Despite many policy reforms since the late 1980s, Latin America’s economic performance continues to disappoint. Since 1993 the region’s GDP has risen by barely more than the growth rate of the population, while labor productivity has been practically stagnant. Even considering the higher GDP growth of the past three years, the contrast with Asia’s booming economies is stark. What’s holding Latin America back?

A big part of the answer is the weak performance of services. In Latin America they represent a large share of the economy, given its level of development, yet their productivity is relatively low. This pattern has a long history. During the import substitution era (the half century after the 1929 depression) the region’s competitive intensity was low because of public-sector ownership in electricity, telecommunications, and other important sectors, combined with restrictions on foreign direct investment in most service industries. At the same time low-skill services such as retail trade and personal services became the default form of employment for workers leaving agriculture. As a result the share of services in GDP and employment across Latin America is already comparable to that of high-income economies—but with low productivity and wages.

Although policy changes have had some impact, much remains to be done before the service sector’s overall performance turns around. Privatization in many countries has raised productivity in telecommunications and utilities. Countries that have opened their banking and retailing industries to foreign competitors have brought in much-needed capital and increased their competitive intensity. But reforms to make labor more flexible and to cut the cost of doing business have come much more slowly. These areas of stagnation continue to trap the more labor-intensive, high-turnover services in a miasma of informality and slow growth.

The biggest challenge for Latin America today is to make services the engine of badly needed growth in high-value-added jobs. Manufacturing won’t be a source of net job growth; the region is adjusting to its rising exposure to global competition. Governments must create an institutional environment that fosters entrepreneurship and growth among a broad range of service businesses, including small-scale, labor-intensive services. The informal and underemployed workers in these areas are losing patience with economic reform, as the recent political shift away from it suggests. Workers must share in the economic benefits of change—and the solution must include a substantial increase in the service sector’s performance.

Why focus on services?

Once an economy reaches the middle-income level of development, service industries become a more important source of job growth than manufacturing. Since 1997 all the net new jobs in most developed economies—and almost as many in Latin America—have been created in service industries (Exhibit 1). Among middle- and high-income economies, services now generate, on average, 62 percent of all employment; the higher a country’s GDP per capita, the greater the share of services. Meanwhile, employment in manufacturing is shrinking around the world as companies use labor more efficiently, automate, and introduce new forms of IT. Roughly 22 million manufacturing jobs disappeared globally from 1995 to 2002, despite policy efforts to preserve them. Even China, the world’s “factory floor,” lost 15 million manufacturing jobs.

Yet in Latin America services are largely absent from government policy priorities. Why? There appear to be two reasons. The first is the persistence of a long-established view that manufacturing is technologically more advanced and therefore more desirable. This idea propelled the pre-1990 import substitution policies that explicitly promoted industrialization as the route to economic modernity, as well as the more recent policies seeking to attract foreign investors to Mexico’s maquiladoras¹ and Brazil’s automotive-assembly sector. Second, services have a poor reputation; low-skill, low-wage jobs such as street vendors or beauty parlor owners, for instance, hardly seem like the building blocks of a modern economy. Both of these arguments are wrong.

For one thing, service industries could create more high-skilled work than manufacturing does. In the United States upward of 30 percent of service jobs are in the highest skill category—professional, technical, managerial, and administrative occupations—compared with only 12 percent of manufacturing jobs. The same pattern holds in other developed nations. Moreover, the distribution of wages in the US service and manufacturing sectors looks similar, with a much wider variance within than between each sector (Exhibit 2). So while roughly a quarter of all service jobs involve low-wage sales and personal service, there are just as many highly skilled doctors, lawyers, and technicians, as well as high-wage business-to-business employees in wholesale, consulting, accounting, and the like.

Sheer size makes local service industries such as retailing and construction important drivers of overall GDP growth. Access to high-quality local services affects rates of growth in all industries because every enterprise uses them. As a result of the globalization of retailing, the service content of traditional agricultural or manufacturing products is increasing: retailers look for suppliers with strong logistics and inventory-management skills to coordinate the full value chain from farms or factories to retail shops around the globe. In these service components Latin American producers can differentiate themselves from Asian competitors with lower labor costs. Good local services can also help to attract foreign direct investment. The cost and quality of electricity, communications, and transportation all influence the overall attractiveness of an offshore location to multinational companies choosing where to invest.

Most important, services can be a source of economic growth. In the United States the sector’s rising productivity was responsible for 75 percent of the aggregate productivity acceleration during the late 1990s. (See the McKinsey Global Institute (MGI) report, US Productivity after the Dot-Com Bust, available free of charge online.) South Korea, by contrast, has hit the limits of a growth model that excludes services. In view of the service sector’s high share of total employment, sustained growth isn’t feasible without strong performance in the sector. Yet in many Latin American countries, the number of high-quality service jobs has failed to grow substantially.

Improving the service sector’s performance

Research by the McKinsey Global Institute (MGI) shows that, after years of regulatory constraints and neglect, the productivity of the local service sector in many Latin American economies lags far behind its potential. In food retailing Brazil boasts one of the region’s highest shares of modern formats, yet its labor productivity is only 16 percent of the US level. In more capital-intensive services such as retail banking MGI has found that Latin American productivity is less than half of the US level. The good news is that when governments change their policies to create the right institutional environment, the service sector as a whole can be a powerful source of wealth creation and jobs. Latin America’s governments have already taken major steps through privatization and the opening up of local services to foreign direct investment. These measures have improved the performance of capital-intensive services such as banking, telecommunications, and utilities in many countries, though more remains to be done.

Much less progress has been made in simplifying the myriad business regulations and laws that continue to dampen the development and growth of a dynamic, well-performing service sector. Complex, expensive registration and licensing requirements for new businesses are often prohibitive for small ones, so many entrepreneurs operate in the informal economy. Strict laws to preserve job security give businesses less incentive to hire more workers and grow. Retail stores, restaurants, and other personal-services businesses burdened by these laws are less likely to use formal labor to meet fluctuations in demand over the course of a day or a week. Unclear and costly processes for registering land and property make it difficult for small businesses to use assets as collateral—or to dispose of them for liquidation.

Finally, in services there are more small and midsize enterprises than in manufacturing, and employee turnover rates tend to be higher. Regulatory friction thus creates a real barrier for the sector’s overall performance: it slows down the “creative-destruction” cycle, in which more productive companies are born and gain share from less productive ones—the main source of productivity growth in many service industries.

Here are some of the main policy areas to consider:

Continue to privatize and build regulatory capabilities

Despite the wave of privatization since the late 1980s, many of the region’s utilities, telecom companies, and banks remain in the hands of governments, a fact that stunts the growth of productivity and limits investment. Mexico, for example, has forgone $50 billion of potential investment in the electricity grid because it has been entirely state controlled since 1993. In Brazil government ownership is perhaps most prevalent in banking; state-controlled institutions account for 37 percent of the financial system’s assets and 40 percent of its employment. These publicly owned banks are about half as productive as privately owned ones; as a result, Brazil incurs an estimated $8 billion in extra banking costs each year.²

A significant body of evidence, including MGI research, shows that privatization has enhanced competition and productivity in Latin America. In the 1990s, when Argentina privatized many of its state-owned enterprises—including the electricity, transport, and telecom monopolies—median labor productivity increased by 46 percent, unit costs declined by 10 percent, and production rose by 25 percent.³ In Mexico, where a broader number of industries as diverse as tourism and manufacturing underwent privatization, the gains have been even larger: a 68 percent median rise in real sales and a swing in the median ratio between net income and sales to +7 percent, from -13 percent, with higher productivity accounting for nearly 60 percent of the higher income.

The evidence gives policy makers a clear mandate to continue reducing public-sector ownership. At the same time governments should continue to strengthen their regulatory capabilities, particularly for telecommunications, utilities, and other services that tend to be natural monopolies because of their network infrastructure costs. Getting regulation right, an ongoing process, calls for skilled regulatory agencies. Much can be learned from the experience of countries such as Chile, which embarked on privatization 15 years earlier than the rest of the region did.⁴

Foster competition

The removal of barriers to foreign direct investment in banking and retailing, among other industries, has also significantly boosted the performance of the service sector. When most Latin American countries lifted such restrictions in retail banking, during the 1990s, foreign companies invested more than $50 billion in banking over the next decade, providing greatly needed capital and diffusing best practices more broadly.

Multinational companies had an even bigger impact on the competitive intensity of the local retail sector. The retailing of food in Mexico provides a good example. (See the MGI report, New Horizons: Multinational Company Investment in Developing Economies, available free of charge online.) In the mid-1990s, after Wal-Mart Stores acquired Cifra, Mexico’s largest modern food retailer, the US company adapted many of its practices to the needs of its Mexican operations. With faster productivity growth and “everyday low prices,” or “precios bajos todos los dias,” Wal-Mart increased the sector’s competitive pressures. Other players followed suit by rolling out a variety of productivity enhancements: for instance, by 2001 85 percent of Wal-Mart’s products were delivered through distribution centers instead of being transported by suppliers directly to each Wal-Mart store. The result was a radically more efficient supply chain. Over the next four years two other leading retailers in Mexico followed this example, at least doubling the share of products delivered through distribution centers. The shift to more concentrated purchasing and delivery by other leading retailers increased the pressure on domestic suppliers of food and other goods to become more productive. Consumers have clearly benefited; Mexican food prices have uncharacteristically lagged behind the overall rate of inflation.

MGI productivity studies show that market regulations are typically the biggest barrier to increased competition and to the diffusion of more productive practices in the service sector. Poor regulations governing land ownership and zoning, as well as the direct regulation of prices or products, inhibit competition by limiting the entry of new players, discouraging innovation among existing ones, and restricting the scale of businesses. In Latin America there has been a trend away from direct regulation, though more remains to be done—for example, the removal of Argentina’s subsidized electricity prices (which distort consumer and supplier incentives) and the elimination of directed lending by Venezuela’s banks.

Promote creative destruction in services

Services are dynamic by nature, so to maximize overall service employment companies must be free to start up, grow, and create more jobs—or if they can’t compete, to shrink, lay off workers, and close. To lubricate this process of creative destruction, governments should consider these policy changes:

Make it simpler to start and expand new businesses and close failing ones.

Countries should cut the red tape surrounding start-ups and bankruptcies. According to surveys by the International Finance Corporation (the World Bank’s private-sector arm), it costs more to start a business in Latin America than anywhere else except the Middle East and Africa; furthermore, Latin America is the most difficult place in the world to enforce contracts. The first remedy is to simplify the current regulatory requirements and forms. (For example, Brazil requires 11 different clearance certificates—Certidão Negativa—to register property.) Much can be gained just by spreading already-existing best practices from one area to another. Mexico, for example, could improve significantly just by applying to the whole country the electronic business registration processes of San Luis Potosi and the single access point for business registration pioneered by Aguascalientes.⁵

In addition to removing red tape, most Latin American countries must also strengthen the institutions that facilitate the establishment and growth of small and midsize enterprises—for example, by creating reliable titles for business ownership that entrepreneurs could use either as collateral for loans to expand their businesses or to sell their assets and move on when that would be economically rational. National credit and collateral registration will reduce credit risks and thus costs for borrowers. Out-of-court settlement procedures to enforce debts and contracts effectively would not only shorten the length of time needed to resolve disputes but also ease demands on overburdened legal systems.

Enhance labor mobility. Latin American labor legislation is among the world’s most restrictive, particularly in the areas of hiring and firing workers. Some countries prohibit the firing of employees without just cause. When it is possible to fire them, the cost is high: mandated severance pay worth, on average, 2.7 months’ salary, compared with none at all in the United States, 1.1 months in Europe, and 1.5 months in Asia.

Large severance costs and labor laws intended to promote job security actually deter companies from taking on more people when business is brisk. Companies try to get around such laws by employing temporary workers and then firing them just before they would have the right to become permanent. Restricting temporary, seasonal, or part-time employment also makes it hard for businesses to adjust staffing to fluctuations in demand.

Removing protective labor legislation would require a change in mind-set for many people in Latin America, which has a strong union tradition. But as manufacturing employment declines and net job growth comes from services, this path is the only option. Service industries as a whole create more jobs than they destroy—often through the entry of new players and the exit of older ones. Creating a dynamic service sector will therefore help guarantee lifetime employment opportunities for everyone but won’t guarantee the same job for life.

Tackle informality

Service industries have a high proportion of small companies, which are particularly likely to operate informally—ignoring tax requirements, employee benefits, and other regulations. Informality is a much larger barrier to growth than most policy makers in Latin America acknowledge. Steps to make informality less common will be rewarded with significant gains in productivity, growth, and employment. In the early 1990s the government of Peru, for example, implemented several measures to make its economy more formal. Registering a business now takes just a single day instead of 300 and costs $175 rather than $1,200. As a result 671,000 companies and 558,000 jobs were “formalized” in Peru from 1991 to 1997.⁶ Beyond reducing red tape, Latin America’s policy makers should consider other measures to make informality less attractive:

Reconsider high tax rates. Many Latin American countries have generous governments. But they finance their generosity by imposing high taxes on the formal sector, thereby giving companies a financial incentive to operate informally. High taxes also drive up costs and push down demand. Although the costs of producing similar automobiles in Brazil and the United States are comparable, for instance, Brazil’s high sales taxes—around 30 percent on a new car, compared with 7 percent in the United States—reduce demand for cars and the average value of those sold in Brazil.

More broadly, the high social-security and health insurance taxes levied on formal employers create strong incentives for informality. In Mexico Santiago Levy, the main architect of the successful poverty reduction program Progresa-Oportunidades, has argued that increasing access to health, housing, and insurance benefits has promoted informality because employees think they have little to gain from the social-security taxes that formal employers pay. For policy makers the challenge is to identify a comprehensive financing solution for public services in order to minimize any unintended consequences.

Enforce fiscal and administrative rules. Most informal businesses evade taxes and bend rules because they can get away with it. According to a 2005 report, half of the respondents in five Latin American countries—Costa Rica, Ecuador, Mexico, Nicaragua, and Venezuela—believe that corruption will become more common.⁷ Less red tape, stronger inspection and audit services, and stiffer penalties for breaking the rules will help push enterprises into the formal sector.

Level the playing field

Policy makers need to remove any remaining bias against the service sector and give it equal treatment in fiscal, financial, and development policies so that it can compete for capital and workers on the same terms as companies in the manufacturing sector. Several measures can help accomplish this goal:

• Open up capital markets to small companies. In most economies small companies are more numerous in services than in manufacturing. Latin America’s shallow financial markets are a real barrier to the creation of a dynamic service sector.
• End subsidies to manufacturing. In the 1990s Brazil offered foreign automakers subsidies of $100,000 for every new job they created, prompting overcapacity and low productivity. This policy not only wasted the taxpayers’ money but also put the service sector at a disadvantage.
• Ensure favorable business conditions for services. Several Latin American countries have offered foreign and export manufacturers access to special economic zones, with favorable tax and tariff rates and less regulation than purely domestic companies must follow. The best-known examples are the Mexican maquiladoras, on the US border, and the Manaus Free Trade Zone, in Brazil. Governments should offer the same encouragement to service businesses—and make sure that service and manufacturing activities are not physically segregated, thus making it easier for manufacturers to outsource previously in-house functions to third-party service providers.

The biggest challenge for Latin America is to help services become the engine of growth in high-value-added jobs, which the region badly needs. No other strategy will bring the benefits of economic reform to the largest employment sector—a change that is sorely needed to prevent the political winds from turning further against economic reform. Policy makers must continue to remove regulatory barriers and, at the same time, build stronger institutions that can unleash the power of local services to generate growth and jobs. They must continue to privatize publicly owned services and open up local ones to competition from foreign companies, remove pointless regulatory complexity, fight informality, and reform some of the world’s strictest employment regulations. At the same time they should build institutions that can regulate newly privatized utilities and telecom companies, as well as invest in more transparent and efficient business processes, including credit registration and the enforcement of contracts.