Though the pace of expansion in the services sector in China has remained strong in recent years to combat the slowdown in the industrial sector, analysts at HSBC suggest such a re-balancing may slow the country’s productivity catch-up in the medium term. In their July 21 research piece titled “China’s new challenge,” Qu Hongbin and Jing Li forecast 6.7% GDP growth in 2016 for China and said they believe worries about the country’s sharp slowdown are overblown.

China’s services growth cushions overall economy’s slowdown

Hongbin and Li attribute the fast industrialization in China to the country’s unprecedented economic growth over past decades. They argue that such fast growth drove millions of farmers away from their land to work in urban factories. However, the HSBC analysts note that things are changing, with the industrial sector affected by the combination of weakening external demand and domestic corporate restructuring.

Hongbin and Li, however, point out that the services sector has taken over the heavy lifting work to drive the country’s economic growth. The analysts note that the rapid expansion in the services sector helped prevent GDP growth from sliding too fast. They note that between 2012 and 2015, the services sector maintained robust growth of around 8.1% y-o-y, while output growth in the industrial sector dropped from 8.2% y-o-y to 6%.

 China, HSBC, Middle-Income Trap

However, the HSBC analysts caution that it’s too early to take cheer from such a transition. They highlight that such a shift towards services-led growth will result in several high-productivity manufacturing jobs getting replaced with less productive jobs in the services sector. The analysts underscore that such a move resulted in overall productivity growth in the economy getting slowed, endangering the country’s long-term growth prospects.

Drawing experience from some Latin American countries, the HSBC analysts point out that a lack of adequate investment and a tendency of specializing according to short term, rather than long term, comparative advantage are common mistakes made by developing countries.

Re-balancing towards services sector implies efficiency loss

Hongbin and Li argue that labor productivity in most services is only half as much as in manufacturing. As can be deduced from the following charts, the output per worker in the services sector was only 80% of that of the industrial sector, implying a huge efficiency loss being involved in the process.

Less productive services sector

The analysts point out that migrant workers tend to concentrate in lower-end sectors such as wholesale and retail, residential services, transportation, and logistics. They note that these three sectors combined accounted for 65% of migrant worker employment in the services sector in 2015. They caution that with weakening momentum in the manufacturing sector, China faces the danger of losing more good jobs in exchange for less productive ones.

Comparing the economic development of countries that have de-industrialized at different income levels, the HSBC analysts point out that the U.S., the U.K., Korea and Singapore have all overcome the middle-income trap after their fastest growth periods. Highlighting some of the common threads among these countries, the analysts note that the countries started to de-industrialize when their GDP per capita levels were already relatively high (30% to 60% of the U.S. level) and quickly caught up with the frontier countries.

Premature de-industrialisation

However, they note that China’s GDP per capita was only 14% that of the U.S. in 2015, which is about the same income level at which the Latin American countries began shifting toward the services sector.

Hongbin and Li suggest that the Chinese government should adopt a package of demand-lifting policies, including more tax cuts or exemptions for small and medium enterprises, simplifying administrative procedures, and more aggressive policy easing.