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10 Understanding the Growth Momentum in India’s Services

Author(s):
Catriona Purfield, and Jerald Schiff
Published Date:
August 2006
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Author(s)
Enric Fernandez and Poonam Gupta 

Astriking feature of India’s growth performance over the past 15 years has been the strength of the services sector.1 The sector has benefited tremendously from the globalization of services and the increasing openness of the Indian economy to trade and foreign direct investment (FDI). Indeed, the services sector has benefited far more than has industry. Thus, India has become a leading exporter of services in the global economy with a share in global exports of services that is more than double its share of global exports of merchandise (Table 10.1). The most visible and well-known dimension of this phenomenon has been the takeoff in exports of software and services based on information technology (IT). But the growth in services has been broader than this and has also involved domestically consumed services. The pickup in growth since the 1990s has been most remarkable in business services, which includes the IT sector, and telecommunications, a sector that has witnessed a phenomenal expansion in domestic demand. This chapter shows that important roles have been played by economic reforms, and growing external demand for services exports in explaining the growth momentum of the services sector. The chapter also discusses the growth potential, in particular, of the IT sector and the challenges India faces in realizing this potential.

Table 10.1.Leading Exporters of Goods and Services, 2004
RankMerchandiseShare in World TradeRankServicesShare in World TradeRankServices Other Than Travel and TransportationShare in World Trade
1Germany10.01United States15.01United States16.7
2United States8.92United Kingdom8.12United Kingdom11.8
3China6.53Germany6.33Germany7.3
4Japan6.24France5.14Japan5.2
5France4.95Japan4.55France4.3
6Netherlands3.96Spain4.06Ireland4.0
7Italy3.87Italy3.97Netherlands3.9
8United Kingdom3.88Netherlands3.48Italy3.3
9Canada3.59China2.99India3.1
10Belgium3.310Hong Kong SAR2.510Belgium2.8
30India0.816India1.9
Source: World Trade Organization, International Trade Statistics 2005.
Source: World Trade Organization, International Trade Statistics 2005.

Sectoral Growth Rates

The growth of services picked up sharply in the 1980s and has since accelerated further. Since the takeoff in reforms in 1991, the services sector has grown faster than industry with an average growth rate of more than 7½ percent a year (Table 10.2). In the last three years, growth in services has increased by a full percentage point above this recent historical trend and in the first half of 2005/06 it reached 10 percent. This increase has coincided with an explosion in the growth rate of exports of services (see discussion below). Growth in the services sector has also been less cyclical than the growth of industry and especially agriculture. The coefficient of variation (CV) for the annual growth in services is less than one-tenth the CV for growth in agriculture.

Table 10.2.Sectoral Growth Rates1
Average Growth and Coefficient of Variation (CV)

(In percent a year; CV in parentheses)
1951–801981–901991–20002001–05
Agriculture2.14.43.02.0
(3.1)(1.4)(1.3)(3.2)
Industry5.36.85.86.2
(0.7)(0.3)(0.6)(0.2)
Services4.56.67.67.6
(0.3)(0.2)(0.3)(0.2)
GDP3.55.95.85.9
(1.0)(0.4)(0.3)(0.3)
Sources: Central Statistical Organisation; and IMF staff estimates.

Underlying data are for fiscal years ending in March.

Sources: Central Statistical Organisation; and IMF staff estimates.

Underlying data are for fiscal years ending in March.

The remarkable growth of the services sector in India is not unique but has come early in the development process. As an economy matures, its sectoral growth pattern typically evolves in two stages. In the first stage, both industry and services grow faster than agriculture, and their share in total output increases. In the second stage, services tend to grow faster than the rest of the economy, and its share in GDP continues to increase, accompanied by a stagnant or declining share of the industrial sector. Though the Indian experience fits in this pattern, services have overtaken the industrial sector faster and at a lower level of income than in other countries. Consequently, India’s services share of GDP is now higher than the average for other low-income countries (Figure 10.1). This outcome results, at least in part, from constraints that have affected industry disproportionately, such as poor infrastructure, labor restrictions, and reservations for small-scale industries.

Figure 10.1.International Comparisons of Shares of Services and Industry in GDP, 2003

(In percent)

Source: World Bank, World Development Indicators.

Interestingly, the substantial rise in the share of services in GDP has not been accompanied by a commensurate increase in the shares of employment and capital used by the sector (Table 10.3). This suggests that technological improvements or efficiency gains arising from liberalization have played an important role in the sector’s growth performance. Productivity improvements in services may also indicate that the growth in services has been concentrated in subsectors that are more dependent on skilled labor rather than on unskilled labor or capital.

Table 10.3.Share of Services Sector in GDP, Employment, and Capital Stock(In percent of total)
GDPEmploymentCapital Stock
197032.120.043.7
198037.718.944.0
199040.724.447.0
199442.820.446.6
200048.322.543.3
200451.423.544.2
Sources: Hansda (2002); Central Statistical Organisation, National Accounts; National Sample Survey Organisation; and IMF staff estimates.
Sources: Hansda (2002); Central Statistical Organisation, National Accounts; National Sample Survey Organisation; and IMF staff estimates.

Which Services Have Grown Rapidly?

The acceleration in services growth has not been uniform across activities. The acceleration was most pronounced in business services, starting in the 1980s albeit from a low base and picking up further in the 1990s-2000s; communication, in the 1990s and picking up further in 2000s; and banking, in the 1980s and 1990s (Table 10.4). While the increase in growth in the trade subsector has been less spectacular, its contribution to growth in the 1990s-2000s has been significant given its higher share in GDP. Growth in the insurance sector has also risen in the current decade after a sluggish performance in the previous decade.

Table 10.4.Growth Rates and Sectoral Shares in GDP
Average Growth in 1950s-70sAverage Growth in 1980sAverage Growth in 1990sAverage Growth in 2000s
SectorActivities Included(Share in 1980)(Share in 1990)(Share in 2000)(Share in 2004)
CommunicationsPostal services, money orders, telegrams, telephones, overseas communication services, and miscellaneous.6.76.114.924.4
(1.0)(1.0)(2.2)(4.3)
Business servicesSoftware and business process outsourcing.4.213.519.820.7
(0.2)(0.3)(1.1)(1.8)
InsuranceLife, postal life, and nonlife.7.110.96.714.4
(0.5)(0.8)(0.7)(0.9)
Hotels and restaurantsServices rendered by hotels and other lodging establishments, restaurants, cafes, and other eating and drinking places.4.86.59.38.5
(0.7)(0.7)(1.0)(1.1)
TradeWholesale and retail trade in commodities, both produced at home (including exports) and imported, purchase and selling agents, brokers and auctioneers.4.85.97.37.4
(distribution services)(11.7)(11.9)(13.6)(14.5)
Transport by other meansRoad, water, air transport, and services incidental to transport.6.36.36.97.0
(3.6)(3.8)(4.2)(4.4)
Personal servicesDomestic, laundry, barber, beauty shops, tailoring, and others.1.72.45.06.9
(1.6)(1.1)(1.0)(1.1)
Community servicesEducation, research, scientific, medical, health, religious, and other community.4.86.58.46.7
(4.0)(4.3)(5.5)(5.7)
Railways4.24.53.65.8
(1.5)(1.4)(1.1)(1.1)
Other social and personal servicesRecreation, entertainment, radio and television broadcast, and sanitary services.3.44.32.85.4
(1.1)(1.0)(0.7)(0.7)
BankingBanks, banking department of the Reserve Bank of India, post office saving bank, nonbank financial institution, cooperative credit societies, and employees provident fund.7.211.912.74.3
(1.9)(3.4)(6.3)(6.0)
Public administration, defence6.17.06.13.1
(5.3)(6.0)(6.1)(5.6)
Source: IMF staff calculations from data provided by the Central Statistical Organisation.
Source: IMF staff calculations from data provided by the Central Statistical Organisation.

The communication and business services subsectors alone have contributed 0.75 percentage point to overall GDP growth in the 2000s. Their contribution to GDP growth has increased from 0.2 percentage point in the 1990s and 0.1 percentage point recorded in the 1980s. By 2004, the last year for which a detailed breakdown of growth by sector is available, both sectors had a combined value added similar to the banking system but were contributing 2.5 times as much to growth.

Explaining Services Sector Growth

The growth of the services sector in recent years reflects a number of factors. These include a switch to a more service-input-intensive method of organizing production, that is, splintering (see Bhagwati, 1984); rapid growth in the final demand for services from domestic and foreign consumers; and technological advances, whereby new activities or products have emerged. Important policy reforms were also made starting in the early 1990s, including deregulation, privatization, and opening up to FDI, which were also conducive to the growth of the services sector.

Using input-output coefficients and sectoral shares in output, it is possible to illustrate that splintering has had some impact on services growth. The matrices for different years show that the use of service sector inputs accounted for 31 percent of all intermediate inputs used in 1998/99 (the latest available), up from 27 percent in both 1978/79 and 1989/90. The use of services inputs in industry increased to 17.8 percent of gross industrial output in 1998/99 from 14.1 percent of gross output in 1979/80, while the use of services inputs into agriculture, which is much lower, increased by less than 2 percentage points over the same period to about 5 percent of gross agricultural output. Thus, the input-output coefficients for services input into the nonservices sector increased by about 2.3 and 1.8 percentage points during the 1980s and 1990s, respectively. These coefficient changes (Δθ) would have increased output demand for services (YS) (as a first-round effect) by

where YNS is nonservice output.

Adding additional variables on both sides of this formula (VA denotes value added in the services or nonservices sector and TVA denotes total value added) allows the use of the input-output tables to estimate the impact of splintering:

Evaluating this formula at the average output-value-added ratio and value-added shares in each decade indicates that splintering may have added about 0.6 percentage point to annual services growth during the 1980s and 0.5 percentage point during the 1990s.2

A rise in domestic demand for services reflecting higher incomes appears to also have some merit in explaining the pickup in services growth in some subsectors. Available data indicate that private final consumption expenditure on certain categories of services has increased sharply since the 1990s. This has been the case, in particular, for transport services and medical care and health services, which have experienced an increase in their shares of expenditure in GDP of 2½ and 2 percentage points of GDP, respectively, over 1990–2004. The fact that the relative price of both types of these services also increased over the period (relative to the GDP deflator) further suggests that income effects may have played a role in raising demand. In contrast, while expenditure on communication has also risen sharply over the period, its relative price has plummetted (falling by more than 60 percent since 1990).3 In this case, although income effects may help explain the rise in private expenditure, falling prices as a result of technological advances and deregulation are likely to have played a much bigger role. The still relatively low levels of telephone penetration suggest that growth in telecommunications can remain high for many years (Figure 10.2).

Figure 10.2.Telephone Penetration Rates

Source: IMF, World Development Indicators.

Technological advances (and, ironically, a technological glitch—the millennium bug) appear to have played an important role in raising foreign demand in the most dynamic sectors. Due to the revolution in IT and telecommunication sectors it has become possible to deliver services over long distances at a reasonable cost, increasing trade in services. India has been a particular beneficiary of this trend benefiting from the rapid growth in exports of software, business process outsourcing (BPO) activities and other business services, and telecommunications (Figure 10.3). Exports of services took off sharply in the second half of the 1990s, growing at an average rate of 18 percent a year from 1994/95 to 2003/04 (in U.S. dollars). Growth was especially rapid prior to 2000, as Indian companies took on the massive task of fixing the so-called millennium bug in computer codes.4 More recently, in 2004/05 and the first half of 2005/06, services exports have ballooned, with annual growth rates of more than 70 percent. Exports of software and BPO accounted for about one-third of services exports in 2004/05.5 Future areas of growth for offshoring activities beyond IT services are likely to include industrial research and development, including in the pharmaceutical industry, medical research, and back-office functions.

Figure 10.3.Service Exports

Source: IMF, World Economic Outlook.

Exports may have added an average of about 1 percentage point to services sector growth a year in the 1990s. In contrast, it is estimated that exports contributed a negligible amount to the increased growth rate of the services sector in the previous decade. To arrive at these estimates, the share of value added in services from exports is approximated by the share of services output that is exported, as given by the input-output tables of 1978/79, 1989/90, and 1998/99 (which is a good approximation if the share of value added in output of exported and domestically consumed services is similar). Then, that share is used to weigh the respective growth rates in the different time periods. While in 2000/01–2003/04, the contribution of services exports did not rise above the level of the 1990s, the growth rate experienced in 2004/05 (of around 60 percent in real terms) would imply an additional contribution to service sector growth of more than 5 percentage points in that year. This result does not seem plausible as the growth of value added in the services sector rose by much less (approximately 10 percent). This casts some doubt on the comparability of the data with previous years, as it would imply that the share of value added in exported services declined sharply in that year.

While the explanations above explore the proximate causes for the pickup in services growth, at a more fundamental level, policy changes appear to have been an important factor in allowing the services sector to respond dynamically to changes in demand and technology. The sector was an important beneficiary of liberalization reforms, including the opening up to the private sector and foreign investment (Box 10.1). To test for the significance of policy changes, a panel of 13 service activities is used. The time period used is 1970–2004, and the observations are averaged over 1970s, 1981–85, 1986–90, 1991–95, 1996–2000, and 2000–04, which results in six observations for each service subsector. The following regression equation with sectoral fixed effects is estimated by ordinary least squares:

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Box 10.1.Selected Policy Measures Affecting the Services Sector

Telecommunications

  • Telecoms Policy of 1994 opened basic telecommunications services to private entrants, including foreign entrants.
  • Telecom Regulatory Authority of India established (1997).
  • New Telecoms Policy of 1999 further liberalized the sector, including for long-distance calls.
  • Use of Internet telephony allowed for international services (2001).

Tourism

  • FDI liberalized (1991/92).

Financial and insurance sectors

  • Liberalization of private sector entry, including foreign participation (1992).
  • Securities and Exchange Board of India is given statutory powers (1992).
  • Access of companies to capital markets deregulated (1992).
  • Insurance Regulatory and Development Authority established (1999).
  • Private sector entry in insurance allowed, including foreign entities (2000).

Transport

  • Private sector entry allowed in scheduled air transport services (1995).
  • Foreign equity allowed (1997).
  • Foreign investment in ports liberalized (1996–98).

The dependent variable, GSER, is average growth in activity i in period t. The right-hand side variables are average growth in industry (GInd), average growth in agriculture (GAgr), average growth in external volume of trade in goods (GTG), and average growth in the export of services (GTS) over period t. A dummy variable accounts for the fact whether reforms were carried out in each segment of services (RSer).6

The reform dummy has a positive, and the most significant, coefficient in the regressions (Table 10.5). Services growth is also significantly correlated with the growth in the industrial sector. As a robustness test, specification II introduces a time dummy for the 1990s-2000s but its coefficient is not significant after controlling for the reform-specific dummy. This suggests that it is liberalization per se that is contributing to growth.

Table 10.5.Explaining Services Growth Using Panel Data, 1970–20041
III
Average growth rate of agriculture in period t0.770.02
0.800.05
Average growth rate of industrial sector in period t1.36*0.88*
1.781.86
Average growth of external trade (exports + imports) of merchandise in period t0.32
0.79
Average growth of exports of services in period t0.17*0.13
1.761.55
Reform dummy variable5.34***5.64***
3.763.71
Dummy for the 1990s-2000s−1.01
-0.96
R2, adj. R20.63, 0.520.63, 0.52
F test for equality of intercept across units3.20 (F-stat)3.20 (F-stat)
0.00 (p-value)0.00 (p-value)
Source: Authors’ calculations.

Number of observations is 78 in each regression. ***, **, * indicate significance at 1 percent, 5 percent, and 10 percent levels, respectively. t-values are given below the coefficients in each cell.

Source: Authors’ calculations.

Number of observations is 78 in each regression. ***, **, * indicate significance at 1 percent, 5 percent, and 10 percent levels, respectively. t-values are given below the coefficients in each cell.

Growth Experience and Key Challenges in the IT Sector

As mentioned above, the IT sector has grown very rapidly, at an annual rate of about 31 percent between 1998/99 and 2004/05, with turnover reaching $22 billion.7 While IT software and services continue to account for close to 60 percent of the industry’s turnover, growth has been increasingly driven by BPO activities. These accounted for 21 percent of total industry revenues in 2005 compared with just 7 percent in 2000 (Figure 10.4). The export market for IT services grew twice as fast as the domestic market, with average respective growth rates of 37 percent and 19 percent. In the last two years, however, domestic demand has been increasingly important, with annual growth picking up to around 25 percent.

Figure 10.4.Composition of the Information Technology (IT) Sector

(Sales in millions of U.S. dollars and in percent of total)

Source: National Association of Software and Service Companies.

The National Association of Software and Service Companies (NASS-COM) has set ambitious targets for the industry. Exports are targeted to grow by about 30 percent a year over the medium term, implying a very mild deceleration from the current pace of growth. Domestic sales are targeted to grow at the same pace as exports, as there appears to be significant untapped potential in sectors such as retail, telecommunications, banking, and small and medium-sized enterprises. It is estimated that the global IT/ BPO offshoring market will amount to $110 billion by 2010, of which India could capture more than 50 percent (India’s share in the global market is currently estimated at 44 percent).8

Despite rapid growth in recent years, employment in the IT sector remains a negligible fraction of the labor force. Employment has been growing by more than 25 percent a year in recent years. Nevertheless, total employment still amounts to only 1 million people. Industry estimates are that total direct employment could reach 2.3 million by 2010 and that 6.5 million jobs could be created indirectly. However, given India’s need to generate employment for some 100 million new job entrants in the coming decade, its contribution to total employment will still be modest. This underscores the need to encourage the expansion of labor-intensive industries, including by tackling the two most important constraints faced by them: inadequate infrastructure—on power, roads, ports, and so on—and restrictive labor market regulations.

Looking forward, there are a number of external and domestic constraints that India may face in realizing the growth potential of the IT sector. The external factors include nontariff barriers such as visa restrictions, and the negative publicity in importing countries affected by offshoring. The greater bottleneck, however, is likely to be the shortage of skilled workers. Indeed, there is evidence that although wages in the IT sector have accelerated, the industry has also witnessed an increase in employee turnover rates.9 India’s universities have failed to expand in a manner commensurate with the growing demand for skilled labor. In this regard, there is a need to multiply institutions like the Indian Institutes of Technology and regional engineering colleges on which much of the current success of the software sector is based. To achieve this, private sector and foreign entry in the education sector should be encouraged. At the same time, to make urban centers attractive centers of employment for knowledge workers, urban infrastructure would need to be upgraded.

References

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    FarrellDianaNoshirKaka and SaschaSturze2005“Ensuring India’s Offshoring Future” The McKinsey Quarterly 2005 Special Edition: Fulfilling India’s Promise;available via the Internet atwww.mckinseyquarterly.com.

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1The chapter is largely based on papers by Gupta (2005) and Gordon and Gupta (2004).
2The output-to-value-added ratios are averaged over the years for which input-output tables are available.
3Private final consumption expenditure on communication rose by ½ percent of GDP at current prices over 1990–2004 but, at constant prices, it increased by 2 percentage points.
4The millennium bug or Y2K problem arose because computer programs stored years with only two digits and the year 2000, represented by 00, would be interpreted by software as the year 1900. This could have caused computers to stop working or produce erroneous results.
5Unfortunately, there is no breakdown for exports of other types of business services and telecommunications, which are recorded together in a miscellaneous category. That category, excluding software and BPO, accounted for about one-third of services exports in 2004/05.
6The dummy variable for reform measures is based on information provided in other studies and is assigned a value of 1 if the activity was opened up for FDI, external trade, or private ownership. The following observations were assigned a value of 1: hotels, from 1991 to 1995; transport other means, from 1996 to 2000; communication, from 1991 to 1995; banking, from 1986 to 1990; insurance, from 1996 to 2000; business services, from 1991 to 1995; and community services, from 1996 to 2000. The dummy was created using information in Mattoo and others (2003) and information provided by Arpita Mukherjee of the Indian Council for Research on International Economic Relations.
7The IT sector encompasses software and services (ITS—systems integration, packaged software support and installation, application outsourcing, custom application development, etc.), IT-enabled services (ITES—human resources, customer care, payment services, finance, etc.), and hardware.
9Wages for entry-level software developers rose by almost 50 percent between 2002 and 2004, while wages for project managers almost doubled (Farrell and others, 2005).

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