Manufacturing versus services: Why privilege one over the other?

The origin of modern development theory can be traced to the regularities that Simon Kuznets and others observed in the 1950s and 1960s on how the structure of an economy evolves with growth. A key feature he observed is that as per capita GDP (a concept he invented) rises, the dominant sector of the economy shifts from agriculture to industry and then services.

This regularity, combined with Arthur Lewis’s foundational theory about how the transfer of labour and surplus from a traditional agricultural sector to a modern industrial sector constitutes the fundamental process of development, became the core of development economics.

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These pillars were supplemented with seminal contributions by many others, but the main focus of enquiry was on the transfer of labour and savings from a traditional agricultural sector to a modern industrial sector, especially manufacturing, which was seen as representative of the entire capitalist non-agricultural sector.

The key policy debate at this sectoral boundary between agriculture and the rest of the economy was about the desirability and appropriate scale of the surplus transfer out of agriculture. Theodore Shultz wrote about the importance of transforming traditional agriculture. Mellor and his school of economists at IFPRI developed models of agriculture-led growth. Ishikawa argued that growth in developing economies required a reverse transfer of resources into agriculture.

My own doctoral thesis investigated the interaction between inter-sectoral resource transfers and patterns of long-term growth in India.

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Since then, the sectoral boundary of interest in India and policy debate have shifted. The boundary in focus now is between industry, especially manufacturing industry, and services.

There is a broadly held view among economists that manufacturing has to lead development. However, on close questioning of why they think so, the response is usually a cursory reference to historical experience.

Manufacturing industry indeed led the high growth phase of many countries in Europe after the Industrial Revolution. This is also true of East Asian countries in their high-growth phase. But how much of that growth in Europe is attributable to surplus transfers from colonies—and in East Asia to their strategic and economic alliance with America—remains an open question.

Of the 30 most advanced countries in the world today (in per capita GDP terms, excluding some small island economies), manufacturing accounts for 10% or less of GDP in a third of these and 15% or less in another third. Ireland is the only outlier where manufacturing accounts for over 29% of GDP.

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So, what is the evidence pointing to the special importance of manufacturing? The only evidence-based answers I have seen are those by Professors Veeramani and Nagesh Kumar. Both of them argue that strong backward and forward linkages unique to manufacturing industry make it an ideal sector to lead developing economies.

Surprisingly, few remember the robust theory of manufacturing-led growth developed by Nicholas Kaldor 50 years ago. Building on the even earlier work of Allyn Young, Kaldor argued that manufacturing typically has the characteristic of increasing returns to scale, driving down costs but correspondingly increasing demand as multiple industries reinforce one another in an expanding process of cumulative causation. Keynesian demand management can greatly strengthen this process.

Thus, there are compelling reasons for expecting manufacturing to play a leading role in an economy like India’s. If so, why has the long-term record of industrial growth been relatively unimpressive? Industry has typically grown at around 5-6% annually during the past 70 years and its GDP share has risen from around 15% to 29% over this period (see data chart).

Actually, much of our high industrial growth in recent decades is attributable to mining, utilities and especially construction. The share of manufacturing industry is only around 17%. In contrast, the share of services in GDP has grown from 20.6% at the outset to 53% today, its average decadal growth during the last 40 years being in the range of 7-8% annually. 

The more dynamic performance of services is also reflected in its rising share of employment and, significantly, in our growing trade surplus in services. This is in sharp contrast with our trade deficit in goods. It is sometimes argued that manufacturing has been hamstrung by dysfunctional regulations and undue interference by an overbearing state. But it is the same regulatory ecosystem in which the services sector has performed so much better.

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Thus, from a policy perspective, we must ask: Why is the slogan of ‘Make in India’ and related policy incentives limited only to manufacturing industry, when, say, transport and trade services, financial services, hospitality, education, health and other services are just as important as tangible goods like textiles, steel, cars or pharmaceuticals? 

We should carefully study the only two decades when industry grew significantly faster than services, 1950-51 to 1960-61 and 2000-01 to 2010-11. What made the difference? Meanwhile, the government would do well to pursue at least an even-handed policy between industry and services, especially if it wishes to maximize employment growth and minimize or eliminate India’s trade deficit.

These are the author’s personal views

The author is chairman, Centre for Development Studies.