Malaysia cannot afford to go slow on structural reform implementation


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Malaysia is emerging strongly from the worst export slump in its economic history. With a robust recovery underway, Malaysia is now focusing on the medium-term growth agenda and a New Economic Model has been proposed. It is against this backdrop that the World Bank launched its new report on the Malaysian economy on April 19 (full disclosure: I lead the team who authors the report).

The key message from the report is that Malaysia cannot afford to go slow on the implementation of structural reforms. Our analytical work suggests three reasons why:

  • High-income economy. Growth to date has been driven primarily by greater quantities of capital and labor. To break the glass ceiling between middle and high income, growth will need to be based on innovation with greater emphasis on the quality of capital and labor as well as the efficiency with which these are combined in production. Structural reforms, as argued in the report, will be essential to unleash Malaysia’s innovation potential and achieve the high-income objective.
  • Inclusive growth. Affirmative action is an essential policy instrument in many countries around the world and can be designed and implemented in ways that are conducive to growth. Pro-growth affirmative action requires a refocusing on needs so that the errors of inclusion and exclusion are minimized.  More broadly, structural reforms that boost growth and enlarge the pie of national income make it easier to meet distributional challenges which remain significant. Poverty in Malaysia is four times higher than in Korea and Singapore, and inequality remains high at levels comparable with Indonesia and Vietnam.
  • Government debt sustainability. Extraordinary times call for extraordinary measures and governments around the world expanded their balance sheets. The experience in Malaysia has not been different. Structural reforms, however, will be essential to ensure that the growth momentum is sustained and the debt level is gradually reduced. Slippages on the structural reform implementation front could be costly and cause the debt to rise relative to national income, which in turn would require additional fiscal consolidation. Structural reform thus matters not only for growth but also for debt sustainability.

Whether policy changes translate into tangible outcomes will depend on the scope of the reform effort and on the capacity of the institutions implementing them. As picking and choosing individual reforms measures would diminish synergies between reforms, a comprehensive effort is more likely to yield success. Institutional capacity matters as well and further efforts to coordinate and streamline the government machinery would be conducive to effective reform implementation particularly where numerous stakeholders are involved.

If reforms can be implemented both comprehensively and timely, the benefits are likely to be considerable. Addressing the imperfections in the enabling environment could generate, for example, a powerful transitory boost particularly to the services sectors, where further liberalization could boost productivity by as much as 40 percent, as our research suggests. Over time, additional momentum can be squeezed from reforms that unleash Malaysia’s innovation potential. These measures would bring Malaysia significantly closer to the objective of becoming a high-income economy.


Philip Schellekens

Lead Economist, Development Prospects Group, World Bank

Join the Conversation

Danny Quah
April 22, 2010

Thank you for this blog post and for your work on the World Bank Malaysia Economic Monitor. The Economic Monitor is a wonderful collection of information; I will be referring back to it often over the next few months.

While in the main I cannot disagree with your analysis, on a few points I might have placed somewhat altered emphasis:

An observation brought to great attention in the early 1990s (especially by Paul Krugman and Alwyn Young for East Asia) is how economic growth cannot continue from just ever-greater capital and labour inputs, i.e., from "mere sweat alone". At some point, the law of diminishing returns sets in; truly enduring growth can come only from productivity increases through innovation.

Although the World Bank Malaysia Economic Monitor achieves a lot more besides, one of its principal messages (indeed, its subtitle) ends up following that thinking in policy prescriptions: it leaves a reader with the impression that unless innovation occurs, the Malaysian economy will be held back at middle-income level plateau, unable to transit to high income.

I agree that obstacles are, indeed, holding back Malaysia's economic development. But is the most critical of those bottlenecks that Malaysia's capital and labour inputs are already flush, so that unless there is innovation, Malaysia will not break out of its middle-income trap?

I suggest that this last is just false. I don't disagree that Malaysia desperately needs a strong knowledge base, a lively scientific and intellectual community, and well-performing world-class universities and research laboratories. It needs all those but more besides. But, in my view, focusing overly on just one dimension - without the coordinated big push generating synergies across all the principal problems - runs the risk of misallocating resources and undermining economic performance.

Why do I think this? Since 1997, physical capital investment in Malaysia has gone into free-fall. As a fraction of GDP, Malaysia's investment is now 50% what it was before 1997. That it has remained as high as it has is due to government pump-priming: private investment has declined even more sharply; as a fraction of GDP it is now just one-third what it used to be. Over 25% of local public university graduates remain unemployed 6 months after graduation. Four-fifths of Malaysia's current workforce is educated only up to high-school level.

This is not an economy straining at the bit to escape the curse of diminishing returns, needing to be rescued by innovation. What it is, instead, is an economy desperately needing an integrated package of reforms, simultaneously to repair a grotesque under-employment of resources as well as to ignite innovation. In the short to medium term, breaking out of the middle-income trap might rely more on fixing the former than it does on succeeding with the latter.

Your report is refreshingly up-front about how innovation is a complicated, multi-dimensioned, multi-faceted process. I might emphasize further only that patterns of development across the global economy have now reached a point where our understanding of innovation also needs to be enriched in new dimensions. Innovation to produce the next iPad or Google gadget is sexy. But not-so-sexy "frugal innovation" - using cheap labour to redesign products and processes, to make the world's cheapest, lowest carbon-footprint car, to run the world's largest assembly line for solar panels and zero-carbon energy storage - will likely have by far the greatest impact on the greatest number of people's lives in the next decade, and is likely where countries like Malaysia (or China or India or elsewhere in East Asia) need to lead.

On the urgent need for structural reforms, we agree. But, again, I don't think those reforms are just to permit innovation (to drive growth), nor do I think Malaysia's middle-income problem is now because it has already reached the limits of what the economy can do with its workers and its capital.

April 19, 2010

For the past 40 years Malaysia implemented the NEP purportedly to alleviate poverty of the Malay (Bumiputras). That policy was defacto not a policy of affirmative action but was positive racial discrimination. While it supported the elite Bumiputras in seeking scholarships, shares at discounts, land, licenses it was not a level playing field for even the Bumiputras. The Royalty and elite benefitted from this policy. As for the non-Malays it was un developing them-not being able to participate in the economy or attend universities that carried a quota. Worst still for race relations it tore up the country through this segregation-there is still much hatred today with the government’s policies.

Now in 2010, Malaysia finds itself unable to compete globally in the market. Free trade rules do not allow for discrimination and the failure to obtain an FTA with the USA, speaks by itself-the USA will not accept apartheid. In the process of trying to participate, the Malaysia government has come out with the NEM (New Economic Model). Let me say at the outset, that this is nothing more than a relabeling of the NEP to satisfy conditions to be accepted into a multilateral treaty of sorts! The World must not allow this. This will enable the Malay government to work with US and other companies in Malaysia contracts leaving out the Chinese and Indians. This must never be allowed to happen. The Malaysian government is attempting to enter the backdoor knowing fully well that the front is shut and locked because of the racial discriminatory policy.

Yara Salem
April 19, 2010

Hi philip, I read your blog this morning. later today I read an article on The State of Entrepreneurship in Malaysia…
the article talks about Malaysia’s relatively high entrepreneurialism and its reflections in its entrepreneurship and innovation rank by the Legatum Prosperity Index: 28th out of 104 economies. the article says that Malaysia’s performance is boosted by a flourishing high-tech industry. High-tech exports constitute over half of total exports. Moreover, high levels of royalty receipts indicate that Malaysia is able to capitalize on its innovations, according to the Legatum study. Similarly, the World Bank ranks the country 23rd out of 183 economies in the ease of doing business.
I am intrested in your take of the above.

Philip Schellekens
April 19, 2010

Thanks, Yara. One of the observations that we make in our recent report is that Malaysia has been highly successful in plugging the export-oriented segment of its economy into cross-border production networks. But Malaysia has been less than successful in attracting value from this growing integration with the region and the rest of the world.

An entrepreneurial, talented and creative workforce, the ability to develop and access technological capabilities, and the adequacy of finance all matter to change this situation, as the article you refer to mentions. In each of these dimensions, Malaysia still has some way to go. For example, Malayia ranks top of the world on the Doing Business indicators of ease of credit and has many incentive schemes in place for innovation. Yet, the latest National Innovation Survey (2005-08) suggests that 43 percent of innovating firms consider lack of finance as a very important concern hampering their ability to innovate.

As our report mentions, for innovation to lift off, more is needed than just the innovation capabilities of talent, technology and finance. Competition, which is the driving force of innovation, also needs to be stimulated. Furthermore, to make sure that innovation efforts deliver the greatest bang for buck, the amplifiers for innovation also need to be in place. Efforts can be concentrated in product niches and in geographical clusters. That way, efforts are not diluted.

Philip Schellekens
April 19, 2010

Anonymous, thanks for your comment. Your observation is consistent with the fact that income inequality in Malaysia remains at high levels. This applies to the country as a whole but also within broad segments of society and in fact within each of the ethnic groups in Malaysia.

Regarding the New Economic Model, I would not pre-judge how this is going to unfold. Of course, the broad policy principles that have been announced will need to be implemented first - and implemented successfully - before any real change is going to happen. But I find it encouraging that the NEM, which was made publicly available, contains a frank assessment of the challenges facing Malaysia. The report highlights for example that the gap between rich and poor is widening in Malaysia and it does refer to many of the issues that you mention.

The NEM does not stop at making assessments; it offers a way forward. The NEM proposes a whole range of policy initiatives. Affirmative action is just one of them (even though this is the one the domestic and international media focused the most on). The NEM proposes to modernize the country's affirmative action policies, by making the policy more transparent, market-friendly and targeted to the needy.

To quote directly from the report on page 25(

"A key component of inclusiveness is the fostering of equal and fair economic opportunities. Affirmative action programmes and institutions will continue in the NEM but, in line with views of the main stakeholders, will be revamped to remove the rent seeking and market distorting features which have blemished the effectiveness of the programme.

Affirmative action will consider all ethnic groups fairly and equally as long as they are in the low income 40% of households. Affirmative action programmes would be based on market-friendly and market-based criteria together taking into consideration the needs and merits of the applicants. An Equal Opportunities Commission will be established to ensure fairness and address undue discrimination when occasional abuses by dominant groups are encountered (Table H)."

Philip Schellekens
April 27, 2010

Thanks for these insightful comments, Danny. They touch upon a fundamental issue, worth exploring into some more detail.

But before responding to your question, let me first make a general remark about two fallacies that invariably pop up in different shapes and shades when discussing the role of innovation in growth and development.

The first fallacy is that growth through innovation is just about technological change resulting from ground-breaking discoveries often in the context of formal R&D programs. Innovation of course goes much beyond this and includes also nontechnological types of innovation and these types of innovation may apply to not just products but also processes and organizations. Innovation is also not just concerned with the creation of ideas that are completely new to the world. Equally (and, for growth, perhaps more) important is the diffusion of existing ideas that have been long established but may be new to a firm, an industry or even a country. Innovation through diffusion is a powerful source of productivity growth, but this is all too often insufficiently emphasized.

The second fallacy is that innovation can be separated from the accumulation of human and physical capital. This fallacy arises perhaps from the fact that innovation—hard as it is to conceptualize, measure and control—is not easily captured by the straightjacket of the four- or five-variable economy-wide production function, where the accumulation in the factors of production and the growth rate of total factor productivity are separated. While this separation is analytically convenient and useful for broad-brush assessments, the reality is that innovation itself depends on factor accumulation. For innovation to thrive, it therefore needs to be supported by a healthy level of investment in human and physical capital.

Turning to the question of whether innovation is essential to Malaysia’s high-income ambition, the short answer is yes. Let me amplify why by addressing the following three questions.

Can Malaysia squeeze additional growth momentum out of factor accumulation? Certainly. On physical capital accumulation, as documented in our November 2009 report, the share of private investment collapsed dramatically following the Asian financial crisis and, unlike most other countries in the region, it never fully recovered. While there are several reasons why investment shares should not be expected to fully recover to pre-crisis levels, the current level of investment appears to be low for a dynamically efficient economy and the current report suggest some reasons why this may be the case. On human capital accumulation, there is also scope for improvement. The skills issue is perceived by some 1,400 manufacturing and services firms as the number-one obstacle in consecutive World Bank investment climate assessments. We also know that, while labor force participation of Malaysian males is among the highest in the region, female labor force participation is among the lowest.

Will additional factor accumulation be sufficient to break through the glass ceiling between middle and high income? Not necessarily. All will depend on the type of factor accumulation. If the old ways of plain-vanilla accumulation measured by numbers is to be repeated, then the collateral benefits of economy-wide productivity growth are unlikely to materialize. Malaysia does not just need additions to the number of people or the stock of physical capital. To climb up the income ladder, it will be the skill, talent and entrepreneurship of the workforce and the quality of domestic and foreign investment that will determine the rate of success or failure in moving up the value chain.

Is innovation essential? Yes, but not just the narrow forms of innovation (where focusing on easy metrics may produce inferior results) and not just through total factor productivity growth but also on the back of better-quality human and physical capital. To put it bluntly in the terms of the debate in the 1990s, the fundamental driver of growth needs to shift from ‘perspiration’ to ‘inspiration’ and the economy needs to transform from ‘sweatshop’ to ‘smartshop’. Innovation—the successful exploitation of new ideas—holds the key to success in this transformation. The alternative—perspiration without inspiration—will undoubtedly produce some benefit of growth, but is a risky proposition given the increasingly intense competition. With other countries striding ahead and moving up the value chain (China being the case in point), standing still is an option but it is not a very good one. In the current environment, innovation is not just required for growth, it is also essential for survival in the global marketplace.

Greg Lopez
June 07, 2010

Hi there Philip,

Thanks again for another sound intellectual argument on the need for economic reforms, specific areas as well the accompanying policies that needs to be taken

I get the sense that Premier Najib, at this point in time, needs a political strategy rather than an economic one.

He appears to be floundering at every turn - coming under attack from within and without his party on any economic reform initiative that he attempts.

Would it be a good time for the WB to do a study on "sequencing reforms" with a focus on the political economy taking lessons from other economies that have managed disparate stakeholders but also learning from how Malaysia's earlier reforms were done in managing the different stakeholders and if it can be implemented at all under the present political arrangements.

I am sure that you are aware that many of these recommendations have been coming in different forms since 1990 (when the NEP was to be reviewed) but have yet to gain traction because of the political arrangements. I fear the NEM, which captures many of the WB recommendations here and in last year's monitor, may go the same way.

At this point in time, how to actually to get the reforms done is what Najib & Malaysia needs.


The FT
June 16, 2010

Danny’s optimism is commendable but the NEM reforms could turn out to be a second (or third) best means of driving growth. My logic agrees that Innovation should be the prime driver, while the second best option is a structural reform package without a strict innovation focus:-

“Innovation led growth” will be difficult if not impossible to achieve without the requisite human capital base. Analogizing Ibn Taymiyyah, Copernicus, and most recognizably Gresham – The playing field is unbalanced such that a couple “bad guys” have driven the good innovators ones out, and will continue to do so.

This human capital bottleneck is illustrated via your typology of 3 kinds of innovation – Product Innovation; brain flight of product innovators, Organizational Innovation; distorted incentives and moral hazard has thoroughly corrupted the Organizations, and, Process Innovation; staff turnover leading to lack of institutional memory which could drive said innovation. To elaborate on latter point, the employee reaching a level of education or experience capable of driving process innovation will leave or is poached – it’s an artificially tight market for such talent.

The second best option (Danny’s “the more besides”) is not feasible – precisely because these “other” reforms have are driven by a flawed government:-

Government structures are corrupt; and worse, widely perceived as corrupt. Years of abuse have made the public disbelieving and cynical. “Trust” or social capital has been destroyed to such a large extent to make government driven reforms relatively ineffective. Yes, Malaysia’s existing structures are improving – recent reforms (the GTP) have shown encouraging results especially with regards to efficiency and, dare I say – “productivity” – of delivery. BUT, climbing back out of the hole will take a lot more resources than is able to be mustered based on the prevailing political will for reform.

I’ll end with a name drop of a related and more recent theory – that of Ersatz Capitalism or Lemon Socialism – referenced to by no less than the eccentric laureate Stiglitz. Moving away from the individual perspective to a company level one, the government is driving good companies out by supporting weak ones. Your argument of facilitating vs orchestrating would seem relevant here.

The pessimism might change as our work progresses – but my frank assessment is that we will have to live to fight another day.

August 02, 2010

Hello Philip,

I'm interested in studying the economic reform process from the perspective of household savings in Malaysia.

Do you by any chance have information on household savings or know where I might be able to find it? Bank Negara apparently does not publish the figure.

Thank you,