China's Yawning Gap

China’s dream is for its economy to go upscale and value-added – rising from cheap goods producer to high-end services provider. But the economy is not following the official script.
Externally, the services industry is unable to compete. And domestically, the lack of home-grown talent squashes any hope of high-speed development in the sector.
Growth numbers are often cited to show that the re-balancing of the economy and its move up the value chain are going well. But growth in and of itself is not evidence of achievement. As an economy grows, so will its industries. And percentages are always impressive when starting from a low base.
The deficit in services trade: why size matters
More telling is the continuing and steepening deficit in China’s trade in services. What it shows is a services sector unable to keep pace with demands from even a slowed-down economy.
The nation has had to import services over the years to support its economic expansion. The push to develop the sector in recent years has had little impact in terms of meeting domestic needs. Even as China’s balance in merchandise trade notched up another record high in 2014, its deficit in services plumbed new depths (see chart below).

China’s net trade in services has been in negative territory since 1994. And the deficit each year for the past 15 years has been sizeable enough to more than offset the year’s increase in net merchandise trade over the previous year (the exception was in 2009 when exports plummeted in the wake of the global financial crisis).
Last year, the services deficit reached $198 billion. The increase in the merchandise trade surplus over the previous year was $112 billion (merchandise trade data is calculated here on a balance of payments basis, and not customs receipts.)
In the building of low-cost roads and dams in emerging economies in Africa and elsewhere, China has few competitors. Net export of construction services reached $26 billion last year.
But at the higher end, China remains a laggard. Net export of insurance services, for example, is in negative territory for the Chinese, to the tune of $50 billion.
Breaking into the global market for services has proved much tougher for services than for manufacturing, the backbone of Chinese exports. Of the 13 sectors in the services account, only four show the trade balance as being in the black for China.
Growing at home (but not by much)
Domestically, growth in the services industry has been moving in the right direction. But progress has been much slower than what nominal indicators might suggest.
Much has been made of the fact that services, or the tertiary industry, has overtaken manufacturing and construction as the biggest segment of the economy. In 2013, the services sector came out top for the first time, accounting for 46.1% of gross domestic product.
Last year, it expanded its share to 48.2% compared with 42.6% for secondary industry.
(Economic activities in China are divided into three groups. Primary industry refers to agriculture, secondary industry to manufacturing and construction, tertiary industry to services and everything not included in the first two groupings.)
But strip out price effects and the picture looks quite different (see chart below).
The Peterson Institute for International Economics, an American think tank, has published calculations showing that divergent price movements can account for the seemingly strong and rising contribution of services to GDP.

Prices have been falling in the industrial sector and rising in the services sector since early 2012. The industrial GDP deflator indicates that prices fell 1.4% in the first half of 2014 compared with the same period last year. But prices in the services sector rose 3.3% over the same period.
Ryan Rutkowski, a researcher with the think tank, calculates that after adjusting for inflation, services' share of GDP increased cumulatively by 0.4% between 2010 and 2013. This compares with the much larger 2.9 percentage point increase reflected in the nominal figures.
The story is reversed for secondary industry. After adjusting for deflation, the industrial sector’s share of GDP rose by 0.6% compared with a decline of 2.8 percentage points in nominal terms. (Agriculture, the primary industry, has always been in third place accounting for about a tenth of GDP.)
China's industrial sector is growing faster than services once price divergence is accounted for. Photo: iStock
In real terms, services' share of GDP has barely moved in three years while industry’s share of GDP has risen rather than declined. In 2010 constant prices, the services share of GDP remains smaller than that of secondary industry.
The industrial sector has been in deflation since early 2012. Contracting domestic and external demand for raw materials has led to overcapacity causing prices to plummet. The owner of one of the largest privately-owned steel mills in China famously said at a public event that year that the profit from a ton of steel was lower than the margin on a typical dish of stir-fried meat.
A common sense approach tells much the same story of slow progress in developing the services sector. The dearth of skills in China is well known. The government itself publicly laments the lack of home-grown professionals.
From pharmacists to actuaries to auto mechanics to corporate translators, the shortage of qualified professionals is so dire that the government has launched various recruitment programmes to retain local talent and attract skilled workers from overseas.
A member of the influential cabinet-level think tank Development Research Centre of the State Council has warned that the nation’s skill gap could derail its economic upgrade. We concur.
Pauline Loong is managing director of Asia-analytica Research and Senior Fellow of the CIMB ASEAN Research Institute
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