Services-led development: Some caveats

With global manufacturing concentrated in East Asia, prospects for industry-driven development seem to have diminished elsewhere. In many developing countries, industrialization opportunities have reportedly vanished at much lower levels of income than those of the early industrializers. Consequently, the idea of a services-led development model (SLDM) has lately gained popularity as a viable alternative to industrialization. However, in a recent assessment of Tanzania’s economic performance, we detected three obstacles to SLDM—low export dynamism, low fiscal revenue generation, and low foreign direct investment (FDI) attraction—which can limit its implementation, at least in the short run.  

Services-led development: Core ideas

A key stylized fact that motivates SLDM is the divergence of sectoral employment patterns between East Asian nations and other developing countries. Between 1991 and 2018, the employment share of industry increased from 21% to 28% in China, but it stagnated at 20% in lower middle-income countries (LMICs). Their surplus labor from agriculture was instead absorbed by services, whose employment share increased from 40% to 50%. Advocates of SLDM suggest that these trends may depict a new development paradigm based on two factors:

• The changing nature of services trade: With technological progress, previously non-tradable services, such as software production and other digital services, have become tradable across borders. This should relax constraints from insufficient domestic demand and, ceteris paribus, enable production at a larger scale without major price reductions.
• The productivity of services: Conventionally, industry was associated with rapid productivity growth, but recent evidence shows services in many LMICs have surpassed industry in labor productivity growth since the 1990s. If sustained, this trend could offer a viable alternative for promoting economic development.

An oft-cited success story for SLDM is India. Between 1987 and 2011, the country’s per capita income almost tripled largely thanks to services, including non-tradable consumer services such as restaurants. Urban dwellers enjoyed a welfare increase of up to 37% owing to the increase in the productivity of non-tradable services. This productivity growth also explains about half of the observed 18 percentage points reduction in agriculture’s share of employment. Can this performance be replicated in other countries such as Tanzania?

Structural transformation in Tanzania— A tale of services-led growth

Tanzania’s recent experience with structural transformation was broadly like those of other LMICs, with the increase in the employment share of services roughly matching declines in agriculture’s share. From 2006 to 2014 (the first period), business and trade services absorbed most of the labor shed by agriculture (6 percentage points of employment share out of 7). From 2014 to 2021 (the second period), labor flowed from services back to agriculture (2 percentage points), reflecting a contraction, especially in the demand for hotel and restaurant services during the COVID-19 pandemic. The employment share of manufacturing barely budged.

While productivity growth in services was negative over the first period, it turned positive in the second one, dwarfing productivity growth in manufacturing. Infrastructure investments, which increased rural electrification eightfold and overall internet access sevenfold in less than a decade, were reportedly instrumental for this productivity growth. Tanzania’s public gross-fixed capital formation increased from 33% of GDP to 43% over the second period, and the subsequent improvements in transport and information and communication technology (ICT) helped to boost market access and reduce operating costs.

The second period also witnessed a proliferation of small firms employing less than 10 workers. In 2013, about 145,000 firms were formally registered. By 2021, this number increased to almost 400,000. The share of business and trade services in formal employment increased from 10.5% to 26.1% and that of transport and communications from 18.5% to 27.6%. In short, services have played a key role in Tanzania’s structural transformation.

The future of services-led growth in Tanzania: Challenges

While Tanzania’s recent economic performance has unambiguously been tilted toward services, there are three concerns.

Lack of export dynamism: From 2000 to 2019, Tanzania’s exports first grew rapidly, more than doubling in proportion to GDP by 2012, then decreased steadily, losing most of those gains. While large infrastructure projects in transport and energy kept the GDP growth momentum up (averaging at about 6.1%, annually), thereby retaining a robust import demand for processed goods (chemicals, machinery, electronics, fuel, and processed food products), the accompanying services expansion did not increase exports despite absorbing more labor. Even the largest firms in services have been domestically oriented.

To be sure, a trade deficit does not always pose a challenge to SLDM. In theory, trade could be balanced through adjustments in prices (wages, goods prices, and exchange rates). In practice, governments face several short-term constraints to such adjustments. For example, while exchange rate depreciations can eventually re-balance trade by boosting exports and suppressing imports, they can also make external debt more expensive in domestic currency terms, elevate the prices of imported goods (which contributes to inflation), and even widen the trade deficit initially when imports are a necessity as in many developing countries.

In Tanzania, an increase in natural resource exports helped mitigate wider trade imbalances. For example, gold exports increased by almost sixfold between 2010 and 2019, raising its export share from 6.5% to 20%. Nevertheless, persistent foreign exchange supply-demand imbalances eventually led to weakening external positions, and with overlapping shocks including the Federal Reserve’s rate hikes, the country faced foreign exchange shortages in 2023. While ad hoc interventions, such as limited depreciation and reserve use, have helped stabilize the markets in the short term, a more structural solution will require stronger export performance. The ability to earn sufficient foreign exchange and manage it well, e.g., from natural resource exports, becomes particularly important when imports comprise necessity goods and key inputs for domestic production (including agriculture), and devaluations cannot immediately fix external imbalances.   

Fiscal imbalances: The second concern is insufficient tax revenues. In Tanzania, the proliferation of small firms (mostly in services) and the drive for formalization led to a rapid increase in tax revenues from $2.7 billion in 2013 to $3.9 billion in 2021 (in real 2015 U.S. dollar). While the share of small firms’ contributions to tax revenues increased from 13.4% to 22.5%, large firms (mostly in manufacturing) still contribute close to 60 % of tax revenues despite their small numbers.

The expansion of backbone infrastructure services, which facilitated the boom of small domestic market-oriented firms in services, has narrowed Tanzania’s fiscal space directly and indirectly, through contingent liabilities associated with state-owned enterprises. While the full extent of the country’s quasi-fiscal exposure is not known, its implications are clear. To be sustainable, these efforts would need to rapidly boost growth and tax revenues. Yet, with size-dependent tax exemptions and costly tax enforcement, small service-sector firms do not often constitute a sufficient tax base— driving governments to rely on less desirable revenue sources like indirect taxes. Thus, for SLDM to be viable, a sizable initial fiscal space or recurrent sources like taxes/royalties from natural resources may be necessary.

Low foreign direct investment (FDI): The third concern is the relatively low share of FDI in services. In recent years, services have received only about 15 percent of all inflows to Tanzania. This is in contrast with trends in more developed countries, where services (about 55% of all inflows) have consistently attracted more FDI than manufacturing (about 40%). Such limited FDI attraction can restrict productivity growth not only in services, but also in manufacturing in the long term.

Furthermore, in a developing country setting, FDI in non-tradable services may be preferred to FDI in other sectors from an employment perspective. While mining and natural resource-intensive sectors can help boost exports, and more easily attract FDI, they do not create many jobs. The same problem is sometimes true for large manufacturing firms. Similarly, tradable services like finance and insurance can attract FDI more easily (two-thirds of services FDI went to these sectors in Tanzania), and they even help train the workforce, but they hire a small number of highly skilled laborers. Most Africans in services work in retail and wholesale trade.

Conclusion

The three major challenges to SLDM— low export dynamism, low fiscal revenue generation, and low FDI attraction— are in part driven by the domestic market orientation of the services boom in Tanzania. Therefore, the tradable versus. non-tradable distinction is a crucial consideration, even within the services sector. While India serves as a success story based on non-tradable services, factors such as India’s large economic size, which reduces import dependency, may have contributed to its success. The low export dynamism associated with a non-tradable services boom poses a challenge for smaller developing countries heavily reliant on importing essential goods.