The link between manufacturing growth and accelerated services growth in India

Rajeev Dehejia and Arvind Panagariya discuss the link between manufacturing growth and accelerated services growth in India. The critical role of manufacturing growth, especially in the labor-intensive sectors, in the early stages of development in the labor-abundant economies is widely recognized. The authors test two hypotheses aimed at linking growth in manufacturing to accelerated growth in services. They use an instrumental variables strategy to deal with the remaining omitted-variable concerns and with simultaneity. The authors employ two large-scale firm-level cross-sections of the service sector that allows them to distinguish between the effects of reforms on small versus large firms and rural versus urban firms. While it is tempting to interpret the significant effect of manufacturing on services, even after controlling for labor regulations, as evidence for violation of the exclusion restriction, this is not a valid econometric test of the exclusion restriction. Nonetheless, it does provide additional motivation for our strategy of allowing for a direct effect of labor regulations on services, not channeled through manufacturing, and then instrumenting for manufacturing growth.