East Asia Forum
January 19th, 2011
Author: Hal Hill, ANU

Malaysia is one of the developing world’s great success stories. Few countries outside of East Asia can match its development record. Since its independence over 53 years ago per capita incomes have risen more than eight-fold, and absolute poverty has been all but eliminated.

But it currently faces three key, interrelated challenges, some generic to upper middle income developing countries, others specific to Malaysia itself.

The first, how to graduate to the rich-country club, has been clearly articulated by the country’s Prime Minister, Tun Najib: ‘We are now at a critical juncture, either to remain trapped in a middle-income group or advance to a high-income economy … We now have to shift to a new economic model based on innovation, creativity and high value added activities.’

The second, shared by some of its Southeast Asian neighbours, is the country’s slower development trajectory since the Asian financial crisis of the late 1990s. Even before the current global financial crisis, which it has navigated quite successfully, economic growth in the 2000’s was about two percentage points below that of the decade 1986-96.

Particularly worrisome is the slump in investment, which has been stuck at little more than 20 per cent of GDP since the late 1990s. This is 10-15 percentage points of GDP lower than the country’s historic ratio. With savings remaining buoyant, the country’s external position has been transformed dramatically. In 2002, the country had net liabilities equivalent to 35 per cent of GDP. By 2008, this had been transformed to net assets of 20 per cent of GDP. Put simply, Malaysians have been finding overseas investment increasingly attractive, while foreigners have been less attracted to Malaysia.

The third challenge relates to the development of high-quality institutions to underpin a modern market economy in a country that has experienced continuous one-party rule for over half a century. Malaysia’s ruling United Malays National Organisation (UMNO) is in fact the world’s longest-serving governing party currently in power among all ‘quasi democracies’. Not surprisingly, elements of UMNO exhibit the problems of complacence and arrogance that one expects from entrenched one-party dominance.

Malaysia’s strengths are not to be underestimated. It has always been one of the most open economies in the developing world, to both trade and foreign investment. It has rarely had a severe macroeconomic crisis, in large part because of this openness. It derived a major early mover advantage from its adoption in the early 1970s of export oriented industrialisation through foreign direct investment, before it was fashionable to do so. Among emerging economy manufactured goods exporters, it has progressed from 15th ranked and 1.2 per cent of the total in 1969-70 to 5th ranked and 5.2 per cent of the total in 2006-07. It is a major player in the global electronics industry. In 2006-07, it accounted for 3.8 per cent of global parts and components exports, in East Asia behind only the highly industrialised economies of China, Japan and Korea.

But Malaysia is struggling to shift out of low-skill activities, where it is no longer competitive with lower wage neighbours. These problems have been exacerbated by its vigourous promulgation of one of the longest running affirmative action programs in the developing world. Designed to redistribute employment and wealth to the dominant Bumiputera – principally ethnic Malay – community after the nasty communal conflict of May 1969, the so-called New Economic Policy (NEP) and its successors played an important role in promoting racial harmony in the country where there are large differences in living standards across racial groups.

But these programs have created a culture of entitlement, and they have resulted in institutionalised leakages that permeate practically every aspect of Malaysian commercial, social, political and educational life. The programs to advance Bumiputera development have benefited spectacularly the politically well-connected within this community, through preferential contracts, share allocations, and general commercial advancement, while all too little has trickled down to the general community. The programs can hardly be justified as anti-poverty programs when the principal beneficiaries are already egregiously wealthy.

As a result, some of the country’s industry policies have backfired. Malaysia might have been expected to be the leading Southeast Asian automotive producer, but Thailand has become the ‘Detroit of Asia’ owing to Malaysia’s disastrous national car program. In addition, the ‘spillover’ benefits from the large multinational presence in manufacturing have been limited by the fact that Malaysia’s small and medium enterprises (SMEs), that are predominantly owned by the ethnic Chinese community, prefer to stay small, below the threshold above which Bumiputera employment quotas become mandatory. The country’s public universities, once among the region’s best, have also slipped in East Asian rankings owing to these ethnic quotas as well as heavy bureaucratic control. The civil service is bloated and in need of reform, while there is a very large state enterprise sector that functions in a non-transparent manner and subject to little public accountability. Moreover, Malaysia has missed out on emerging service sector opportunities owing to the slow pace of liberalisation in that sector, itself a product of the very large presence of state-dominated firms and the NEP-preference schemes. And the country continues to experience a substantial brain drain as a result of the exodus of skilled professionals from the Chinese and Indian communities.

It is fashionable in Malaysia to attribute its current malaise to China, a country that is able to out-compete Malaysia in low-end and increasingly a sophisticated range of manufactures. While the ‘export similarity index’ (that is the composition of their exports) for the two countries is quite high, and thus there has some been some loss of market share to China from Malaysia in third-country export markets, the notion that the rise of China explains Malaysia’s current difficulties is untenable. That view overlooks the positive sum game for Malaysia from China’s rise. As a resource-rich economy, Malaysia has benefited from the general China-fuelled rise in commodity prices, for example its exports of palm oil and oil and gas. Similarly, commercial opportunities in tourism and education have been rising rapidly, with two-way investments rising very quickly. And Malaysia is a central player in the increasingly China-centred East Asian production networks that export to the world.

Hal Hill is HW Arndt Professor of Southeast Asian Economies at the Australian National University. With Tham Siew Yean and Ragayah Haji Mat Zin, he is co-editor of ‘Graduating from the Middle: Malaysia’s Development Challenges’, forthcoming in 2011.