The industrial composition of Hong Kong’s economy has undergone a very rapid structural change over the past three decades. Between 1980/1 and 2010/11, the share of service sector employment in Hong Kong grew from 47.1% to 87.5%, while the share of manufacturing employment fell from 41.3% to 4.0% (see Table 1). In terms of their shares in real GDP, the service sector grew from 74.2% to 92.6% and the manufacturing sector fell from 17.1% to 1.8% (see Table 1). When measured in nominal GDP terms, the change is even steeper – the service sector grew from 68.8% to 92.9% and the manufacturing sector fell from 22.8% to 1.8% – because the price of services increased faster than that of manufactures.

 

These are extremely rapid rates of change. But the economy adjusted well to the demand shifts due to the flexibility of its labor market. Unemployment rates were low throughout the entire period, except for the recession years during the Asian Financial Crisis. A major cause of this rapid structural change was the migration of manufacturing industries across the border during the 1980s and 1990s. The relocation of the production base to the Pearl River Delta allowed firms in Hong Kong to quickly enlarge their export oriented manufacturing operations in an era of expanding international trade and rising globalization. At its peak Hong Kong employed over 10 million workers in Guangdong alone.

 

The structural transformation of the economy was also accompanied by accelerated price inflation from the late-1980s to the mid-1990s. The enormous expansion of manufacturing production across the border created a huge demand for supporting services in Hong Kong, including import and export services, business services, professional services, financial services and so on. The higher income from cross-border operations also increased the demand for goods and services in Hong Kong.

 

While most goods could be imported from abroad, it was much more difficult to import many services. The non-tradable nature of many services meant their prices rose relative to the price of tradable manufactured goods. Under the linked exchange rate system the HK Dollar is fixed to the US Dollar, therefore, the price of tradable manufactured goods has to adjust to world inflation rates. Structural inflation appeared in Hong Kong as the prices of non-tradable services soared ahead of those for tradable manufactured goods.

 

The Growing Service Economy

 

Monetary expansion was accommodated by running a surplus in the balance of payments. From the late-1980s to the mid-1990s, world interest rates were relatively low and Hong Kong experienced a long period of negative real interest rates. This fuelled property price increases, especially for domestic premises, whose final use – as residence – also happened to be a highly non-tradable service. Unfortunately for Hong Kong the supply of land did not increase adequately during most of this period. Furthermore, planning, land and building restrictions were tightened in response to a greater concern for development control making it even more difficult to increase the supply of property. As a result the rise in property prices failed to abate.

 

In the mid-1990s, the loss of the manufacturing industry and the rise of the service industry were perceived by many to be a threat that hollowed out the Hong Kong economy. The initial fear was higher unemployment, but this was quickly allayed as the labor market adapted.

 

Next there were fears that replacing high productivity growth manufacturing industries with low productivity growth service industries would be bad for Hong Kong’s long term economic growth prospects. It is true that measured productivity differs enormously across these sectors. It is also well known that measured productivity usually, but not always, rises faster in the goods industries than in the service industries, although financial services in Hong Kong is one of the exceptions. But the measures of productivity are fraught with many problems.

 

In particular, it is difficult to construct industry specific deflators for services, and service quality improvements are also notoriously poor to measure accurately. For these reasons it is highly likely that the measured inflation rate of the price of services is probably exaggerated because improvements in the quality of service over time are underestimated. It is difficult to make like for like comparisons in the service industry.

 

The measured slow growth of productivity in the service industries is often perceived as the cause of many economic problems, such as slower economic growth, rising inflation, widening income inequality, and high rates of unemployment. While it may be true that a shift to services could eventually lead to a lower measured rate of productivity growth, this conclusion presents a misleading view about the contributions of the service sector to overall productivity levels and growth. Moreover as long as the shift out of manufacturing into services results in higher wages for the workers, GDP is enhanced, not worsened, by the process.

 

Another misleading view about the service sector is that it results in an economy built on people doing each other’s laundry and flipping hamburgers. This view has turned out to be grossly exaggerated, if not totally mistaken. The most important flaw is that it associates services with final personal consumption by households and individuals.

In all city economies where services are the predominant industry, most of these services are designated for intermediate input in the production of goods and other services, not final consumption.

 

This is illustrated in the breakdown of service industries by the production-based measure of GDP. There are four broad service sectors: distributive, consumer, producer, and government service (see Table 1). The distributive services include wholesale, retail, imports-exports, transport, storage and communications. The producer services include financing, insurance, real estate and business services. These are primarily intermediate inputs used by companies in the production of goods and other services rather than final consumption services used by individuals and households.

 

Using these classifications, we can see that most of the growth in real GDP and employment has been in the distributive services and producer services. From 1985/6 to 2010/11, the share of distributive services in real GDP increased from 27.3% to 34.9% and the employment share increased from 25.6% to 36.6%. The share of producer services in real GDP increased from 16.5% to 25.9% and the employment share increased from 6.0% to 18.8%. In contrast to these intermediate services, the growth rates of consumer, government, and other services were much more limited.

 

Increases of Labour Productivity

 

However, the use of production-based classifications does not adequately describe the subtle differences between intermediate inputs and final consumption services. For example, a person staying in a hotel on a business trip should be treated as using an intermediate service, but to stay on holiday should be classified as final consumption. A different approach to categorizing the service industry therefore is needed to separate intermediate inputs more clearly from final consumption services. In Table 2 the service industry is divided into “intermediate production services”, “final consumption services”, and government services. 

 

While government services are the same as those from the production-based estimates of real GDP, final consumption services are estimated from the expenditure based estimates of GDP and are distinguished from consumer services in the production-based classification of GDP. Using this approach, the share of final consumption services in real GDP increased from 35.6% in 1980 to 37.9% in 2010. 

 “Intermediate production services” are measured as a residual after deducting “final consumption services” and government services from total services. The measure of intermediate production services is a better approximation of all those services that are used as intermediate inputs. We can see that the share of intermediate production services in real GDP rose at a much faster rate than that seen for final consumption – from 29.8% in 1980 to 47.9% in 2010. The rapid increase in these services in Hong Kong is closely linked to the expansion of manufacturing firms into the Pearl River Delta. 

 

The opportunity to scale up manufacturing production was a key driver in the demand for intermediate production services. Intermediate services add value to goods and services production and in this case the effect was dynamic as it percolated throughout the economy, creating many more rounds of demand for intermediate inputs.

 

It is interesting to note that in terms of real value the annual rate of increase of labour productivity in the manufacturing industry was 5.1% in 1981-96, -2.4% in 1996-2006, and 22.1% in 2006-10. The period 1981-96 was the peak period for the relocation and expansion of manufacturing across the border. The parallel growth in the intermediate production service industry in Hong Kong resulted from this and contributed to the growth of labor productivity in manufacturing in Hong Kong as it expanded across the border. These two complementary developments increased the dynamism of Hong Kong’s economy while it was in the process of structural transformation.

 

During the decade 1996-2006 the process began to run out of steam as almost all manufacturing production had been relocated and the regional economy was also negatively impacted by the Asian Financial Crisis. Labor productivity in manufacturing therefore declined. But interestingly, labor productivity in manufacturing increased very rapidly between 2006 and 2010. It is still too early to tell what has caused this and whether it will be sustained in future, but it certainly deserves a close and careful look. 

 

Rise of Intermediate Production Services

 

Economists of the Austrian and Swedish Schools have long recognized that labor productivity is enhanced when the production process is reorganized and becomes more “roundabout,” that is, when it includes more stages of production and employs an increasing number of intermediate inputs. Labor and capital become more specialized when production is more “roundabout”.

 

The growth of the service sector goes hand in hand with the appearance of more specialized firms producing a greater diversity of intermediate production services. Firm size is likely to decline as a consequence. Table 3 shows that in the period 1980-2010, the average number of persons engaged per establishment in industries primarily associated with final consumption services tended to remain unchanged over time. The same was the case with the average establishment size of community, social and personal services, which was 11.5 in 1980 and 11.4 in 2010.

But industries associated with a substantial production of intermediate goods and services generally had a declining establishment size over time. The average establishment size in the overall economy declined from 12.7 in 1980 to 7.7 in 2010, reflecting the increasing “roundaboutness” of a service economy dominated by intermediate production service industries. 

 

Specialization through the market has variously been called the process of unbundling, vertical disintegration, and contracting out. The process is facilitated when the size of the market grows and the transaction costs of doing business through the market are reduced. Also contributing to this process are the increasing complexity of business operations, the rising cost of monitoring the performance of employees in large organizations, the rapid rate of technological change in increasingly specialized activities, and the falling cost of information and communication in the marketplace. 

 

Any close examination of the service sector in Hong Kong reveals that it is a highly heterogeneous industry. The rapid expansion of the service sector reflects a positive dynamic market process at work, whose purpose is primarily to support the growth of goods-producing industries which have expanded overseas and across the border into southern China. Hong Kong’s service economy developed in response to market demands, to service the requirements of firms wishing to operate across borders, in different nations, and under different jurisdictions in what is an increasingly integrated regional and global economy.

 

Government’s Role in a Service Economy

 

In general, many services are provided by bankers, accountants, engineers, and scientists whose output is used by firms to produce goods. In addition there are the distribution services without which there could only be self sufficiency in production and consumption. Finally, it is possible to interpret the production of education and medical services as inputs into the creation and maintenance of society’s stock of human capital and health capital. Without these expenditures, the productivity of any population would fall quickly.

 

In free market economies, the satisfaction of consumers is continuously increased through better and cheaper products. Entrepreneurial firms draw heavily on highly educated workers. They also develop and apply new technological and scientific knowledge and sell advice and deliver innovative services to other firms. These firms in the intermediate service industries are the main vehicles through which human and knowledge capital are produced and introduced into the production process. The new technology lowers production costs, supports the development of improved and new products, and urges the adoption of new and more efficient methods for the distribution of goods. These intermediate services change the mix of goods and services that are supplied and demanded. Evidence of the greater educational attainment of service sector workers when compared with workers in the goods-producing sector supports this view.

 

Human capital is enhanced through investments in education and on-the-job training and in health care. Developing people’s moral and ethical standards helps to build honesty and responsibility in the workplace. Their knowledge capital permits the design of more efficient machinery and products, and the efficient organization of firms and society in general. Last but not least is training in critical, reflective and lateral thinking, which is important for nurturing creativity and innovation. Therefore, even if the measured rates of productivity growth in these intermediate or producer services are not high, their existence is the reason that all other firms can enjoy high rates of productivity growth.

 

Given the important role of intermediate services in the promoting productivity and international competitiveness, and its diversified and dispersed nature in the economy, the economic role of the government should only be to provide infrastructure for innovation, invest in human capital formation, maintain a stable and transparent business environment, deregulate professions and occupations to lower the barriers of entry, and to open up markets outside Hong Kong.

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