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Ethiopia Economic Update: The inescapable manufacturing-services nexus

Ethiopia Economic Update: The inescapable manufacturing-services nexus
Photo credit: UN | Eskinder Debebe

16 May 2018

Services & Manufacturing Linkages: Exploring the Potential of Distribution Services

This Ethiopia Economic Update focuses on the connection between services and manufacturing, to help advance the government’s export development agenda. Although the importance of services for development is widely recognized, the role of services, tradable and non-tradable, in growth and structural transformation is generally less understood.

Services not only offer promising opportunities for export diversification, but also are key inputs in the production of most goods, for export and domestic consumption. Services imports are equally important, as they can improve the availability and quality of services through increased competition, better technologies, and access to foreign capital. This, in turn, can have a strong impact on the domestic business environment and lead to productivity increases through broader access to essential services inputs.

A dynamic services sector is a necessary condition for manufacturing and agroprocessing to thrive. Access to quality services as inputs to production is important for manufacturing performance. Lack of quality services as inputs can impede the emergence of a competitive manufacturing sector, which matters for the quality and value addition of goods. Manufacturing and agroprocessing cannot be competitive without accessing good quality and varied inputs from the services sectors. At this stage, however, Ethiopia seems to lack adequate access to necessary services inputs, such as finance, electricity, and water, as evidenced by several studies.

The objective of this Economic Update is to invigorate and deepen the discussion about the role of services as tradable activities, and as intermediate inputs in Ethiopia. The analysis is conducted in the context of the debate on growth and structural transformation in Ethiopia. World Bank (2015) shows that Ethiopia did not follow the conventional path of economic development through export-oriented industrialization, with workers moving from agriculture to high-productivity manufacturing.

The analysis contrasted this “premature deindustrialization,” characterized by a shift of labor from agriculture to services, with the potential of services becoming the new growth escalator for Ethiopia. The report concluded that rather than following one approach or another, Ethiopia would need to move forward across all sectors, focusing on agricultural productivity improvements, manufacturing growth to support the strategy of industrialization, and development of services.

At the government’s request, emphasis will be placed on distribution services, with individual case studies on the role of distribution services as inputs in the dairy, teff, sesame, and textiles value chains complementing the analysis.

Setting the Stage: Services in Ethiopia’s Economy

Services are a large and dynamic sector, but manufacturing remains a relatively small and stagnant part of Ethiopia’s economy. As shown in World Bank (2015), “Ethiopia’s Great Run,” the services sector was one of the driving forces behind the country’s growth acceleration. Recent data confirm that services continue to contribute considerably to economic growth and structural change. Services remain not only the largest sector in economic output, accounting for 41 percent of GDP in 2016, they also accounted for about 50 percent of economic growth over the past decade.

Over the past years, Ethiopia’s output more than tripled in real terms, taking over agriculture as the sector contributing the most to GDP.18 Since 2005, the sectoral drivers of growth have shifted further toward services, and more recently, industry. However, as noted in World Bank (2015), the recent rise of industry is due to a construction boom rather than being driven by a rise in the manufacturing sector, which has been largely stagnant at about 4 percent of GDP.

Although the structure of output shifted from agriculture toward services, the corresponding employment shift was modest. Despite the shift of output from agriculture to services, agriculture continued to dominate employment, although its employment share declined from 80.2 to 77.3 percent between 2005 and 2013. Although workers moved mainly into services (1.8 percentage points), Ethiopia’s services sector still absorbs only a small share of the population. In high-income countries, where services tend to explain the largest share of GDP, compared with agriculture and manufacturing, services employ 74 percent of the workforce on average (40 percent in upper-middle-income countries and 33 percent in lower-middle-income countries).

By contrast, in Ethiopia, in 2005 the services sector employed only 14.7 percent of the workforce even if it accounted for about 40 percent of value added,and in 2013 it was estimated to employ about 20 percent of the workforce. This share lies significantly below the average for countries at similar levels of development with a similar share of services in GDP, and is lower than all comparators.

Fast labor productivity growth in services may explain the gap between the composition of employment and output changes. Labor productivity in most services grew much faster than in agriculture and manufacturing, pointing once again to the dynamism of services. Labor productivity levels are the highest in sectors such as distribution (commerce), finance, utilities, mining, and transport, and lowest in agriculture and manufacturing. For instance, labor productivity in distribution was twice as high as in manufacturing and construction.

Distribution (or commerce), other services, and the public sector are the most important services subsectors for services output and employment in Ethiopia. These three sectors account jointly for 85 percent of sector value added and 92 percent of services jobs. Specifically, each sector accounts for roughly a half, a quarter, and a fifth, respectively, of value added and jobs in the services sector.

The remaining services sectors are transport (10 percent of services output and 6 percent of services jobs) and finance (5 percent of services output and 2 percent of services jobs). Output shares have hardly changed over time, although the employment shares have increased in “other services” and public services and declined in commerce.

A striking feature of the Ethiopian services sector is its significant role as an exporting branch of the economy. Not only did services exports account for more than 50 percent of Ethiopia’s total exports between 2005 and 2015, but the share of services exports in the sector’s output (fluctuating between 17 and 26 percent over the past decade) was comparable to the export-to- output ratio of Ethiopia’s traditional export products.

For example, Taffesse and Ferede (2004) reveal that in 2000 the “other services” sector’s exports-to-output ratio was marginally higher than that of the “traditional agricultural exportables” sector, which includes tea, flowers, fruits, and vegetables. Furthermore, despite relatively underdeveloped infrastructure, Ethiopia’s services trade has registered dynamic growth rates over the past 10 years. Recent data reveal a compound annual growth rate for services exports of 16 percent over 2011-13.

Services exports and imports are higher than expected from an average country at Ethiopia’s level of development. A cross-country regression based on the International Monetary Fund Balance of Payments Statistics shows a positive picture, indicating that Ethiopia’s services exports were slightly higher than expected for an average country at its level of development.

It is important to point out that although exports of services are critical to the efficient functioning of an economy, services imports are equally important. Imported services, especially from developed countries, often enhance the total factor productivity of domestic firms. Ethiopia seems to be taking advantage of cheaper and higher quality services from abroad. Ethiopia’s services imports are again higher than what would be expected for a country at its level of development.

Ethiopia’s exports and imports are concentrated heavily in traditional services activities; the country’s modern services exports remain among the lowest of its comparators). “Modern services” include communication, banking, insurance, business, and remote access services; transcription of medical records; call centers; and education.

These services differ from “traditional services,” such as transport or travel, which demand face-to-face interaction. In addition to being important inputs into production, modern services exhibit higher productivity and generate high-skilled and better-paid jobs. However, many modern services sectors have relatively low employment intensity and require higher educational levels.

Ethiopia’s exports and imports of traditional services as a share of GDP reached 7 percent in 2010-12, significantly overperforming comparator countries (except Tanzania and Kenya) and other countries at a similar level of development. Instead, Ethiopia significantly underperforms in modern services exports and imports, which measured close to 2 percent of GDP in 2010-12.

The expansion of Ethiopia’s services exports was mainly driven by transport and travel. Jointly, they accounted for 90 percent of total services exports in 2012, up from 75 percent in 2002. This is attributed to Ethiopian Airlines, which is Ethiopia’s largest export earner (three times as big as coffee) and accounts for 60 percent of Ethiopia’s services sector.

Ethiopia’s services export structure is very similar to that of Zambia or Kenya, with high shares of transport and travel. It contrasts with that of Korea, a substantially more developed economy, where, even if transport is one of the largest subsectors, modern services such as insurance play an important role. Modern services exports have been growing slower and inconsistently for some sectors, including financial and other business services. China and Korea, as well as Tanzania and Uganda, have been successful in exporting other business services.

Although important, the contributions of services to GDP and gross trade data ignore the links that services have with other sectors of the economy. Indicators such as forward and backward linkages, gross exports, direct value-added exports, and total value-added exports can be used to assess the role of services in the domestic economy and in relation to international trade.

Linkages exist primarily with traditional rather than modern services, with distribution services, such as wholesale and retail activities, seemingly the most important services inputs for manufacturing production in Ethiopia. The structure of services-manufacturing linkages in Ethiopia’s domestic economy is very similar to that observed in its exports. The following key findings emerge from the linkages analysis:

  • The most important services inputs for manufacturing production in 2011 were distribution and trade, transport, and business and information and communications technology (ICT). These three sectors combined accounted for more than 90 percent of all intermediate services inputs for manufacturing production; 60 percent is from distribution and trade services alone.

  • Although, in general, manufacturing in Ethiopia uses few modern services as inputs, business and ICT services are an exception. Business and ICT services represent about 20 percent of total services inputs in manufacturing in Ethiopia. Exporting firms appear to be far ahead of non-exporting firms in adopting modern business processes.

  • The linkages between financial services and manufacturing are particularly weak. Access to finance has been flagged as a serious constraint in Ethiopia. In 2011, financial services represented only about 3 percent of total services inputs in manufacturing. The percentage of investment that is financed through firms’ own funds, or the ratio of collateral to the total loan, is very high in Ethiopia, suggesting difficulties in access to finance. This is not an issue of demand, but one of supply; the Government of Ethiopia operates a rationing scheme whereby credit is allocated to the highest need (public investment, export priority sector, critical imports, and others). The negative real interest rate leads to excess demand and quantity rationing, such that many firms are completely excluded from access to finance.

Distribution services are the most important input for 11 of 14 manufacturing sectors. Key findings based on a disaggregated analysis by manufacturing sector reveal that distribution services continue to be the most important services input for nearly all of Ethiopia’s manufacturing activities except paper and publishing and beverages and tobacco). When considering all inputs (not just services), distribution services are the most important input for 11 of 14 manufacturing sectors, and in nine manufacturing sectors distribution services contribute more value added than the manufacturing sector directly contributes.

Source World Bank
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Date 16 May 2018
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