The potential positive effect of liberalization and foreign presence in services sectors is reflected in the results of a firm survey conducted by the World Bank in the Czech Republic in 2004. A majority of the 350 Czech enterprises interviewed believed that liberalization of services industries contributed to improvements in the quality, range and availability of services inputs in their country.

A closer look at services industries in the Czech Republic reveals substantial differences between domestic and foreign-owned services providers. Foreign-owned providers exhibit higher labor productivity than their domestic counterparts and have a higher propensity to invest. The data also reveal an increase in productivity and investment taking place following the foreign acquisitions of Czech services firms. Moreover, the data show that after a foreign acquisition, target firms experience an increase in their market share, indicating a revealed consumer preference for the services provided by foreign-owned companies.

To examine the link between services sector reforms and the performance of services users, this study relates the total factor productivity of manufacturing firms to the state of liberalization in services sectors weighted by the respective manufacturing sector’s reliance on inputs from each service sector. The analysis is based on firm level data from Amadeus, a commercial data base including financial statements and ownership information for approximately ten thousand Czech companies for the 1998-2003 period. The reliance of manufacturing sectors on services inputs is assessed based on the national input-output matrix.

Several measures are used to capture the extent of reform in services sectors. The first is a set of policy reform indices published by the European Bank for Reconstruction and Development (EBRD). Sectorspecific time-varying indices are available for banking, telecommunications, electric power, railway transport, road transport, and water distribution. The indices reflect the overall state of policy reform in a given services industry. Three additional measures capture a particular aspect of liberalization: (i) the extent to which foreign investors have entered Czech services industries, which is proxied by the share of an industry’s output produced by foreign-owned companies; (ii) the progress of privatization in services industries, which is captured by the share of an industry’s output produced by private companies; (iii) the level of competition in services industries, which is measured by the market share of the four largest providers.

In addition to proxies for services reform, the empirical analysis includes a comprehensive set of controls for other channels through which increased openness may affect firm performance. In particular, we control for the availability of material inputs provided by foreign-owned companies operating in upstream manufacturing sectors and for tariffs on imported intermediate inputs. To capture the level of competition in the output markets, we control for foreign presence and tariff protection in the same sector. The model includes firm fixed effects which control for unobserved firm heterogeneity and capture time-invariant effects specific to the industry and the region in which a firm operates. As a robustness check, we also estimate a model in first differences. To take into account the possible simultaneity between productivity shocks and input selection, we estimate the total factor productivity using the methodology proposed by Olley and Pakes (2003).

One final concern is the possible endogeneity of services liberalization. This concern is alleviated by the fact that services liberalization in the Czech Republic was undertaken in preparation for the country’s accession to the European Union (EU) in May 2004, which lends considerable exogeneity to the pace of reforms and suggests that services liberalization and opening to foreign entry were exogenous developments rather than a response to domestic lobbying. Nevertheless, we demonstrate that our results are robust to using measures of services reforms lagged two periods. Moreover, taking advantage of the fact that neighboring countries, such as Slovakia and Hungary were also preparing for the EU accession, we use their progress in services reform to instrument for foreign presence in services industries in the Czech Republic and find that our conclusions remain unchanged.

Our main finding is a positive correlation between liberalization in services sectors and the productivity of manufacturing firms relying on services inputs. When each measure of reform is considered in isolation, a positive and statistically significant relationship is found for the overall progress in policy reform, the presence of foreign providers in services sectors and the extent of privatization in services industries. No 3