Why least developed countries are switching to ‘services-based’ economies

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Brendan Vickers, Adviser and Head, International Trade Policy, Commonwealth Secretariat, Salamat Ali, International Trade Economist, The Commonwealth Secretariat & Neil Balchin, Economic Adviser – Trade Policy Analysis, The Commonwealth Secretariat

• Cross-sectoral labour movements during the Istanbul Programme of Action highlight transformation patterns and growth drivers in Least Developed Countries.
• Policies aimed at enhancing workforce skills are key to ensure growth.
• Least Developed Countries need more support to grow their economies, especially services and tackle the digital divide.

Least Developed Countries (LDCs) have historically faced various binding constraints to their sustainable development. These range from low productivity and limited capacity in manufacturing and other productive sectors, to a lack of economic diversification, high levels of dependence on commodities and minerals, low investment rates and limited government capacity to implement growth-oriented structural policies.

Rarely has a country evolved from poor to rich without sustained structural economic transformation from an agrarian or resource-based economy towards an industrial or service-based economy. For this reason, the Istanbul Programme of Action (IPoA), which ran from 2011-2020, prioritised the building and diversifying of productive capacity in LDCs.

Transformation patterns and drivers in LDCs

A comparison of cross-sectoral movements of labour from the start of the IPoA to 2019 reveals three economic transformation patterns: 27 LDCs saw labour move out of agriculture and into both industry and services; 17 LDCs underwent a service-driven transformation, and two LDCs saw an increase in the relative contribution of agriculture along with declining shares of industry and services (Figure 1).

Figure 1: Patterns of structural transformation in LDCs

While most LDCs failed to significantly increase their productive capacity and diversify their economies during the IPoA period, some managed to achieve encouraging levels of structural transformation. Rwanda and Cambodia stand out in industry- and service-led transformation, while Burkina Faso and Mali led the way in service-driven transformation (Figure 2).

Figure 2: Comparing LDCs’ structural transformation patterns from 2011-2019

Understanding the transformers

Cambodia presents a compelling case of industry- and services-driven transformation, reflected in a large decline in the share of agriculture value added (VA) in gross domestic product (GDP) in favour of industry.

Apparel exports have contributed to a significant rise in manufacturing activities in Cambodia, helping to transform the country’s economic structure while also boosting access to the global clothing market.

Alongside Lao People’s Democratic Republic (7.1%), Cambodia (7.2%) was the only other LDC to achieve the annual growth target of 7% per annum set under the IPoA. Cambodia’s strong focus on infrastructure development underpins this growth.

Figure 3: Changes in economic complexity and labour productivity during the IPoA

Rwanda has mostly seen services-driven transformation, underpinned by increasing digitalisation. The country has emerged as a champion for digitally led development in Africa, and its innovative use of digital technologies has helped advance economic and social development priorities while also facilitating trade.

Burkina Faso and Mali stand out among the services-driven transformers. Yet these two countries registered contrasting patterns of sectoral value addition during the IPoA. The share of services in total VA rose in Burkina Faso but declined in Mali. Employment seems to be moving into services in Mali, but this shift is not reflected in a higher contribution to VA.

This means that workers are moving into low-value, low productivity services. This is a worrisome trend for economic transformation and fits the premature de-industrialisation narrative. In turn, the share of agricultural VA declined in Burkina Faso but increased in Mali. The rising share of agriculture in total VA in Mali could also indicate that agricultural productivity has improved: relatively fewer workers are employed in the sector but the value of their output is increasing, mainly due to the mechanisation of agriculture.

In the two economies at the bottom of the structural transformation ladder, Uganda and Yemen, apart from some growth in the industry share in Uganda, the shares of VA seem to be falling across all three broad sectors, which collectively account for the bulk of total VA. In Yemen – a fragile state – governance issues, compounded by economic and political instability and armed conflicts, have brought the economy to the verge of collapse.

The differences between the leading transformers and those LDCs with little or no change are evident in variation in the complexity of their production and in aggregate labour productivity growth rates (Figure 3). Economic Complexity Index values improved in the countries that underwent industry- and/or services-driven transformation but declined in Uganda and Yemen.

Similarly, labour productivity growth was positive for five LDCs except for Yemen. As increasing aggregate labour productivity is a common denominator for all kinds of transformation, policies aimed at upgrading workforce skills can help shift labour away from low-productivity agricultural activities and into higher-productivity industry and service sectors, in the process enhancing the diversity and complexity of LDCs’ export baskets.

Accelerating economic transformation in the post-pandemic era

Some of the LDCs considered here performed markedly better in transforming their economic structures during the IPoA. A comparison of sectoral value addition across the six countries generates two interesting insights.

First, the shares of industry and services in total VA increased in countries that experienced large shifts in employment towards industrial and services sectors, but the pattern is not consistent for services-driven transformation. Second, the leading industry- and services-driven transformers raised the economic complexity of their production and experienced labour productivity growth, whereas these indicators generally deteriorated in the others.

This rising trend of services-driven economic transformation can be accelerated by further liberalising trade in services and improving digital literacy, regulation and infrastructure in LDCs as more services are delivered by digital means. In October 2021, LDC trade ministers adopted a declaration that emphasises the importance of the LDC Services Waiver to support their integration in global value chains, aid export diversification, boost infrastructure development and enhance access to trade-related capacity building.

To date, 51 WTO members have granted preferences for services trade in favour of LDCs. However, these preferences tend to be shallow with limited commercial benefits, while many LDCs are unable to take advantage of them because of supply constraints and lack of competitiveness of their services firms.

Operationalising the services waiver and providing targeted support to build LDC services firms’ productive and export capacities could help structural transformation by furthering the participation of LDCs in world services trade and addressing digital shortfalls in these countries.

Addressing these constraints and sustaining economic transformation is crucial for the long-term development of LDCs and should be prioritised during the implementation of the Doha Programme of Action. Changes in economic structure will be the main driver of their transition from low- to middle- and, ultimately, high-income status. It will also help ensure LDC economies be more resilient to future shocks.