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Tertiarization of the Economy and its Trade Policy Implications industrial policy, free trade

Author Siwook Lee and Yongseok Choi Series 20-02 Language Korean Date 2020.12.30

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   Over the past several decades, we have witnessed an accelerated pace of the tertiarization of the global economy. The tertiarization of the economy – the expansion of the service sector - has long been understood as a major characteristic of advanced economies, but the GDP and employment shares of the service sector in developing countries have been also increasing rapidly in recent years. For instance, the GDP share of the service sector in middle-income developing countries increased by 8.9% points from 45.2% in 1997 to 54.2% in 2017, exceeding the 4.8% points increase in high-income countries during the period.
   The tertiarization of the economy is driven by various socio-economic factors such as increased demand for income-elastic services, the spread of labor-saving technologies in manufacturing, the expansion of global value chains, ICT development, the aging population, and the participation of women in economic activities, etc. The advent of Fourth Industrial Revolution and the recent COVID-19 outbreak are expected to further accelerate such trend by breaking down the boundaries between manufacturing and services.
   Against this backdrop, the main purpose of this study is to examine the major characteristics and status of the ongoing tertiarization, investigate the competitiveness of Korean services in the global value chain, and discuss the direction of mid- to long-term trade policies for the Korean economy. In this study, a particular research focus is drawn on the servicification of manufacturing, which has not been adequately addressed in existing economic literature. The servicification of manufacturing refers to the situation that manufacturers expand the use of services as intermediate goods in the production process and/or provide services in the form of final goods. It encompasses not only outsourcing of service functions, but also increasing the proportion of in-house services generated by manufacturers themselves or simultaneously producing and selling goods and services.
   As the servicification of manufacturing spreads globally, there has been an upsurging policy and academic interest in intermediate types of services that are embodied in goods and thus indirectly traded in the form of goods exports. These services tend to promote high value-added manufacturing, not only by mediating the international division of manufacturing through transportation, telecommunications, finance, and logistics services, but more importantly by providing knowledge- intensive services such as engineering, R&D, marketing, design, and advertising.
   This study empirically investigates the value-added structure of services embodied in the export of final goods. Specifically, we divide intermediate-type services into three types: domestically-outsourced services, foreign services, and in-house provision of services within manufacturers, and then examines the value-added contribution of each type to commodity exports for the period of 2005-2015.
   The major analytic results of this study can be summarized as follows: first of all, compared to major exporters in the global market, Korea’s manufacturing exports tends to rely more on foreign services outsourcing and less on domestic services. This phenomenon is not attributed to certain industrial sectors, but rather to the overall manufacturing sector. The proportion of domestic outsourcing for distribution services and knowledge-based business services is found to be particularly lower than that of other major exporting countries.
   Second, the overall contribution of intermediate services to the total value-adds of manufacturing exports has been around 45~50%. It declined from 50.0% in 2005 to 44.8% in 2011, and then has been on the rise again afterward. Such trend stems mostly from year-to-year variation of in-house services within manufacturing firms, rather than from that of domestic or foreign outsourcing.
   Third, our analytic results indicate that the in-house provision of services within manufacturers is complementary to domestic outsourcing activities of services, but substitutable to foreign outsourcing. This suggests that the increase of the in-house provision of services by manufactures could be an effective way to reduce the extent of foreign outsourcing while helping to improve the outsourcing demand for domestic services.
   Fourth, Miroudot and Cadestin (2017) recently examine the contribution of services to commodity exports for the sample OECD countries. Basing on the Korean Labor and Income Panel data, they claim that the contribution of in-house services to the total value-adds of manufacturing exports is only at around 8% for the Korea case, which is one of the lowest levels among OECD countries in comparison. On this other hand, when re-estimating the service contribution by employing the Labor Survey by Employment Type, we finds that the contribution of in-house services in Korean manufacturing amounts to 18.6%, being well above the OECD average. Miroudot and Cadestin (2017) may have underestimated the actual contribution of serviceization in Korean manufacturers, taken into account that the Labor Survey by Employemnt Type is a more representative and comprehensive data source, compared to Labor and Income Panel data that they use.
   Finally, servicification within Korean manufacturers has been mainly centered on large-scale companies with a high export share, and their contribution continues to increase, especially after the global economic crisis. On the other hand, it is shown that servicification of small and medium enterprises remains stagnant at quite a low level. This implies that the government needs active policy support to help small and medium-sized companies increase service utilization and/or production, in order to improve the competitiveness of the overall economy.
   Given the aforementioned findings into consideration, this study provides the following implications regarding mid- to long-term trade policies; first, the importance of manufacturing has been highlighted again in the aftermath of the recent global economic recession. At the same time, as aforementioned, intermediate services embodied in manufacturing products is emerging as a driving force for manufacturing competitiveness. Furthermore, the development of new technologies related to the Fourth Industrial Revolution will gradually blur the boundaries between manufacturing and service industries, and accelerate the servicification of manufacturing industries. Therefore, the government should establish and implement trade policies that help to maximize synergies between manufacturing and services in the value chain. As our analysis suggests, the contribution of services to the manufacturing value-adds, through either the intensified in-house provision of services or increased domestic service outsourcing, is expected to increase. Hence, it is imperative for the government to establish support policies considering these areas.
   Second, one of the key results of this study is that there is a complementary relationship between in-house service provision and domestic outsourcing of services, and these domestic activities help to reduce the reliance on foreign outsourcing. The government's “Smart Factory Support Project” for SMEs is a very encouraging policy in this respect, which aims to encourage the use of IT technology and related services and combine them into the entire process of value chain, such as product planning, development, production, and sales. If the smart factory system is successfully settled, then the use of domestic services or servicification within SMEs can be further promoted, leading to enhance the overall productivity. The government should further develop and implement support schemes that allow SMEs to increase their utilization not only in these IT services but also in other knowledge-based services.
   Third, efforts should be made to strengthen the domestic value chain and revitalize the domestic outsourced service market by actively incorporating intermediate goods services into the "Export Supply Chain Support System" introduced as a countermeasure to Japan's recently triggered export regulations. This system refers to a policy measure that provides financial and technical support to small and medium-sized Korean companies that supply intermediate goods to export firms. Until now, the support system has mainly targeted small and medium-sized manufacturers that produce materials, parts, or equipment, but it should be expanded to service providers that supply intermediate-type services to manufacturing exporters. In the case of service providers, their core assets are in the form of intangible assets, and therefore have very limited access to finance due to the lack of fixed tangible assets with collateral value.
   Finally, if the Korean government pushes for new FTA negotiations or amends existing FTAs, it is necessary to prepare and implement negotiation strategies related to the servicification of manufacturing. The existing FTA negotiations have focused mostly on reducing tariff and non-tariff barriers in the commodity sector and expanding access to the market for Modes 1-4 service transactions defined by GATS. On the other hand, future FTA negotiations should also make great efforts to liberalize services in the form of intermediate goods.
   Within the GATT/WTO multilateral system, the liberalization of goods and services has been pursued separately within the GATT and GATS systems, respectively. As a result, the blind spots of these international norms are gradually expanding as the servicification of manufacturing and industrial convergence further proceed. In this regard, the EU has recently raised calls for defining intermediate-type service transactions that are embodied in commodity exports as Mode 5 and urged to initiate multilateral discussion on Mode 5 liberalization. Therefore, the government needs to preemptively identify how liberalization and potential revision of international norms related to Mode 5 will affect the price competitiveness of our product exports and establish policy alternatives.

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