_“Ever since Adam Smith and David Ricardo, economists have explained and extolled the gains in living standards that derive from international trade. Those arguments are just as valid for trade in services as for trade in goods.”_ Alan Blinder, 2006

# **1. Introduction**

What drives growth has been a perennial question of enquiry in economic literature, and recent rapid growth of China and India has rekindled this debate. These two countries have taken two different routes to achieve growth rates of nearly 7 percent per annum. While China has followed a more traditional manufacturing led growth strategy, India‘s growth has been driven by growth in the services sector. The Indian experience has led researchers to challenge the conventional notion that industrialization is the only plausible route to rapid economic development (Ghani and Kharas, 2010; Felipe et al., 2007; UNCTAD, 2003). Services have grown as a share of the world‘s GDP in the last decade accounting for 70 percent of global GDP, and service exports in developing countries have almost tripled between 1997 and 2007.<sup>1</sup> Even though manufacturing continues to be a dominant driver of growth, recent developments suggest that we must include the service sector in the debate. Services are no longer exclusively an input for trade in goods but have become a "final export" for direct consumption. In view of these changes in the nature of services and their growing importance, the objective of this paper is to examine whether growth in service exports and its sophistication can provide an additional route for rapid economic growth in developing countries. Sophistication has a multitude of interpretations but it broadly aims to capture the productivity level associated with a country‘s production, empirically mirrored in exports data. We develop a new index of ―service exports sophistication‖ and examine its relation with growth.

As countries develop, they undergo structural transformation. Traditional theories have focused on growth as transition from agricultural to industrial production, with manufacturing being the prime ―engine of growth‖ (Kaldor 1966, 1967). This has led to a large body of empirical research that has focused on manufacturing export led growth and related industrial policy. This was further motivated by the growth experience of the East Asian Tigers (Rodrik, 1999, 2004; Hausmann et al., 2005; Pack et al., 2003, 2006; UNIDO 2009; Schott, Peter, 2008).

However, as per capita income increases, most countries witness a rising share of services in the total output. The exact cause of this shift and its implications for future growth is still not very well researched. The negligence of services as drivers of growth in the policy and research debate stems from the notion that services are associated with low productivity and are merely inputs in the production of goods. However, the mid 1990s saw two seemingly separate but related developments. First was the revolution in information and communication technology (ICT) and, second, rapid growth in the global forces often referred to as the 3Ts – technology, transportability, and tradability – with the advent of internet age. Both events had a profound impact on the nature, productivity, and tradability of services (Ghani and Kharas, 2010; Baumol,

> 1 The global value cross-border services exports in 2007 was $3.3 trillion, (20 percent of total world trade). However, the share of services rises to almost 50 percent if transactions are measured in terms of direct and indirect value added content—that is if measured in terms of processing of imported components into final products for export (Hubert Escaith 2008). Adding the sales of services by foreign affiliates of multinational firms, then the value of trade in services rises further. Data for fifteen OECD countries puts the value of such sales at some $1.5 trillion in 2007 (WTO 2009, Hoekman et al., 2010).

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