Eichengreen: China Needs a Service-Sector Revolution

With wages increasing in China, which has effects similar to a currency appreciation, will it be possible for China make the transition to an economy where the domestic service sector expands to take up the slack created as manufactured goods become more expensive and hence more difficult to export?:

China Needs a Service-Sector Revolution, by Barry Eichengreen, Commentary, Project Syndicate: China is getting its exchange-rate adjustment whether it likes it or not. While Chinese officials continue to mull the right time to let the renminbi rise, manufacturing workers are voting with their feet – and their picket lines.

Honda has offered its transmission-factory workers in China a 24% wage increase to head off a crippling strike. Foxconn, the Taiwanese contract manufacturer for Apple and Dell, has announced wage increases of as much as 70%. Shenzhen, to head off trouble, has announced a 16% increase in the minimum wage. Beijing’s municipal authorities have preemptively boosted the city’s minimum wage by 20%.

The result will be to raise the prices of China’s exports and fuel demand for imports. The effect will be much the same as a currency appreciation. ... With exports of manufactures becoming more expensive, China will have to ... move ... toward the model of a more mature economy, in which employment is increasingly concentrated in the service sector. ...

But the bad news is that the transition now being asked of China – to shift toward services without experiencing a significant decline in economy-wide productivity growth – is unprecedented in Asia. Every high-growth, manufacturing-intensive Asian economy that has attempted it has suffered a massive slowdown. ...

Why is this? In countries that have traditionally emphasized manufacturing, the underdeveloped service sector is dominated by small enterprises – mom and pop stores. These lack the scale to be efficient...

In both Korea and Japan, large firms’ entry into the service sector is impeded by restrictive regulation, for which small producers are an influential lobby. ... Foreign firms that are carriers of innovative organizational knowledge and technology are barred from coming in. Accountants, architects, attorneys, and engineers all then jump on the bandwagon, using restrictive licensing requirements to limit supply, competition, and foreign entry.

One can well imagine Chinese shopkeepers, butchers, and health-care workers following this example. The results would be devastating. ... Employing workers in sectors where their productivity is stagnant would not be a recipe for social stability. China needs to avoid the pattern by which past neglect of the service sector creates a class of incumbents who use political means to maintain their position. Perhaps China will succeed in avoiding this fate. Here at least may be one not-so-grim advantage to not being a democracy.

Update: The People's Bank of China announces plans to enhance the RMB exchange rate flexibility.