As Malaysia redefines its growth strategy , the question of which sector to promote has been a subject of ongoing debate. Some have argued that the strategy should emphasize manufacturing – and preferably high-tech manufacturing – as innovation activity is most forthcoming in this sector. Others have countered that services are key, as the typical economic structure of an advanced economy is oriented towards services. Tradable services are also fast becoming an engine of growth.
Efficiency and innovation are the key enablers of future growth
The prevailing consensus in modern growth theory is that the fundamental long-run driver of growth is productivity improvement. Malaysia, as an upper-middle income country, has passed the stage where the mere accumulation of production factors triggers rapid growth. It has entered the stage where growth hinges on the country’s ability to put its factors of production to good use—and this, as cross-country experience suggests, is a much more difficult endeavor.
How to enable rapid productivity growth? It is useful to distinguish, at a conceptual level, between efficiency and innovation as growth enablers. Efficiency enablers tackle the inefficiencies that arise in the way the factors of production are combined and employed, the result being that production falls short of the production frontier. Innovation enablers, simply put, are all about facilitating innovation that moves the production frontier in new directions.
The efficiency and innovation indicators of the World Competitiveness Report  are instructive. Out of 133 countries, Malaysia currently ranks 25th on indicators of efficiency and 24th on indicators of innovation. The indicators suggest that Malaysia has scored comparatively well among its peers, but in order to join the select group of high-income countries by 2020, further improvement will be necessary.
The growth enablers are sector specific
Do efficiency and innovation enable growth in Malaysia's manufacturing and services sectors in the same way? The answer is probably not, as it appears at the current juncture that the two sectors are, broadly speaking, at two different stages of development.
- Services are at a lesser stage of development, leaving much scope for efficiency improvement. Malaysia is the third-highest in the number of regulations it needs to revise to meet ASEAN’s service sector liberalization requirements. Liberalization could produce large beneficial effects. The World Bank’s recent Productivity and Investment Climate Assessment Update has found for example that alleviating foreign equity investment constraints can raise services productivity by 40 percent.
- With manufacturing closer to the efficiency frontier, innovation is key for this sector. While the products produced and exported are high-tech, the processes that make up the domestic part of the supply chain contribute less value-added and are not yet innovation-intensive. The sector needs to shift its manufacturing processes into higher value added—from assembly into research and development or logistics and branding—and improve the productivity of these processes through technological and nontechnological innovation. Innovation is also critical in the process of strengthening backward and forward linkages and the development of clusters that are technological and not just logistical.
Differences of course also apply at further levels of disaggregation . Some service subsectors (e.g. financial services) are already close to the efficiency frontier and may require more focus on innovation enablers. Some manufacturing subsectors (e.g. car industry) may not yet have exhausted efficiency gains and require more attention to efficiency enablers.
A balanced growth policy may work best
What does this tell us about growth policy? The point is that growth policy needs to take into account these sectoral and subsectoral differences. The implication is that tailored policies could energize both manufacturing and services, as there is a large untapped potential—although for different reasons—in both sectors. A growth policy that balances these differing needs may work best.
But there are also other reasons that favor a balanced growth policy. Not only can manufacturing and services provide an independent boost to growth, there are also synergies between the two sectors to be captured.
- Based on interviews of 1,100 manufacturing firms and 300 services firms, the World Bank’s recent investment climate assessment concluded that a lack of business support services was a key factor holding back the growth potential of the manufacturing sector. Growth in the services sector could therefore bring about positive synergies in the form of stronger manufacturing growth.
- Further development of the services sector also produces synergies in other dimensions. The new economics of geography suggests that geographical concentration of economic activity generates agglomeration economies and the resulting hubs may act as a magnet to creativity and innovation. But for these hubs to develop and prosper, close attention is required to aspects of livability—and this is where the development of a high-quality services sector can make a difference.
Potential for growth
In sum, both manufacturing and services hold significant potential for growth, be it independently and through synergies. To realize this potential, several hurdles will need to be cleared—see the World Bank’s recent Malaysia Economic Monitor  (disclosure: for which I led the team of authors).
But if an integrated growth strategy is adopted that addresses the key obstacles to the enablers of private sector development and puts in place sector-specific levers, both the manufacturing and services sectors can provide significant impetus to the country’s growth momentum.