September 12, 2012
Malaysia: Growth without Private Investment
by Jayant Menon, ADB
It was not long ago that the Malaysian development story was hailed as a model of FDI-driven, export-led industrialisation worthy of emulation by aspirants in the developing world.
Malaysia remains an outstanding model of how openness to trade and FDI can transform a poor, agrarian economy into a thriving, manufacturing-based, middle-income one in a generation.
During this time, Malaysia also successfully preserved social harmony in its multiracial society, relying on economic openness to sustain growth under an expensive affirmative action program that skewed incentives, the New Economic Policy (NEP).
In this sense, the NEP performed an important signalling role and played its part in delivering the peace and stability that enabled Malaysia to sustain high growth. This growth, combined with revenues from large oil reserves, facilitated a massive tax-transfer scheme that favoured the majority, without significantly eroding macroeconomic stability.
But all that changed after the Asian financial crisis. FDI flows fell sharply and continued to remain low even after recovery. While foreigners continue to shun Malaysia, even domestic investors seem to have fled, with Malaysia becoming a net exporter of capital since 2005.
Malaysia continues to grow, but without private investment it is unlikely to break out of the middle-income trap. Indeed, these days Malaysia is often discussed as a classic case of the middle-income trap. Growth without private investment is also unsustainable and Malaysia risks sliding back.
What happened and can it be fixed?
The investment malaise can be attributed to two interrelated factors: distortions introduced by the NEP and its subsequent policies, and the widespread presence and overbearing influence of government-linked corporations (GLCs) that deter private investment. While the impacts of both factors may have been masked during the heady days leading up to the Asian financial crisis, this is no longer the case in the current competitive environment, where residency options for both capital and skilled labour are much greater. Fixing the problem requires addressing the distortions of the NEP and curtailing the influence of the GLCs.
The NEP is now past its use-by date. Many of Malaysia’s economic problems, including the slump in private investment, are rooted in the distortions resulting from the workings and implementation of the NEP and its subsequent policies.
Quotas and other types of selective quantitative restrictions are the most distortionary instruments of protection. They affect almost every aspect of economic and social life — from gaining entry to post-secondary education and all the way to the boardroom and back down to the factory floor.
Since the NEP had the redistribution of wealth — rather than the redistribution of income — as its target, many GLCs were created to pursue this objective. Thus, the link between the NEP and the GLCs implies that any solution must address both constraints.
It is estimated that the dominance of GLCs is highest in the utilities sector, at 93 per cent, and transportation and warehousing sectors, at 80 per cent. The dominance of GLCs is also greater than 50 per cent in the agricultural sector, banking, information communications and the retail trade. In the aggregate, the GLC share is approximately one-third — unusually high for a country representing itself as an open and modern market economy.
The influence of GLCs is so pervasive in some sectors that it crowds out private investment. It is arguably more important to address the GLC problem rather than the NEP for the revival of private investment.
It remains to be seen whether the government’s plans for divestment in some of these GLCs will remove the barriers that have discouraged new firms from entering what have been traditional strongholds. Whether the proceeds from the government divestment will be channelled back into government involvement in different sectors, as has been happening lately, is another concern.
Although the reforms embedded in the government’s New Economic Model, Economic Transformation Program and Tenth Malaysia Plan (TMP) signalled a departure from the previous government’s priorities and approach to development, implementation has been lacklustre at best and mendacious at worst. The devil is not in the detail but in its implementation. The fact that the TMP itself includes several new affirmative action measures is also telling.
Malaysia has always opted for economic expediency during times of impending crises. It is unclear whether the changed political landscape and tighter electoral prospects that prevail today — in the context of a slowing world economy with negative impacts threatening to spill over domestically — will prevent such risky but necessary policy change. Although there have been a few recent moves to dilute the NEP, some of these measures have already been reversed. Similarly, while there is an active program of divestment from GLCs, there are also GLC acquisitions in new sectors, making it more of a diversification than a divestment program. Malaysia’s investment malaise can be fixed, but not in this way.
Jayant Menon is Lead Economist (Trade and Regional Cooperation) at the Asian Development Bank. The views expressed in this paper are those of the author and do not necessarily reflect the views and policies of the Asian Development Bank, or its Board of Governors or the governments they represent.
I would have thought the new Economic Model introduced by Najib and now subsumed under the Economic Transformation Programme is supposed to tackle the issue of middle income trap. There is nothing patently wrong with GLCs as a vehicle for spurring growth as this vehicle has been used to compensate for a slowdown in politically sensitive foreign direct investments.
Political uncertainty (and delay in GE1-3 is not helping), rampant corruption and the breakdown in the Rule of Law are factors that tend to impede FDIs from coming here. If we can deal with these matters as a matter of priority, Malaysia will get its share of FDIs because Asia will remain a region of rapid economic growth. It will be driven by massive investments in infrastructure and human capital. –Din Merican
GLCs? Dismantle them and sell off the assets. Enough of plying Monopoly to the masses. The government is not supposed to be intruding into the activities of Hasbro or Lego.
Also enough rubbish of “Towering” this and that. The higher they are the lower they seem to be. The GLCs are run by a whole spectra of disabled has-beens and retarded entitled morons. Sufficient to say, sycophancy is a dastardly art of the Impossible! That’s why you’d see the large number of luxury German/British marques whizzing past plebeians like me on the tolled highway to hell.
If our local businesses are not reinvesting and the capital flight is reaching into the stratosphere – tell me, what hope is there for FDIs? Perhaps the writer’s conversing with the ‘Impenetrable, Irrefutable Wall of Inanity’ – which basically makes up this Lembek Administration.
The middle income trap is a piece of fiction cooked up by the World Bank and the ADB, as marketing for their consultancy and lending services. There’s virtually nothing in the serious economics research literature on defining a middle income trap, much less positively identifying which countries are in one.
Malaysia’s drop off in growth since the Asian Financial Crisis can be almost wholly explained in demographic terms – a sharp slowdown in population growth, which in turn caps headline growth rates. Average GDP per capita growth has barely budged in the last twenty-five years. Japan, Korea, Taiwan – they’ve all undergone the same transition, and China is next.
I would not even call the middle income trap a theory, more a hypothesis – the data simply does not support its existence.
How about Singapore, Hong Kong, Switzerland and Luxembourg, those tiny dots hishamh? Demographics play a part there too? Is it the governance, political will, industry and capacity of the population to adapt, progress and innovate? The examples you quoted are ‘Asian Confucianism overvalued’ economies. Is it in the genes, environment (air, water, whatever), philosophy, business models and other anthropomorphic measures?
While the middle income trap may be a theory, it doesn’t help solve the conundrum that we are living in – where income stagnates, inflation breathes down our necks and disparities become unbridgeable.. It not pure economics. it has to do with human foibles and folly. That is why macro-economists need to factor in huge amount of socio-cultural and psychological impact, which makes it at best pseudo-scientific.
CLF,
With respect to those countries you mentioned, yes, demographics plays a key role. Singapore for instance would not have been able to maintain its 6%+ growth rate over the past decade without active encouragement of inward emigration. The rate of increase of Singapore’s overall population over the past decade is nearly 3%, yet the rate of increase of citizens is actually declining.
Hong Kong’s growth rate over the past decade is worse than ours (population growth rate about half of Malaysia’s), Switzerland and Luxembourg are barely growing at all despite still positive population growth rates (implication: low productivity growth).
Digression 1: All four of these countries by the way are tax havens, with significant inflows of capital and FDI taking advantage of loose regulation and low taxes.
Digression 2: Singapore is infamous in the economics literature for having very low/negative productivity growth, due to over-investment in capital.
If you are referring to their income levels, in 1965 Singapore’s per capita income level was 2.6x Malaysia’s while Hong Kong’s was 3.0x Malaysia’s. The current estimated ratios are 4.0x and 3.0x. In other words, Malaysia’s income per capita has grown at approximately the same rate as Hong Kong’s and somewhat slower than Singapore’s. However, Singapore’s income lead came in spurts, not continuously. The relevant periods are 1965-1970 (before the NEP), 1986-87, 1997-98, and from 2004 onwards. The first because of Tunku’s laissez faire policies (Malaysia’s relative income per capita ratio actually declined from Independence to 1970) and poor commodity prices, followed by the deep recessions of 1986-87 and 1997-98 (which did not affect Singapore as much), and Singapore’s emigration boom from 2004.
I’d like to stress again, the middle income trap is not even a theory – a theory is a hypothesis that plausibly explains the observable facts. In this case, the facts do not support the hypothesis.
As for your last point – those have little to do with growth or governance, and more to do with tax and social support policies. Income and wealth inequality are actually worse in SG and HK than it is in Malaysia, believe it or not, though our level of inequality is bad enough. Four key points of similarity:
1. No taxes payable on capital gains (except for the rather mild RPGT)
2. No taxes payable on inheritance/estates (Malaysia’s was abolished in 1992, Singapore in 1996 IIRC; the top rate was 60%)
3. Relatively low marginal income tax rates (Optimum income tax rate should be above 40%)
4. Almost no unemployment or social security benefit structure
Under these circumstances (and there’s very solid theory and empirical work looking into these factors) workers do not gain higher wages from their higher productivity, while gains in incomes accrue mainly to high income earners and the already wealthy, and wealth is further concentrated and transmitted across generations. Inequality, income stagnation, unequal economic opportunities are thus embedded and perpetuated.
Thanks for the heads up, hishamh.
Interesting that the middle income theory has had so much bad press.
Would a more cohesive or efficient social safety/security net enable a better outcome as far as the economic output per capita is concerned and would a developing country like ours benefit from such programs?
For e.g., S.Australia has one of the world’s best social and health security, with most employment – but they’re still stagnating economically. Their income taxation rate is already astronomical and there seems to be little impetus for increased productivity. Perhaps there is a case for for voodoo economics, like Paul Harvey’s supply side economics (Reaganomics) in certain cases?
Tax havens are nothing new, but our Labuan Banks haven’t exactly lived up to expectations and are underutilized. Any comments on that?
CLF,
A social security net wouldn’t boost growth – it might actually cap it to a certain extent, especially if tax rates are too high and labour protection laws too rigid. Taxes higher than our current levels would probably lower the incentive to invest (this is debatable), but at the very least we would have a healthier, more equitable, and less stressed-out society.
There is after all no point in having higher income per capita, it only a certain segment of the population benefits. There is also no point to boosting income, if all the other quality of life metrics fall by the wayside. In that sense, a social security net might be net welfare positive – slightly lower headline growth, but better income and wealth distribution, better social cohesion, and higher quality of life (e.g. lower crime, better health, less social ills like drug use).
As far as Labuan is concerned, I think the problem is too much focus on the financial aspects, and not enough on the other factors that have helped form other financial centres. It’s not just low taxes and loose regulation, but also connectivity, availability of labour, diversions (shopping, sightseeing, gambling etc), and developed world infrastructure. What’s there in Labuan?