I am going to propose below is not based upon any serious study. So the possibility of holes are not excluded. Thus it goes.

If there are two tradeable sectors in an economy, and if one of them is a leading sector and the other one lagging, Rybczynski (pronounced Rib-Chin-Skee) theorem predicts that, over a period of time, there would be more than proportionate expansion in the leading sector, at the cost of the lagging one. This would happen when one reads Rybczynski's theorem in the light of Heckscher-Ohlin model. Alongwith, you might be interested in understanding the mechanics, by reading about what's popularly known as Dutch disease.

Cut to India. We have a leading sector in services, and a lagging (albeit important) sector in manufacturing. When I say leading, I am not referring to the sheer size, I am referring to the productivity and comparative advantage the sector enjoys in international trade. In this respect, services sector is a leading sector today. Now, if I read the theory right, what should happen over a period of time is this: 

The service sector booms, at the cost of manufacturing sector and ultimately, the manufacturing sector loses its comparative advantage in the international markets. Service sector will do very well and will be the mainstay of our trade. 

How would this happen?

Three things would work in tandem. 

First. Exchange rate mechanism would work in favor of services. India will increasingly adopt floating exchange rate in future (it is almost floating as of now). This means that the real exchange rate would ultimately settle at a value which will be determined by the net exports, which in turn will be a function of all tradeable sectors' performance combined (plus capital flows). The value, whatever it is, will be an aggregate of all sectors competitiveness. For any given exchange rate, services sector will be at a discount, as by our definition, it is more competitive in international market. This would lead to strengthening of this sector. Manufacturing sector, being relatively a laggard, will face an adverse exchange rate when compared to its level of competitiveness. This would lead to gradual erosion of comparative advantage. 

Second. Service sector will pay relatively higher wages to the labour due to the above advantage. This would lead to a tendency in the labour market to lean towards services. As the sector expands, it would start absorbing labour from other sectors, mainly manufacturing and agriculture. This would make availability of labour in manufacturing sector scarce, leading to wage increase and further erosion of competitiveness.

Third. Investments would move into sectors where returns are maximized. The relative margins in service sector is better than manufacturing in the present, and will continue to be so for some time to come. This would mean, that given limited investment funds, a more than proportionate portion would invest into services sector.

Is this a cause for concern? My answer is yes. Services sector is not employment intensive, unlike manufacturing. A disproportionate growth in services doesn't bode well for a job-scarce economy. Absorption of new labour, and the labour released from agri sector is an important issue. Absorption could be higher in manufacturing sector, when compared to services, and the growth of manufacturing is important from this point of view. 

The Rybczynski effect is my speculation. It might not happen. There are good reasons for our manufacturing to do well in future. Let me deliberate on that part too.

Increasingly, our manufacturing, especially sub sectors such as auto and ancillary components, engineering etc are integrating into global value chains, or what I prefer to call, International production networks. Once our sector plugs in into the global manufacturing chains, the relative comparison with services will matter less. This alone might offset the Dutch syndrome.  

Secondly, productivity of manufacturing sector will rise with time, and if things go well, our manufacturing might keep up with the comparative advantage over a longer period of time.

Thirdly, the demographic dividend of having a younger labour force in India, and gradual drying up of chinese labour force, might keep us going (China is ageing faster). The supply of labour will keep the wages low. The challenge is to train and get the labour that's industry-ready, by boosting vocational training capability of the country. Vocational training currently is a disaster in India, I will elaborate on it some other day. 

Finally, the Govt is waking up to the uncomfortable fact that manufacturing sector cannot be ignored anymore. The initiatives on National manufacturing zones is a step in that direction  If right incentives are provided, the future of this sector might become bright.

A combination of above will play out in coming years. The results will determine not only India's trade, but also decide the developmental pace and stability of the society.