metadata: authors: 0: author: Borchert, Ingo
1: author: Mattoo, Aaditya
count: World
docna: 0: docna: The crisis-resilience of services trade
docty: Policy Research Working Paper
subtopic: Labor Markets,Export Competitiveness,International Trade and Trade Rules,Trade and Services,Transport Services
teratopic: Transport,Macroeconomics and Economic Growth,Information and Communication Technologies,International Economics and Trade
abstracts: cdata!: Much attention has focused on the impact
            of the current crisis on goods trade; hardly any on its
            impact on services trade. Using new trade data from the
            United States, and more aggregate data from other OECD
            countries, the authors show that services trade is
            weathering the current crisis much better than goods trade.
            As of February 2009, the value of US goods imports had
            declined year-on-year by 33 percent and the value of goods
            exports by 21 percent; services imports and exports each had
            declined by less than 7 percent. Within services,
            interesting patterns are emerging. Trade in goods-related
            transport services and crisis-related financial services has
            shrunk, as has expenditure on tourism abroad. But trade in a
            range of business, professional, and technical services is
            still increasing, with US exports growing even faster (at 10
            percent) than US imports (at 7 percent). Developing
            countries like India, which are relatively specialized in
            business process outsourcing and information technology
            services, have suffered much smaller declines in total
            exports to the United States than countries like Brazil and
            China and regions like Africa, which are specialized in
            exports of goods, transport services, or tourism services.
            On the basis of new evidence from Indian services exporters,
            the authors suggest that services trade is buoyant relative
            to goods trade for two reasons: demand for a range of traded
            services is less cyclical, and services trade and production
            are less dependent on external finance. Even though few
            explicitly protectionist measures have so far been taken in
            services, the changing political climate and the widening
            boundaries of the state in crisis countries may introduce a
            national bias in firms' procurement and location choices.
repnme: repnme: The crisis-resilience of services trade
display_title: The crisis-resilience of services trade
listing_relative_url: /research/2009/04/10497349/crisis-resilience-services-trade
topicv3: Transport m1326661 135,Trade m1326924 698,Trade in Services m1326928 780,Jobs m1503931 2670,Services Exports m1504156 2612
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Transport,Macroeconomics and Economic Growth,Information and Communication Technologies,International Economics and Trade
no_of_pages: 30
model_extractions: WPS4917 Policy ReseaRch WoRking PaPeR 4917 The Crisis-Resilience of Services Trade _Ingo Borchert Aaditya Mattoo_ The World Bank Development Research Group Trade Team April 2009
Policy ReseaRch WoRking PaPeR 4917

# **Abstract**

Much attention has focused on the impact of the current crisis on goods trade; hardly any on its impact on services trade. Using new trade data from the United States, and more aggregate data from other OECD countries, the authors show that services trade is weathering the current crisis much better than goods trade. As of February 2009, the value of US goods imports had declined year-onyear by 33 percent and the value of goods exports by 21 percent; services imports and exports each had declined by less than 7 percent. Within services, interesting patterns are emerging. Trade in goods-related transport services and crisis-related financial services has shrunk, as has expenditure on tourism abroad. But trade in a range of business, professional, and technical services is still increasing, with US exports growing even faster (at 10 percent) than US imports (at 7 percent). Developing countries like India, which are relatively specialized in business process outsourcing and information technology services, have suffered much smaller declines in total exports to the United States than countries like Brazil and China and regions like Africa, which are specialized in exports of goods, transport services, or tourism services. On the basis of new evidence from Indian services exporters, the authors suggest that services trade is buoyant relative to goods trade for two reasons: demand for a range of traded services is less cyclical, and services trade and production are less dependent on external finance. Even though few explicitly protectionist measures have so far been taken in services, the changing political climate and the widening boundaries of the state in crisis countries may introduce a national bias in firms’ procurement and location choices This paper—a product of the Trade Team, Development Research Group—is part of a larger effort in the department to improve our understanding of trade in services. Policy Research Working Papers are also posted on the Web at http://econ. worldbank.org. The authors may be contacted at iborchert@worldbank.org and amattoo@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **THE CRISIS-RESILIENCE OF SERVICES TRADE**

Ingo Borchert and Aaditya Mattoo* _Keywords_ : Services, trade, crisis _JEL Classification_ : F13, F14

* World Bank, 1818 H Street NW, Washington DC 20433. <u>iborchert@worldbank.org, amattoo@worldbank.org.  This paper is part of a World Bank research project on trade in services supported in</u> part by the governments of Norway, Sweden and the United Kingdom through the Multidonor Trust Fund for Trade and Development.  We are grateful to Bernard Hoekman for asking the interesting question and for providing valuable direction.  We would like to thank Pritam Banerjee, Olivier Cattaneo, Nora Dihel, Ana Fernandes, Caroline Freund, Leo Iacovone, Justin Yifu Lin, Will Martin, Richard Newfarmer, Çaglar Özden, Sebastian Saez, Arvind Subramanian and Randeep Sudan for valuable comments.  We also thank Raju Bhatnagar, NASSCOM’s Vice President BPO and Government Relations, Margrith Lütschg-Emmenegger, president of FIMBank plc, T.V. Mohandas Pai, Member of the Board and Director of Human Resources, Infosys, and Ganesh Natarajan, Chairman of NASSCOM, and, for discussing with us ongoing developments in services trade. The views contained in this paper are those of the authors and not necessarily those of the World Bank or any of the aforementioned individuals or institutions.
# **I. INTRODUCTION**

The current gloom and doom about goods trade has obscured the quiet resilience of services trade. Services account for over one-fifth of global cross-border trade, and for some countries such as India and the US close to a third of all exports. This paper uses data on cross-border trade in services from the United States released in March and April 2009 to show that while trade in goods has declined drastically, trade in some services has held up remarkably well (Figure 1).<sup>1</sup> The more aggregate data available for other OECD countries also suggest that services trade has suffered less from the crisis than goods trade.<sup>2</sup> Monthly US imports and exports of goods declined by about _one-third_ in value terms from peaks of $195 bn and $121 bn, respectively, in July 2008, to $122 bn and $85 bn, respectively, in February 2009.<sup>3</sup> The corresponding decline in services imports and exports was only by about _one-tenth_ , from $29 bn and $38 bn, respectively, in July 2008, to $26 bn and $33, respectively, in February 2009.<sup>4</sup> Figure 1: US Monthly Imports and Exports of Goods and Services, January 2006 – February 2009 <!-- Start of picture text --> 250,000<br>200,000<br>150,000<br>100,000<br>50,000<br>0<br>Goods Imports Services Imports<br>Goods Exports Services Exports<br>2006 Jan2006 Apr2006 Jul2006 Oct2007 Jan2007 Apr2007 Jul2007 Oct2008 Jan2008 Apr2008 Jul2008 Oct2009 Jan<br>USD million<br><!-- End of picture text --> Source: BEA, US International Trade in Goods and Services, millions of dollars, months seasonally adjusted.

> 1 This data also includes consumption of services abroad (in the category “travel”), but does not encompass sales through foreign affiliates or through the presence of foreign natural persons.  Recent data is not available for sales through affiliates and sales by natural persons are not properly measured (see European Commission et al. (2002) and Maurer et al. (2008)).

> 2 The US accounts for about one-fifth of imports and exports of all OECD countries.

> 3 Part of the decline in the value of goods imports could be due to the fall in commodity prices.  But note that US goods exports also declined over the last seven months by one-third.

> 4 In February 2009, the year-on-year decline in the value of goods imports was 33 percent; the decline in the value of services imports was only 7 percent.  US exports present a similar picture of year-on-year declines: a decline in goods exports by 21 percent by February; in services exports by 6.5 percent.

2
Within services trade, interesting patterns emerge. Imports and exports of goods-related services such as international transport have shrunk in the last quarter (year-on-year by about one-fifth) as has expenditure on tourism abroad (by about one-tenth), while imports of other private services have actually grown slightly. Within ‘other private services’, trade in financial services has also contracted in the last quarter (year-on-year imports by 12.5 percent and exports by an even higher 17 percent).

But trade in a range of other services is growing, with US exports growing even faster than US imports. This pattern is evident in insurance (imports by 3 percent, exports by 9 percent), telecommunications (imports by 2.5 percent, exports by 25 percent) and, in particular, a range of business, professional and technical services (imports by 7 percent and exports by 10 percent).

Overall exports to the US of developing countries which are relatively specialized in services, like India (38 percent share of services in total exports) have declined less than exports of countries and regions for which services are less important, such as Brazil (12 percent share), China (9 pecent share) and Africa (15 percent share). The contractions in their total exports (goods and services) to the United States in the fourth-quarter were: India (2.5 percent), Brazil (13 percent), China (9 percent), and Africa (36 percent). This relatively positive outlook is corroborated by Indian industry sources, which suggest that employment in the export-oriented IT and business process outsourcing services is expected to grow by about 5 percent (around 100,000 jobs) in 2009.

Based on new evidence from Indian services exporters, we find that services trade is buoyant for two reasons. First, on the supply side, services trade has been less affected by the crisisinduced scarcity of finance. Services trade, especially in electronically-delivered business services, needs trade finance less than goods trade. When external funds are needed, e.g. for working capital, small and large firms tend to rely on advance payments from clients and their ability to raise finance against orders placed. Moreover, receivables in business process outsourcing are fungible and easily factorized because they typically involve a short-term transaction, a buyer who is creditworthy, and disputes over the service rendered are rare. Generally, services-producing firms have even in normal times tended to be less dependent on external finance than goods production because they have limited tangible collateral. For example, two of India’s largest exporters of software and business-process services, Infosys and Tata Consultancy Services, have no external debt at all and rely completely on retained earnings for their operations.

Second, demand for a range of services seems to have contracted less than demand for goods. One reason is that services are not storable and so are less subject to the big declines in demand in downturns that affect durable goods like shoes and televisions. This is because many services suffer neither from the “vintage effect” – i.e. the willingness to wear an older pair of shoes or drive an older car – nor from the “inventory effect” – i.e. the fact that cuts in final demand translate into bigger immediate cuts in demand for factory output because of inventory adjustment. Another reason is that a larger part of international demand for services – e.g. outsourced back-office services - is less discretionary than demand for goods such as computers. This is both because many outsourced services (e.g. book-keeping) are 3
“necessities” for producers; demand for some of these services is unrelated to the scale of production; and a larger part of services trade seems to involve long-term relationships (e.g. because of relationship-specific investments by buyers and sellers). There are also signs that the crisis is itself generating new tasks to be outsourced, such as legal process outsourcing or debt processing, as well as creating pressure generally to reduce costs through outsourcing.<sup>5</sup> The relative buoyancy of services trade cannot be taken for granted. Over it too hangs the Damocles sword of protectionism. But protection is taking a subtle form, perhaps in deference to the invisibility of services and the fact that they are increasingly delivered electronically. First, explicit discrimination through preferential procurement seems at this stage less damaging than the implicit social and political disapproval of outsourcing. Developing country service exporters argue that it is the latter that has had a chilling effect on demand for their services. Similarly, the few visible explicit restrictions on employing or contracting foreign services providers in specific areas (e.g. financial services) are not as costly for both host and source as the increasing social and political aversion to immigration. In the longer term, subsidies to banks are probably less damaging than financial protectionism. The former are temporarily necessary to ensure the stability of the financial system. The latter seriously erode the case for openness. Inducing national banks to lend domestically in a crisis deprives developing countries in particular of capital when they most need it and greatly strengthens the case for financial self-sufficiency.

Section II describes the trends revealed by the US services trade data, and compares it with developments in other OECD countries for which more limited data is available. Section III suggests reasons for the resilience of services trade, drawing upon evidence from India. Section IV assesses the significance of protectionist measures affecting services trade. Section V concludes.

# **II. SERVICES TRADE DURING THE CRISIS**

In this section, we consider in turn the impact on US imports - in the aggregate and from specific trading partners, on US exports, on US affiliates trade, and on the trade of other OECD countries.

# **II.1 US Imports of Services**

Imports of services have proved much more resilient than imports of goods (as we saw in Figure 1). The upper panel of Figure 2 presents year-on-year growth rates of goods and services imports, respectively, on a monthly basis between January 2006 and February 2009. From mid-2008 onwards, the growth of imports of both goods and services started to decelerate, yet the downturn in merchandise trade was sharper. In February 2009, goods

> 5 Combinations of these factors may also lead to dynamic effects.  Say, the pressure to reduce costs during the crisis induces outsourcing.  Once a firm incurs sunk costs in establishing the new arrangement and relationship, it does not make sense to reverse the arrangement even after the crisis has passed.  The temporary shock might thus permanently ratchet up outsourcing activity.

4
imports had contracted by 33 percent compared to February 2008 while services imports had declined by only 7 percent.

5
<!-- Start of picture text --> SN<br>"<br>ae<br><!-- End of picture text -->
The contrast is even more striking when we look at the components of services imports (Figure 2, middle panel). It is no surprise to see imports of transportation services turn sharply negative (by 20 percent) given the contraction of international freight services. Interestingly, of the major components of commercial services, imports of “other private services” are still growing, albeit moderately (2 percent).

Figure 2 (bottom panel) breaks down “other private services” into its major components, namely financial, insurance, telecommunications, and business/professional/technical services. Again not surprisingly, given the financial origins of the current crisis, imports of financial services have shrunk drastically (by 13 percent). However, even in the last quarter of 2008, well into the crisis, growth rates of other services, i.e. telecommunications (2.5 percent), insurance (3 percent) and business, professional and technical services (7 percent), are still positive.

# **II.2 The Impact on US Trading Partners**

In general, the impact of the crisis on developing countries’ exports to the United States depends on the composition of their exports.<sup>6</sup> Figure 3 shows the relationship between the change in countries’ exports to the US during the crisis (i.e. between the fourth and third quarter of 2008) and the share of services in a country’s total exports. The vertical axis in the upper panel depicts the change in the value of total exports (goods plus services) whereas the vertical axis in the lower panel shows the change in the growth rate of total exports. In terms of both values and growth rates, exports of countries that are relatively specialized in services, like India (30 percent share of services in total exports to the US), have declined less than exports of countries and regions for which services are less important, such as Brazil (14 percent share), China (3 percent share) and Africa (5 percent share).<sup>7</sup> As the lower panel shows, the reductions in growth rates of their total exports (goods and services) to the United States in the fourth-quarter were: India (8 percentage points), Brazil (16 percentage points), China (26 percentage points), and Africa (35 percentage points). 8 As we have previously shown, it is in particular the category of other private services— which includes telecommunications and business process outsourcing services and excludes transport and travel—in which trade has continued to grow. In Annex 2, Figure A.5, we present the same analysis with a country’s share of ‘other private services’ in total exports on the horizontal axis. The relationship is similar, but the slope steeper and the correlation weaker than in Figure 3. The steeper slope reflects the fact that this more resilient class of services offers greater insulation against crisis-related reductions in exports. The weaker correlation reflects the fact that these more specific services represent a smaller share in overall exports.

> 6 For a more detailed view of country and region-level data, see Annex 2, Figure A.4 and Table A.1.

> 7 For countries’ shares of services in their exports and changes in exports, see Annex.

> 8 Even though it is primarily a commodity exporter, Argentina seems to have survived the fourth quarter contraction, but that is only because it had already suffered a significant contraction in the third quarter – because of the decline in commodity prices.  Brazil had a similar experience.

7
Figure 3: Change in the Value and Growth Rates of Exports to the US and Share of Services in Exports, Selected Countries and Regions <!-- Start of picture text --> ARG<br>IND<br>JPN FRA HKG<br>CHN MEX AsiaPacBRA TWNKORBEL GERSGPEuropeNLD AUS<br>GBR<br>ITA<br>SCAmerica<br>CAN<br>ZAF<br>MiddleEast<br>Africa<br>VEN<br>0 10 20 30 40 50<br>Pre-Crisis Share of All Services<br>in Total Exports (%)<br>Change in Export Value During Crisis<br>Fitted Values (slope = .42)<br>ARG<br>JPN BEL GERFRA NLD<br>HKG<br>IND<br>MEX<br>AsiaPacBRA TWNKOR ITA SGPEurope AUS<br>GBR<br>CANSCAmerica<br>CHN<br>Africa<br>ZAF<br>MiddleEast<br>VEN<br>0 10 20 30 40 50<br>Pre-Crisis Share of All Services<br>in Total Exports (%)<br>Change in Export Growth Rate During Crisis<br>Fitted Values (slope = .62)<br>10<br>0<br>-10<br>-20<br>-30<br>Change in Total Exports (%) -40<br>-50<br>0<br>-20<br>-40<br>Change in Total Export Growth Rate<br>-60<br><!-- End of picture text --> Source: BEA, US International Transactions Accounts Data, Tab.12: US International Transactions by Area, millions of dollars, not seasonally adjusted. The slope coefficient in the upper graph is significant at the 2 percent level, the one in the lower graph at the 1 percent level.

8
# **II.3 US Exports of Services**

The qualitative picture for United States’ services exports (Figure 4) resembles that for US imports (Figure 2).

Like imports, exports of services have proved much more resilient than exports of goods (as we saw in Figure 1). The upper panel of Figure 4 presents year-on-year growth rates of goods and services exports, respectively, on a monthly basis between January 2006 and February 2009. From mid-2008 onwards, the growth of exports of both goods and services started to decelerate, but the merchandise decline was precipitous. In February 2009, goods exports were 22 percent lower than in February 2008; decline of services exports amounted to 6.5 percent.

Within services (Figure 4, middle panel), exports of transport services declined (17 percent), as did expenditure by foreign tourists in the US (13 percent), but exports of private services increased marginally (0.7 percent). The most relevant sub-categories of other private services, as shown in the bottom panel, present an even starker contrast: in the last quarter 2008, US exports of financial services have contracted significantly (17 percent), but exports are growing in insurance (9 percent), telecommunications (25 percent), and business, professional, and technical services (10 percent), respectively.

9
<!-- Start of picture text --> ee<br>ae<br>ON<br>oS<br>OO<br>, MA<br> \ a ns<br><!-- End of picture text -->
# **II.4 Cross-Border Trade between Affiliated Firms**

A significant proportion of cross-border trade takes place between affiliated firms. Figure 5 provides an alternative breakdown of “other private services” into payment flows associated with services imports from affiliates and non-affiliates respectively.<sup>9</sup> Over the longer term, the growth of intra-corporate payment flows has generally been more volatile. This volatility may reflect in part the greater discretion firms normally have in reporting the value of flows between affiliates (in terms of both recording the flow and pricing it). However, during the crisis, intra-corporate flows have continued to grow at rates of about 10 percent per annum whereas the growth of arms-length payments has declined in each of the past three quarters and is now close to zero. The relative resilience of intra-corporate flows may reflect a greater sensitivity on the part of firms to maintaining employment in affiliated firms rather than in arms-length suppliers.

Figure 5: Payments from US Companies for Imports of Other Private Services to Affiliated and Non-Affiliated Entities, 2006 – 2008, Annual Growth Rates <!-- Start of picture text --> 50.0<br>40.0<br>30.0<br>20.0<br>10.0<br>0.0<br>-10.0<br>US parent to FA US to foreign unaffiliated<br>2006:I2006:II2006:III2006:IV2007:I2007:II2007:III2007:IV2008:I2008:II2008:III2008:IV<br>%<br><!-- End of picture text --> Source: BEA, US International Transactions Accounts Data, Table 3a: Private Services Transactions, breakdown by affiliation. Millions of dollars, months seasonally adjusted. 4th quarter 2008 preliminary data. “FA” denotes “foreign affiliate”.

# **II.5 Trade of Other OECD Countries**

The US accounts for 17 percent of all OECD imports of services and 20 percent of all OECD exports of services. How far does its experience reflect that of the OECD countries more generally? Trade data for the fourth quarter of 2008 have been released by a number of other OECD countries as well as two non-OECD countries (Brazil and Indonesia). These data are only available at an aggregate level, i.e. for services trade as a whole and not for its subcomponents. Figure 6 shows for each country the quarterly growth rate of goods imports

> 9 Figure 5 does not present the time services for payments and receipts involving non-US parent companies.

11
(on the vertical axis) and services imports (on the horizontal axis). Both rates are negative for all countries – except for Japan for which the services import growth is positive. But interestingly, imports of goods are contracting faster for all countries except Australia and Poland. Until more detailed data become available, we can only conclude that evidence from other OECD countries does not contradict the picture of the relative resilience of services trade emerging from US data.<sup>10</sup> Figure 6: Growth of Goods and Services Imports of 29 OECD and 2 Non-OECD Countries, Quarterly Growth Rates <!-- Start of picture text --> Japan<br>Brazil<br>Canada<br>MexicoIndonesiaSwitzerlandUnited States<br>Australia New ZealandEuro areaFranceGermany Italy<br>PolandHungaryNetherlandsUnited KingdomCzech RepublicPortugalSpainSlovak RepublicDenmark<br>Finland KoreaGreece Luxembourg IrelandBelgium<br>Sweden<br>Norway<br>Turkey<br>-30 -20 -10 0 10<br>Growth Rate Services Imports<br>Quarterly Growth Rates Imports<br>45 degree line<br>10<br>0<br>-10<br>-20<br>Growth Rate Goods Imports<br>-30<br><!-- End of picture text --> Source: OECD, Balance of Payments Statistics, Trade in Services by Partner Country, millions of dollars, seasonally adjusted. Iceland has been dropped.

# **III. UNDERSTANDING THE RESILIENCE:  THE EXPERIENCE OF INDIAN SERVICES EXPORTERS**

This section provides a new perspective on the crisis from the point of view of services exporters. Specifically, we explore the impact of the crisis on Indian companies that export information technology (IT) services or IT-enabled services (ITES) (also referred to as business process outsourcing (BPO)).

At first glance, two aspects of the current crisis do not bode well for Indian services firms’ prospects. First, the epicenter of the crisis, the US accounts for 51 percent of India’s services exports to the OECD countries, and reportedly an even larger 60% share of its exports of IT

> 10 For another assessment of OECD trade during the crisis, see Araujo and Gonnard (2009).

12
and BPO services.<sup>11</sup> The U.K., also affected by the crisis, accounts for a further 21 percent of India’s OECD exports. Second, from a sectoral point of view, financial services and insurance remain the biggest of all markets which Indian services exporters serve.

However, even though the financial turmoil is clearly hurting the industry, Indian exporters have weathered the crisis (much) better than companies engaged in merchandise trade. Growth rates of sales and employment are expected to be cut in half, but this still leaves the sector with growth rates that would be considered buoyant in many manufacturing sectors. Instead of slashing jobs, the industry continues to remain a net hirer. In absolute terms, around 100-110,000 new jobs will be created in 2009, as compared to 223,000 in 2008. Since a counterfactual 160,000 jobs would conceivably have been added in the absence of the current crises, the employment dent left by the financial crisis amounts to about one-third of new job additions lost.

The muted impact at the industry level does hide considerable heterogeneity at the firm level, in terms of size as well as business field (IT versus BPO). Moreover, uncertainty about the consequences for outsourcing providers of growing demand for protectionism in the US and elsewhere further cloud Indian exporters’ prospects.

# **III.1 Impact on Demand for Services Exports**

India’s IT and ITES sector is heavily geared towards foreign markets. In fiscal year 2008, roughly three-quarters (or $40bn) of the sector’s output was destined for exports.<sup>12</sup> The industry’s increasing diversification in terms of geographic base, industries served, and the portfolio of services offered, has to some extent cushioned against the negative demand shock that originated mainly from the US economy. Industry sources expect that domestic sales, which are currently level about $11bn and account for only a quarter of total sales, may compensate for the loss in export demand only to a limited extent.

Nevertheless, as far as the IT export market is concerned, the slump in demand clearly shows up in export figures: while sales grew by some 24% during the first half of the fiscal year 2008 (Apr-Sep), growth slowed down to 12% in the second half (Oct-Mar), so that overall growth is expected to be 16-17%. In the ITES sector, growth in 2008 fiscal year is widely expected to be somewhat higher at 20-22%. No significant growth is expected in 2009, and average growth over the next two years is likely to fall to around 15% - which is one-half of last decade’s annual average growth rate of 30%.

> 11 Even though India’s share in US services imports has more than doubled since 1999, it still accounts for less than 2 percent of US services imports.

> 12 Estimates in this section are based on interviews with Indian industry and industry association sources and are not comparable with the estimates presented in Section II based on US import data.  There are significant differences between Indian and US estimates of India’s exports, particularly of the key category, business, professional and technical services (see e.g. US Government Accountability Office, 2005).  Among the reasons is that for this category of services the Indian data, unlike the US data, includes earnings of temporary Indian workers resident in the United States, exports between affiliated firms, as well as sales made to US-owned affiliates located outside the US.

13
According to industry sources, two factors are contributing to the recent slow-down. First, the negative demand shock is being felt particularly in the case of discretionary IT projects. Secondly, there has been a general mood swing against outsourcing in crisis-hit countries, particularly in the US, which is discussed in Section IV.

As far as demand contraction is concerned, there are significant differences between the IT and the ITES subsector. Indian exporters’ business is more severely affected in IT services, where about 60% of sales are of a discretionary nature, i.e. projects can be withdrawn, or not contracted at all, in times of economic hardship. ITES exports are apparently much less discretionary, with an estimated 70-80% of business characterized as non-discretionary. These latter types of services exports are likely to be more insulated from negative demand shocks because they involve activities that must be carried on even during the current crisis. For instance, in health care a system upgrading project (IT) is discretionary whereas the processing of claims (ITES) has to continue. In banking, a project to realize end-to-end automation of payments (IT) is discretionary even though it might be cost saving, whereas transaction processing is non-discretionary. Figure 7 depicts the growing importance of ITES in the sector’s overall export performance.

Figure 7: Composition of India’s IT and ITES Exports, 2000/01 – 2008/09 <!-- Start of picture text --> 50000<br>40000<br>30000<br>20000<br>10000<br>0<br>IT ITES/BPO<br>2000/01 2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 2008/09<br>USD million<br><!-- End of picture text --> Source: Reserve Bank of India, Monthly Bulletin March 2009, and National Association of Software and Service Companies (NASSCOM). Time periods are fiscal years which start in April.

Another reason for IT to be affected differently from ITES is because of differences between the two segments in the types of contractual relations. In IT, only about 25% of foreign trade takes place between captives (i.e. affiliates) and their parents, whereas in ITES this share stands at some 40-45%. Most of the large financial firms, e.g. JP Morgan, have traditionally conducted their outsourcing business via captives. As demand contracts, Indian firms are apparently also being asked by buyers to reduce prices. The ensuing margin squeeze is likely to be greater in IT services where a larger portion of projects is conducted as arms-length trade.

14
In contrast to the negative effects of the recession, IT and BPO exporters may stand to gain from the current crisis as firms in industrialized countries are under increased pressure to cut costs. The financial dimensions of the crisis seems to have increased demand for certain types of outsourced tasks, such as legal process outsourcing or activities related to debt processing. But in general cost pressures have so far tended to manifest themselves in greater demand for outsourcing in core BPO areas rather than to entice companies to venture into new “context” areas in which outsourcing has been less common. In traditional BPO areas, outsourcing options are being pursued more vigorously both with captive firms and at armslength. There has also been a discernable acceleration in the speed with which outsourcing decisions are being taken. While decisions were being taken within 9-12 months before the crisis, the decision time has now shrunk to 6 months.

The impact of parental distress in sectors such as finance and automobiles is less clear. Industry officials indicate that an increased quantum of work is being done offshore in banking. But the impact is not uniform across firms. For example, in insurance, while AIG may have reduced the amount of outsourcing, AXA has not. In the automotive industry, outsourcing has been significantly reduced (by some 50%) as many operations, e.g. warranty claims or customer care, are discretionary. Thus, experiences of, and choices made by, one firm are not necessarily representative of the industry at large.

# **III.2 Impact on Employment**

The Indian IT and ITES sectors directly employ some 2.2 million people, of which 1.7 million are associated with services exports. The number of people indirectly employed – i.e. providing auxiliary services - is a factor of 3.5 to 4 greater than the directly employed, or an estimated 7-8 million. As in the case of revenues, the employment effects of the crisis largely take the form of reductions in growth rates, rather than layoffs, and a more intensive use of the existing workforce.

The latter effect leads to growth in employment being more muted than growth in sales. In 2009, while sales are still expected to grow by a rate in excess of 10%, employment is projected to expand by 5-6%. As noted above, cast in absolute numbers this means that around 100-110,000 new jobs will be created in 2009 (in comparison: 223,000 jobs were created in 2008). According to industry estimates, in the absence of the current crises a counterfactual 160,000 jobs would conceivably have been added, thus the employment dent left by the financial crisis amounts to about one-third of new jobs not created. There has always been a high level of attrition in the industry and companies are using the crisis to more aggressively “cull” non-performers.

This assessment provides us with some sense of direct employment effects. However, it is hard to assess the impact on indirect employment upstream business, e.g. in the upstream education sector that caters to the Indian services exports industry. These figures should, therefore, be viewed as a rather conservative lower bound.

At the same time, companies are seeking to maximize the utilization of their currently employed labor force through at least two channels. First, firms are pushing up utilization of their existing labor force, e.g. by eliminating reserves such as the 12-18% of labor-time that previously lay idle (workers were not engaged in billable activity but waiting to be 15
employed). This reserve has now come down to 5-8%. Steps such as cutting breaks between login and logout have led to a further increase in productivity of about 6-8%. Second, there is a shift in the service line portfolio towards higher value added services, which likewise leads to increased labor productivity. In general, the Indian workforce is relatively young and skilled - the average age of an Infosys worker is 26 and most have engineering degrees. Workers are reported to exhibit a high degree of adaptability and flexibility in the crisis, reflected for example in the willingness to work on multiple tasks for longer hours.

# **III.3 Limited Dependence on External Finance**

The previous section suggests that the unfolding financial crisis affects Indian services exporters through adverse demand shocks. In stark contrast to the manufacturing sector, tightening credit conditions are not constraining the production and export of services, for three reasons. First, the fact that many services are delivered electronically across borders, as digitized products, and occasionally through the movement of individuals to provide consulting onsite, obviates the need for traditional trade finance, the deteriorating availability of which has hurt goods trade.

Secondly, to the extent that external funds are needed, advance payments and factoring continue to help meet financing needs. The former is important in an industry that produces customized products with significant relationship-specific investments by the service supplier. The latter instrument is available to small and large firms alike, even though the discount margins for large firms may be smaller. Even before turning receivables into cash, many Indian IT firms are able to leverage contracts in order to pre-finance working capital at the time when the order is placed provided the contract involves a recognized party or government.

Importantly, receivables in the BPO industry are fungible and easily factorized because they typically involve a short-term transaction, a buyer who is highly creditworthy, and disputes over the service rendered are rare. The latter feature makes the receivables a negotiable, irrevocable instrument that is detached from the underlying transaction. Since factoring as a trade credit instrument is on the rise, at least as compared to conventional documentary credit, reliance on this particular form of credit puts BPO services a step ahead of other sectors, notably manufacturing.

The third reason for the sector’s tenacity is found in its relative independence from debt finance. Indeed, the financial structure of IT and ITES firms is in general characterized by low leverage with little, if any, debt. While access to external finance is of some importance, working capital is predominately financed by retained earnings or, for start-ups, through venture capital.

A brief glance at Infosys, one of the largest BPO services exporters and a leader in the industry illustrates the point of minimal financial dependence. With over 100,000 employees, Infosys is debt-free. On the cost side, software development expenses are the single most important item, eating up 57% of gross revenues, the overwhelming part of which consists of salaries. In fact, services production involves few intermediate inputs so that 86% of revenue is value added. It may seem that under these circumstances financing working capital poses quite a challenge as nothing tangible is produced that could be used as 16
collateral. But in the case of Infosys, internal cash flows are sufficient to cover working capital, capital expenditure, investment in subsidiaries, dividends, and still leave a surplus. While the excellent financial condition of Infosys might not be fully representative, Tata Consultancy Services (TCS), another large BPO supplier, likewise does not carry any debt on its balance sheet. At the same time, a fair amount of venture capital (some $500m) seems to be available for nascent firms It seems likely that the low dependence on debt finance—which works to the benefit of services firms at a time when sources of external credit dry up—is the result of the fact that services producing firms have to stand on their own feet even in “normal” times. Software development services, for instance, require potentially large upfront expenses which must be financed until payment can finally be collected, and in addition such products typically carry a high degree of uncertainty regarding future profits. With no tangible collateral on hand, financing of working capital is a generic problem of services suppliers that existed well before the current credit crisis. Developing a financial strategy that relies largely on retained earnings (or initially on venture capital) is a consequence of services providers’ inherent difficulty in accessing commercial credit.

Overall, industry officials do not consider access to finance as a major concern for Indian services exporters. The way the crisis is affecting the financial position of services suppliers is by potentially squeezing their margins. To the extent that the length of the working capital cycle is elongated, the cost of funds is increasing which in turn reduces margins.

There is also evidence that the crisis has prompted some changes in payment patterns. As a means of financing, advance payments used to be a common feature in the industry. Apparently, prior to the crisis hardly any firm providing IT and ITES would have considered an outsourcing project without a down payment. The unfolding crisis and the associated slump in demand are eroding Indian exporters’ bargaining position so that some deferral of fees and invoices is increasingly observed.

The relatively comfortable situation of IT and ITES exporters does not necessarily represent the situation of all services firms, as matters are highly specific to individual sectors. Agents providing transportation services, for example, face more or less the same problems in the crisis as do manufacturing firms. Quite apart from the slump in demand, freight charges are usually paid in advance and are financed as part of the trade credit package. Therefore the collapse of trade credit is hitting transport agents as hard as it affects merchandise exporters.

# **IV. PROTECTIONISM**

Services industry sources in developing countries suggest that a bigger problem than any explicit restrictions is the general mood of protectionism emerging in crisis-hit countries. This mood has not produced visible restrictions but generated increasingly strong implicit political pressure to retain jobs domestically. While the negative demand shock can to some extent be quantified, evaluating the effect of the incipient protectionist sentiment is harder. Consider two examples of explicit restrictions drawn from the United States, the market on which this paper has focused and which, because of its size and openness to cross-border trade in services, is of greatest significance to services exporters like India.

17
In light of the Buy American provisions in recent US legislation, it is instructive to recall the history of past sub-federal initiatives that sought to promote onshore employment. For instance, in the years 2001-02 New Jersey drafted legislation for preferential procurement, including stipulations that work was to be done by firms with US employees rather than firms that outsourced. However, the bill was progressively diluted as it passed through the legislative process. To begin with, the Act would only apply to government funded projects, thereby excluding any private sector financed projects. Moreover, in case of a cost differential between potential providers exceeding a certain percentage (approximately 1520%) a waiver would be automatically granted. These modifications rendered the Act ultimately ineffectual, and the New Jersey experience seems to represent the fate of several similar legislative projects in other US states. The apparent popularity of such measures notwithstanding, there appears to be a sizable US business constituency that would potentially be hurt by such measures, as reflected in the recent letter 150 US companies sent to President Obama in which they caution against the Buy American initiative.

Contrast this experience with the following example of how firms’ choices are being influenced by the change in political mood. On April 6, 2009, Sallie Mae, a company which manages $180 billion in education loans and has 10 million student and parent customers, announced plans to move 2,000 overseas jobs back to the United States from India and the Philippines, reversing a cost-savings measure the company took a year ago.<sup>13</sup> The company said it plans to fill jobs, including positions in call centers, information technology and operations, in the United States over the next 18 months. The projected cost is about $35 million annually because of higher labor expenses. The Sallie Mae chief executive Albert L. Lord was quoted as saying: "It's the right thing to do. The value of a company's franchise is essentially measured in financial terms, but there are a lot of values in a company that relate to the long-term value of a franchise. It's a wise investment in the company's future...It was a tough decision to move these jobs overseas. It was a lot easier to make the decision to bring them back." Rep. Paul E. Kanjorski (Democrat from Pennsylvania), who’s Wilkes-Barre district will receive 600 new Sallie Mae jobs was quoted as saying: “It's a patriotic act. It sends a great message to corporate America to think as deeply as you can." In addition to the changing political climate, a related concern is the widening boundary of the state as a result of increased government ownership of firms during the crisis. The US Government has already spent $245 bn under the Capital Purchase Program (CPP) to hold preferred stocks in more than 200 financial companies. Particularly large investments have been made in the financial giants, Citigroup and Bank of America, under the Targeted Investment Program and Asset Guarantee Program, and on AIG under the Systemically Significant Failing Institutions Program. General Motors and Chrysler have received $30 bn under the Automotive Industry Financing Program and the Automotive Supplier Support Program. The worry, for which there is as yet no concrete basis, is that state ownership will induce a national bias in firms’ choices on procurement and location of economic activity.

Another example of explicit restrictions is the provision in the recent US stimulus bill making it difficult for financial institutions that have received taxpayers’ funds to hire

> 13 SLM to Transfer Overseas Jobs to US: Reston Student Lender to Move 2,000 Workers Out of Asia, by Thomas Heath in the Washington Post, April 7, 2009.

18
specialty occupation (H-1B) visa holders if they have recently made US workers redundant. Given the binding aggregate quota on H-1B visas, a restriction on employment in a particular sector probably has limited impact, other than on foreign workers with skills that are specific to the restricted sectors. Thus the restrictions on employing or contracting foreign services providers in specific areas (e.g. financial services) are not as costly for both host and source as the increasing social and political aversion to immigration of service providers and the possibility of retaliatory restrictions. As Lloyd Blankfein, the chief executive of Goldman Sachs warned, the company had 200 people in the US on H-1B visas but also 2000 employees who worked overseas but paid US taxes; the latter could be the target of retaliatory measures by other governments.<sup>14</sup> Finally, in the longer term, subsidies to banks are probably less damaging than financial protectionism.<sup>15</sup> The former are temporarily necessary to ensure the stability of the financial system. The latter seriously erode the case for openness. Inducing national banks to lend domestically in a crisis deprives developing countries in particular of capital when they most need it and greatly strengthens the case for financial self-sufficiency.

# **V. CONCLUSION**

Using new trade data from the United States, we show that services trade is weathering the current crisis much better than goods trade. The currently available evidence from other OECD countries does not contradict this picture. Particularly striking is the continued growth of trade in a range of business, professional, and technical services. We find that developing countries like India, which are relatively specialized in business process outsourcing and information technology services, have suffered much smaller declines in total exports to the United States than countries like Brazil and China and regions like Africa which are specialized in exports of goods, transport services or tourism services.

A key area for future research is to understand the reasons for the resilience of services trade. One possibility is that this resilience reflects delayed adjustment, both domestically and internationally. While some services industries like construction are affected more quickly in a recession, other services industries tend to adjust more slowly.<sup>16</sup> Alternatively, as we have conjectured, resilience could be a consequence of certain features of services or services trade itself: demand for a range of traded services is less cyclical, and services trade and production are less dependent on external finance. We clearly need more thorough investigation of these hypotheses.

We have also argued that even though few protectionist measures have so far been taken in services, the growing political and social aversion to outsourcing is a threat to trade. This

> 14 Francesco Guerrera, “Blankfein attacks bankers’ pay,” Financial Times, April 8, 2009.

> 15 See, for example, Anthony Faiola and Mary Jordan, “British Bank To the World Takes Its Cash Back Home: Battered RBS Caught In Protectionist Storm,” Washington Post, March 28, 2009.

> 16 See, for example, Jiang et al. (2009).  It is also possible that payment for services occurs with a lag so that slackening demand is only gradually reflected in measured payments.

19
aversion is obscuring the economic stake that all countries have in open global services markets. While developing countries like India have seen rapid export growth, by far the largest exporters of these services are the US and the countries of the European Union. The EU and US account for 65 percent of world services exports; China and India for 6 percent.<sup>17</sup> The US and EU have both consistently run a huge annual surplus on services trade, currently nearly $160 billion for the US and $220 billion for the EU countries. While US services imports from India and China have indeed grown to around $22 billion in 2008, US exports to these countries have expanded even faster, to over $26 billion. Even during the crisis US exports of key services are growing faster than its imports.

The US and EU have been powerful advocates of open services markets all over the world. Many developing countries have begun to reform their markets for communications, transport, financial, distribution and other business services. A retreat from openness in services in industrial countries could undermine reform efforts in developing countries, and even trigger a costly spiral of retaliatory protection.

> 17 Data in this paragraph is from the World Trade Organization.

20