Malaysia’s Development Strategy Revisited

October 20, 2010

by Dr. Mohamed  Ariff*

Malaysia has turned 180 degrees since Independence in 1957, transforming itself into a thriving modern economy and leapfrogging from a low-income to a middle-income trajectory. The country owes its prosperity to its economic openness, with trade as the lifeblood and foreign direct investment (FDI) as the backbone of the economy.

Economic Openness  and Vulnerability to External Shocks

The price Malaysia has had to pay for this success is greater vulnerability to external shocks, but it has learned to cope with cyclical ups and downs with remarkable dexterity. This does not mean, however, that all of the crises in the Malaysian economy were caused entirely by external forces, as if domestic policy missteps had nothing to do with them. The Malaysian experience shows that crises tend to be blessings in disguise, as they force the authorities to step back, take a hard look at their policies, learn lessons and move on.

The economy has recently arrived at yet another crossroads, this time in the aftermath of the global financial crisis of 2008–09. Like many other countries, Malaysia is in search of a new economic model with which to reposition itself.

The prospective ‘new economic model’ may be viewed from two different angles: as a short-term rebalancing exercise after the crisis, and as a long-term agenda for structural change. There has been much talk of the need to reorient the Malaysian economy towards the domestic market so as to render it more resilient. But although this is intuitively appealing, the reality suggests it would not work in practice. Malaysia’s domestic market is still too small to be a meaningful substitute for the huge external market.

This observation does not ignore the role the domestic market can play when external demand caves in, but it does help to underscore the point that there is only so much the domestic market can do when exports slump, even in large economies, not to mention small ones like Malaysia.

It is important to understand that the solution to the problems of economic openness is not less openness but more openness. There is nothing wrong with Malaysia being so trade dependent; it cannot afford to be otherwise. The question, rather, is whether the Malaysian economy is too trade dependent for its own good. Rhetoric aside, the optimum trade level relative to a country’s GDP can only be determined by market forces, not by administrative fiat. For market forces to work effectively, there is a need first to eliminate all distortions in the market place.

Distorted Factor Market

In Malaysia, the factor market is much more distorted than the market for goods and services, with a bias in favour of the traded versus non-traded sector or the external versus domestic sector. The proposal to reorient the economy towards domestic demand away from exports would warrant policies to reverse the bias in favour of the non-traded or domestic sector, but this would be a mistake in the opposite direction. What is needed is policy neutrality without any bias, so that resources flow more freely in response to market signals. This would ensure greater efficiency in resource allocation.

No doubt a robust and vibrant domestic sector would help offset the impact of external shocks on the economy. Domestic demand would have played a far more important role in the country’s economic growth and development had income distribution been less uneven and if social safety nets had been in place. It is evident that income inequality has widened in recent times, with the Gini coefficient rising for all ethnic groups in Malaysia.

A more equitable income distribution would have led to increased private consumption and greater economic resilience. After all, Malaysians tend to save more and spend less than their counterparts in the developed world, partly because there are no safety nets for them to fall back on when the chips are down.

This line of reasoning prompts policy makers to focus on social security and income redistribution so that people will save less and spend more, and militates against attempts to divert demand towards domestic consumption through trade distortions.

The rest of the world has also changed dramatically, with more and more economies opening up and joining the bandwagon of export-led growth. In the process, Malaysia has lost its comparative and competitive advantage in several products to newcomers. As a result, its potential growth rate has shrunk from 7.5 per cent in the late 1980s to 5.5 per cent now, putting at risk the goal of making Malaysia a developed country by 2020 with a per capita income of $20,000 in real terms. Estimates show that, to reach a per capita income of $17,000 in 2020, the Malaysian economy would have to grow at an average rate of 7.0 per cent per annum, which sounds like a tall order. At the slower pace of 5.5 per cent per annum – the current potential rate – per capita income would be just $15,000 in 2020.

Input-Driven Growth unsustainable

It goes without saying that Malaysia must grow at a faster pace if it is serious about joining the club of developed countries by 2020 – hence the need to reinvent itself through reforms that can help restore the lost growth potential. Malaysia has learned the hard way that input-driven growth is unsustainable. It is instructive to note that the economy was growing at a rate of over 8.0 per cent in the early 1990s despite declining total factor productivity. To stay competitive, the growth strategy then was to keep wages low with the aid of a large migrant workforce. Obviously there was a dismal failure to understand that there were limits to economic expansion through input increases.

Migrant Workers depress wages

It was a major policy blunder to let migrant workers depress wages in the country, thereby throttling productivity improvements. Malaysia locked itself into low value-added manufacturing by allowing foreign workers to work in the sector for low wages, thus removing the incentive for manufacturers to automate.  The size of the problem is huge: the country reportedly has 1.9 million registered migrant workers and another 600,000 unregistered ones (probably an underestimate), accounting for nearly one-fifth of the working population. These workers are not confined to the so-called 3D jobs – the difficult, dirty and dangerous jobs that the locals shun – but compete with Malaysians in the wider labour market.

This is a race that Malaysian workers are bound to lose, as migrant workers are willing to accept lower wages and work longer hours, with no laws – let alone enforcement of laws – in place to protect their rights. Unless and until there is equal pay for equal work, the employers’ penchant for migrant workers will continue unabated.

This is not to deny that Malaysia needs the services of foreign workers, both skilled and unskilled. But care must be taken to ensure that they are treated with dignity and fairness, and not exploited by agents, employers and the authorities. Condoning the injustices inflicted on foreign workers only serves to increase the demand for foreign workers, to the detriment of locals in the labour market.

Productivity Gains Needed

Malaysia has inadvertently fallen into a middle-income trap by adopting an ill-conceived policy of preserving its fading competitiveness through suppressed wages. High wages need not mean high labour costs if the increased wages are backed by productivity gains. By the same token, low wages may not translate into low labour costs if productivity suffers. In the Malaysian context, the social cost of employing migrant labour far exceeds the private cost to employers. If the negative externalities associated with the excessive presence of migrant workers are taken into account, the short-sighted dependence on the migrant workforce turns out to be a costly affair. Obviously Malaysia has shot itself in the foot!

The New Economic Policy: Pervasive Poverty in the Malay Community

Multi-racial Malaysia’s major structural problems are largely attributable to the New Economic Policy initiated in 1970 in the aftermath of the May 1969 racial riots. With its emphasis on ‘positive’ discrimination in favour of the then backward Bumiputeras (literally ‘sons of the soil’), the objectives of the policy were laudable, serious misgivings about its implementation notwithstanding. The New Economic Policy continued to exist after reincarnating itself in various forms beyond the original 1990 deadline. While it has undeniably helped narrow interethnic income differences, all is not well judging by the outcomes. While interethnic income disparity has narrowed considerably, intraethnic income disparity, especially within the Bumiputera community, has widened.

The growing income disparity within the Bumiputera community reflects the extremely uneven distribution of the benefits of the New Economic Policy. Arguably, all Bumiputeras have benefited in one way or another, but it is clear that the bulk, if not the lion’s share, of the benefits have accrued to the politically well-connected elites at the top. There is a perception that the New Economic Policy has been hijacked by cronyism and nepotism at the top, impairing its ability to improve the lives of the people at the bottom. How else can one explain the existence of pervasive poverty in the Malay community after four decades of affirmative action? Although Malaysia has made considerable progress in alleviating poverty, poverty among the Malays – which is not confined to rural areas – remains glaringly conspicuous, with numerous Malay households struggling below the poverty line. Malay households still account for nearly 75 per cent of the bottom 40 per cent earning RM2,000 or less per month.

To be sure, poverty is not confined to the Malay community, and there are many poor Indians, Chinese and others. But there is absolutely no reason why anyone should remain poor in a land of plenty. With poverty – in both relative and absolute terms – still prevalent among the masses, it is obvious that the New Economic Policy has outlived its usefulness. There is really nothing ‘new’ any more about the New Economic Policy. It does not make sense to keep an obsolete policy ticking along on life support.

As mentioned, the New Economic Policy has continually reincarnated itself beyond the 1990 deadline, in the National Development Policy, the National Vision Policy and, most recently, the New Economic recently, the New Economic Model. In both letter and spirit, it is the centrepiece of the much hyped New Economic Model, the only ostensible difference being a better focus and greater transparency this time round. Despite this, the New Economic Model has been slammed vehemently by the Malay Consultative Council – comprising 76 Malay non-government organizations – for not being unequivocally pro-Bumiputera.

This simply shows the woeful ignorance of the new realities that have rendered such a policy totally untenable and unsustainable, with public debt extrapolated to exceed 100 per cent of GDP in 2019. There is a perception that much of the corruption, rent seeking and cost overruns that place pressure on the country’s coffers are associated directly or indirectly with the manner in which the New Economic Policy has been implemented.

The proponents of the New Economic Policy claim that it was not a constraint on growth, citing the fact that the Malaysian economy was able to grow at near double-digit rates for many years. Some go so far as to credit the New Economic Policy with this impressive growth record. However, one wonders whether the economy was growing because of the New Economic Policy or in spite of it, and whether economic growth would have been even more impressive in the absence of such constraints. The strategy was only going to work if there was robust economic growth in the first place. To avoid the disruption caused by redistribution, it asserted that no one should get a smaller piece of the pie than previously – which was possible only if the pie continued to get bigger. It is no wonder, therefore, that the New Economic Policy was downplayed during economic downturns.

Empirical observation suggests that the government was not oblivious to the constraints imposed by the New Economic Policy, judging by the attempts over the years to liberalize the rules and guidelines governing domestic and foreign investment. The fact that these rules and regulations were slowly chipped away, in the guise of reform, is a manifestation of the recognition that the New Economic Policy was an obstacle to increased investment and faster growth.

Seen in these terms, Malaysia has unwittingly forgone faster growth and denied itself a quantum leap to a higher income trajectory. It is instructive to note in this regard that Singapore, South Korea and Taiwan – which were roughly on a par with Malaysia in the early 1970s – have overtaken Malaysia to gain high-income status thanks to their smarter growth strategies.

In the wake of the titanic shifts that have been taking place in the world economy, Malaysia needs to embrace major structural transformation. It needs to discover new sources of growth, enhance its competitiveness in the global arena, strengthen its regional linkages, energize its domestic sector, move up the value chain in manufacturing, make its services sector the main engine of growth and so forth.

New Economic Model Up Against Formidable Challenges

The structural change agenda presents formidable challenges. The kinds of skills that the new paradigm demands cannot be provided by Malaysia’s archaic education system, which needs a complete overhaul. At the same time, the country is suffering from a serious brain drain caused by both push and pull factors. The importance of a truly independent judiciary cannot be exaggerated: anecdotal evidence suggests that Malaysia’s tarnished judiciary and gutter politics are among the push factors. Seen in these terms, the brain drain is largely a manifestation of frustration that has led some people to vote with their feet.

All this calls for bold structural changes, including institutional reforms encompassing everything from education to the judiciary, backed by governance reforms to strengthen fiscal discipline, transparency and accountability. Nothing short of a holistic approach will set the Malaysian economy far enough or fast enough on a true development path. The politics of policy making, however, may hobble the reform process.

Indeed, there are ominous signs that the New Economic Model may be stillborn. The powerful vested interests that have thrived on the rent seeking put in place by the New Economic Policy will resist reform tooth and nail. The all-inclusive ‘1Malaysia’ concept propagated by the Najib administration and the exclusive New Economic Policy caucus promoted by ultra-Malays simply cannot mix, each being antithetical to the other.

This paradox cannot be resolved by cosmetic changes to win over diehard supporters of the New Economic Policy or increase the appeal of the 1Malaysia concept. Inclusiveness, meritocracy and competitiveness must be the hallmark of the New Economic Model if it is to fly. If it fails to take off, the lofty 1Malaysia initiative will be reduced to an empty slogan.

The 10th Malaysia Plan relies on Private Investment

Unfortunately, the Tenth Malaysia Plan for 2011–2015 does not echo the inclusive sentiments espoused by the New Economic Model. The plan, which targets GDP growth of 6 per cent, looks somewhat similar to the preceding Ninth Malaysia Plan for 2006–2010 in terms of fund size (RM230 billion), sectoral allocation and strategy, albeit with different goals.

The assumption in the Tenth Malaysia Plan that private investment will grow at an annual rate of 12.8 per cent to energize GDP growth is questionable given that private investment slowed to 2 per cent under the Ninth Malaysia Plan. FDI trickled in at a snail speed of 1 per cent per annum during 2006–2009, a far cry from the 9 per cent growth seen before the Asian Financial Crisis.

According to the United Nations Conference on Trade and Development (UNCTAD), there was a massive 81 per cent drop in FDI inflows to Malaysia in 2009 alone. Although it was a bad year for nearly every country in the region (the notable exception being Singapore), the other countries fared much better, with Thailand, Viet Nam and Indonesia registering significantly smaller drops of 30.4 per cent, 44.1 per cent and 44.7 per cent respectively. What is more, the Philippines attracted more FDI than Malaysia for the first time ever, while Vietnam overtook Malaysia as a favoured destination for FDI.

The dramatic drop in inflows in 2009 cannot be dismissed as an aberration given that a downward trend had been evident for several years. Nor can it be explained away by the observation that FDI was in short supply. The fact remains that Malaysia is losing out to its competitors as it seeks to attract increasingly scarce FDI funds. One cannot help but wonder if foreign investors are voting with their feet.

The Tenth Malaysia Plan expects the private sector to be in the driver’s seat, but this assertion alone is unlikely to entice the private sector, especially foreign investors, when there is no strategy to dislodge distortions in the market place related to the New Economic Policy. As Albert Einstein remarked, it is madness to keep doing the same thing over and over again while expecting a different result.

The New Economic Policy is an addiction for some, redundant for some others and unjust for the rest. Like the legendary Gordian knot, the New Economic Policy cannot be loosened but must be cut. Apparently, no one in the corridors of power in the country has the gumption to do away with it, because they all owe their jobs to the current set-up. All this, one must hasten to add, does not constitute an argument against affirmative action per se.

A New Pro-Poor Economic Policy and Reform

There is certainly a need for a clear focus on the needs of the poor and marginalized regardless of race, colour or religion. In other words, Malaysia needs a ‘new’ New Economic Policy that is explicitly pro-poor. The main beneficiary of such a policy would still be Malay households, as they account for roughly three-quarters of the bottom 40 per cent of households in terms of income distribution.

Without a doubt, Malaysia is one of the better-performing economies in the region, with fairly strong macroeconomic fundamentals. The medium and long-term prospects of the economy are bright. Its inherent strengths clearly outweigh its perceived weaknesses, which are by no means insurmountable. Malaysia has only itself to blame for being stuck in the middle-income category for so long, and high-income status is within striking distance if policy makers have the courage to recognize and rectify policy errors. But there should be no delusion that a high income is all it takes to become a developed country; Malaysia has a long way to go to climb up the human development ladder as well.

The Malays are Competitive and Competent

It would be incorrect to give the impression that there is very little political space for serious reform in Malaysia. Fortunately, times have changed. Malays are just as competitive and competent as anyone else, and it would be an insult to Malay intelligence and an affront to the Malay psyche to say otherwise. What is more, thanks to increasingly easier access to information through the internet, the mindset of Malay voters is changing, as is that of their compatriots in other ethnic groups. The constituency for reform is growing – a development that no political party can afford to ignore in a democracy.

Understandably, there has not been much academic discussion or intellectual discourse – let alone public debate – on the issues confronting Malaysia given the ‘sensitive’ nature of the topics. Books discussing such issues candidly and objectively are either dated or in short supply. The present volume, containing solid contributions by eminent writers on related themes, should help fill the vacuum with balanced arguments.

What distinguishes this book from other works on the Malaysian economy is the forthright manner in which the various issues are discussed. The insights and views of the writers cover a wide spectrum of issues, including political challenges, corporate ownership and control, governance, crisis management, macroeconomic and microeconomic policies, service sector reforms, technological upgrading, distributive justice and demographic change. Together, they represent a major contribution towards better understanding of an increasingly complex Malaysian economy.

*Dr. Mohamed Ariff is  Professor Emeritus, University of Malaya and  Distinguished Fellow, Malaysian Institute of Economic Research, Kuala Lumpur

Preface for the forthcoming book by Hal Hill, Tham Siew-Yean and Ragayah Haji Mat Zin (Editors), GRADUATING FROM THE MIDDLE: MALAYSIAN DEVELOPMENT CHALLENGES, Routledge, United Kingdom

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