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January 12, 2011

Malaysia stuck in Middle Income Trap

Here is a 12 page paper that discusses how Malaysia is stuck in a middle income trap

Malaysia has moved from being a raw commodity exporter to an industrial product exporter, from a banana chip exporter to a computer chip exporter. Malaysia has become a middle-income country, and knowledge-led growth is the next development stage for Malaysia.

The expectation in 2001 was that things would return quite rapidly back to normal, back to the pre-Crisis period of impressive material growth and structural transformation. For example, projected private investment in 2010 (21.4 percent of GDP) would be at almost the same level as in 1990 (21.9 percent of GDP).

However, this optimism has proved to be ill-founded even before the arrival of the global financial crisis in the last quarter of 2008. Instead of surging to a 7.5 percent growth rate, the average annual real GDP growth rate turned out to be only 4.5 in the first five years of the Second Millennium, and 6.1 percent in the 2006-2007 period. The fact that, in the same 2001-2007 period, economic growth accelerated in the neighboring countries of China, India and Indonesia certainly makes credible the possibility that Malaysia has descended to a much slower growth path, and would not transition fully to a knowledge-based economy by 2020.

What happened? How could the Malaysian economy get its groove back?

Malaysian Demographics

Ethnicity
Malay 50.4%, Chinese 23.7%, indigenous 11%, Indian 7.1%, others 7.8% (2004 est.)
Religions

Religion
Muslim 60.4%, Buddhist 19.2%, Christian 9.1%, Hindu 6.3%, Confucianism, Taoism, other traditional Chinese religions 2.6%, other or unknown 1.5%, none 0.8% (2000 census)

Malaysia tried to give a free ride to the majority Malaysian population. Although the bias is uneven and favors some groups of Malays over others. Malays would get a free ride and the ethnic chinese would do the work. Eventually too many of the successful ethnic chinese left Malaysia.


The New Economic Policy (NEP) framework of 1970-2009 is inconsistent with knowledge-led growth.

• The quantity target of NEP framework is anathema to quality upgrading emphasis of a knowledge-based society.

A knowledge-based economy requires meritocracy.
Institutionalised discrimination prevents full mobilization of human resources (e.g denying education to women amounts to using only half of the brain for thinking; denying top leadership positions to Chinese and Indians amounts to employing less than 60 percent of the national talent pool)

Ethnic quotas on ownership structure are anti-growth. Ownership quota either discourages successful Chinese Malaysian firms from tapping local stock market to fund expansion or drives Chinese Malaysian firms to move headquarters to foreign lands.

• Ethnic quotas on bank loans, business licenses, government contracts, and employment promote corruption throughout society. Side effects of such ethnic quotas include the perpetual infant industry phenomenon, “money politics”, and increasingly frequent outrageous rulings by the Malaysian courts

• NEP focuses too much on the redistribution of income and not enough on the generation of income. NEP is hence at odds with the basic truth that “a rising tide raises all ships”.

• Essentially, by denying existence of the “trickling down mechanism” and the importance of self-help, the over-interventionist NEP undermines high growth by

o enshrining mediocrity at best, and rewarding incompetence in general
o providing a social justice justification for corrupt practices
o undermining investor confidence through concerns about escalating inter-ethnic
tensions created by unfair government practices.

An effective strategy to transit to knowledge-led growth requires the government

• to get the microeconomic prices right
• to get the framework institutions right, and
• to get the macroeconomic balances right.

“Getting the Microeconomic Prices Right” means that the government has to reduce significantly its interference in the price-setting mechanism by withdrawing the near-monopoly status enjoyed by government-linked companies and by firms affiliated with families of prominent politicians. The federal and state procurement systems should be open tender systems, and the licensing of small businesses (e.g. taxis) should be race-blind. The price-setting mechanism should be an economic instrument of resource allocation and not a political instrument of rent disbursement.


“Getting the Framework Institutions Right” means reform of the key economic, social and political institutions to modernise the governance framework. Specifically, the large-scale institutional reforms undertaken in Indonesia after the dismissal of President Soeharto should be studied for possible relevance to Malaysia, e.g. the decentralization of a significant amount of economic policy decision-making to the provinces, and the structure of its new anti-corruption agency.


“Getting the Macroeconomic Balances Right” means that macroeconomic management should be guided by:

• fiscal balance
• investment balance
• balance in budget priorities
• external balance

Fiscal balance is the most basic element in preserving domestic price stability. Budget surpluses are the norm in the above-trend part of the business cycle, and budget deficits are the norm in the below-trend part of the business cycle. A zero net budget balance is generated over the entire business cycle.

Investment balance refers to the private-public composition of investment. The engine of long term growth is private sector investment, and public sector investments should be limited to investments in
• infrastructure projects that are too large for private capital to finance and that would enable a large amount of private investments to follow;
• poverty-alleviation projects that increase the income-generation capacity of the poor e.g. low-cost public housing when mortgage markets are still underdeveloped, provision of improved educational and health facilities, micro-credit schemes
• environmental restoration and protection

China does not have the worst mistakes of Malaysia, but should do more to ensure effective macroeconomics balance and institutional frameworks.

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