# **1 Introduction**

Services liberalization is a controversial subject, as is evident from recent policy debates in the European Union and the World Trade Organization. The scope for controversy is great because—in contrast to the large body of empirical research on the impact of trade liberalization in goods<sup>1</sup> —little is known about the effects of allowing greater foreign entry in services industries. Since a wide range of manufacturing and services industries rely on services inputs, it seems reasonable to presume that large gains could be achieved through the liberalization of services sectors.

To the best of our knowledge, this is the first study which provides empirical evidence on the link between reforms in services sectors and the productivity of downstream manufacturing industries.<sup>2</sup> Our analysis focuses on the Czech Republic which introduced far reaching reforms of services industries during the 1990s, including opening services sectors to foreign investors. The results, based on firm-level data for the period 1998–2003, suggest a positive association between liberalization in services industries and the productivity of manufacturing firms using services inputs.

Liberalization of services industries involves the abolition of monopolies, elimination of barriers to entry and the privatization of state-owned enterprises. As a result, new domestic and foreign providers are likely to enter the market and hence increase the choice of providers for downstream users of services. Greater choice of services providers may in turn affect the performance of manufacturing sectors in three ways.

First, the quality and reliability of existing services may improve as a result of privatization, competition and the entry of internationally successful players. For instance, telephone communications or electricity provision may become more reliable due to investments in infrastructure by new domestic owners or foreign shareholders, or credit decisions may be made faster as competition among banks increases. These improvements will in turn limit disruptions to production and reduce operating costs in downstream manufacturing sectors.<sup>3</sup> Second, new services may become available through the entry of cutting-edge service providers. Examples include new financial instruments and cash flow management tools, multi-modal transport services, or digital value-added services in telecommunications. Availability of such services may allow manufacturers to introduce productivity enhancing changes to their operations, such as receiving production orders on line or setting up on-line bidding systems for suppliers.

Third, services liberalization may also lead to a wider availability of services that were formerly restricted to certain groups of users, such as internet coverage in rural areas or an improved availability of business consulting services to smaller firms. The improved access may lead to enhanced performance of smaller or remotely located enterprises.

The entry of foreign providers may play a particularly important role in realizing these benefits. Foreign providers may bring know-how and knowledge about new products and international best practices into the country. By setting a higher standard and introducing new products, they may also put pressure on domestic suppliers to make similar improvements. Given the limited scope for cross-border trade in services inputs, we would expect the performance of downstream sectors to be tied more directly to the quality and availability of services supplied by providers operating domestically than is the case for physical intermediate inputs.

> 1 For instance, Pavcnik (2002) and Fernandes (2006) examine the implications of trade liberalization for the productivity of firms in protected sectors, while Amiti and Konings (2005) distinguish between the effects of lowering tariffs on final goods and lowering tariffs on intermediate inputs.

> 2 The most closely related studies by Rajan and Zingales (1998) and Fernald (1999) are discussed in the next section. Recent efforts to estimate the economy-wide benefits of services reform using computable general equilibrium models (e.g. Rutherford, Tarr and Shepotylo 2005) assume downstream productivity effects of foreign entry into services markets, the existence of which the present paper is seeking to establish.

> 3 In a case study of Mexican detergent industry, Javorcik, Keller and Tybout (2006) find that the entry of Wal-Mart reduced the distribution cost for detergent manufacturers. While in the past manufacturers used to deliver their products to individual supermarkets, Wal-Mart instituted a system of deliveries to a central warehouse which was later adopted by other supermarket chains. Moreover, the expansion of Wal-Mart into many regions of the country gave producers an opportunity to expand the reach of their products without having to engage in costly transactions with small wholesalers and retailers.

2