MANILA ― The eurozone crisis has dominated discussion among policymakers over the last few years, but the economic slowdown in Asia’s two giants ― the People’s Republic of China and India ― has become a source of growing public concern as well. How worried should we be about an additional drag on the global economy?

After years of double-digit GDP growth, the PRC’s economy is decelerating. At the Asian Development Bank, we predict that its growth will slow to 7.7 percent this year, from 9.3 percent in 2011. The PRC’s population is aging, real wages are rising, and growth is moderating toward more sustainable rates.

India, too, has massive potential to grow fast and reap a demographic dividend, but it has been struggling with structural reform. We expect that India’s expansion will slow to 5.6 percent in 2012, from 6.5 percent last year.

Weak external demand is partly responsible for the falloff in growth, but internal factors ― namely, slowing investment and stagnating consumption ― are also holding back economic expansion. Maintaining growth in the face of a global slowdown is a daunting task, and it requires rethinking the future of “factory Asia.”

Asia’s boom was driven largely by intraregional manufacturing linkages: intermediate goods and parts were sourced from within Asia for assembly into final goods exported to advanced economies. But, with budget-tightening around the world, demand for Asia’s exports is expected to continue to falter. Where, then, should Asia look for another source of growth?

Upgrading the service sector ― for example, business processing, tourism, and health care ― could play a critical role in the region’s future growth. Asia’s service sector is already large, contributing significantly to growth and employment. Services accounted for nearly half of developing Asia’s GDP in 2010, two-thirds of India’s growth from 2000 to 2010, and 43 percent of growth in the manufacturing-oriented PRC in the same period. In addition, service workers comprise more than one-third of total employment in developing Asia.

If these countries follow the same path traveled by the advanced economies, agriculture’s dominance will give way to industry, which in turn will be supplanted by services, further broadening their role. There is certainly room to grow: the share of industry in developing Asia’s output surpassed the OECD average in 2010 (41 percent vs. 24 percent), but the share of services still lags by a wide margin (48 percent vs. 75 percent).

Making Asia’s service sector more dynamic is essential to future growth. But the sector is still dominated by traditional services, such as restaurants, taxis, and barbers. Modern services ― such as Internet connectivity technology, or financial, legal, and other professional business services ― account for less than 10 percent of Asia’s service economy, well below the 20-25 percent in advanced economies.

While traditional service industries are able to provide jobs, they do not generate much income. Labor productivity is also quite low: For most economies in the region, service-sector productivity is less than 20 percent of the OECD average. Even in South Korea, labor productivity in industry is 118 percent of the OECD figure, but only 43 percent of the average for services.

A vibrant service sector could have broad economic benefits. Synergies between services and industry could improve overall productivity. For example, industrial design, marketing, and legal services could facilitate investment and development of new manufactured products. The service sector also tends to be more effective in job creation, particularly for women, thus supporting inclusive growth.

Developing the service sector could also diversify the production base, thereby enhancing economic resilience and boosting growth momentum. Modern services are becoming increasingly tradable, providing new export opportunities. India and the Philippines, for example, have established themselves as world leaders in the export of outsourced business processes.

Skills gaps and a lack of infrastructure are frequently cited as factors that hinder service-sector dynamism in Asia. But burdensome regulations are the biggest barrier. Excessive regulation that protects incumbent firms and other vested interests undermines market competitiveness and limits prospects for improved productivity and efficiency.

For example, legal markets are dominated by rich lawyers, schools are controlled by teachers’ unions, and the medical sector is influenced by powerful doctors, resulting in high business costs that also hamper industrial development.

Many service firms in Asia are owned by the public sector, so governments have less incentive to deregulate services. But the same authorities have already opened their economies’ manufacturing and agriculture sectors for the common good, even at the expense of minority groups like farmers and factory workers. Why, then, are they maintaining policies that protect the special-interest groups that dominate the service sector?

Many argue that regulations protect small domestic firms against undue competition from large foreign firms. But the truth is that regulations are stifling even for domestic competition.

In India, for example, there is fear that small mom-and-pop retailers will be crushed when Wal-Mart enters the market in the next few months. But policymakers must recognize that there are ways to protect small retailers without stifling competition. The government can, say, impose zoning regulations, help small retailers find specialized niches in the market, or provide skills training to displaced workers. The survival of artisanal retailers should not be used as an excuse to introduce or uphold business regulations that ultimately protect the incumbent rich.

Asian policymakers must remember how they successfully developed their manufacturing sector ― through competition. The same logic should be applied to services. Upgrading the service sector is low-hanging fruit for Asia, because tremendous investments are not required. And yet service-sector reform remains just out of reach for the region, owing to the absence of the political will needed to dismantle the vested interests that keep it there.

By Changyong Rhee

Changyong Rhee is chief economist at the Asian Development Bank. ― Ed.

(Project Syndicate)