Getting Malaysia Out of the Middle-Income Trap

The rapid rebound from the Asian Financial Crisis of 1997-1999 helped lead the Malaysian government to predict that the annual GDP growth rate in 2001-2010 would be 7.5 percent, up from the 7.0 percent in the 1991-2000 period. This higher growth rate would be generated by Malaysia’s transformation into a knowledge-based economy where Total Factor Productivity (TFP) would increase its contribution to GDP growth to 3.2 percentage points from 1.8 percentage points in 1991-2000. This optimism in 2001 has proved to be ill-founded even before the arrival of the global financial crisis in 2008. The annual GDP growth rate turned out to be 5 percent in the 2001-2007 period. The fact that, in the same period, economic growth accelerated in the neighboring countries of China, India and Indonesia reveals that Malaysia has descended to a much slower growth path. Malaysia is now caught in the middle-income trap because it is still using the economic growth strategy, the New Economic Policy (NEP), that was formulated in 1970 when the structure of Malaysia’s economy and the international economic conditions were very different from today. By being inconsistent with knowledge-led growth, the NEP has caused private sector investment to collapse from 32.7 percent of GDP in 1995 to 9.3 percent in 2007. By focusing too much on the redistribution of income and not enough on the generation of income, NEP rejects meritocracy and institutionalises racism, thereby preventing full mobilization of human resources (e.g 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 either discourages successful Chinese Malaysian firms from tapping local stock market to fund expansion or drives Chinese Malaysian firms to move their headquarters to foreign lands. This is why, unlike the Taiwan case, there are very few Malaysian firms that have moved from producing import-substituting (import-competing) goods to become major exporters of these goods. 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, and increasingly frequent rulings by the Malaysian courts on the protection property rights that are at odds with standard practices elsewhere. The NEP undermines high growth by enshrining mediocrity at best and rewarding incompetence in general; provides a social justice justification for corrupt practices; and erodes investor confidence by escalating inter-ethnic tensions.To escape the middle-income trap, the government must implement root-and-branch reform in many areas (most, notably, the civil service, educational and research institutions, the fiscal system, the state procurement system, the judiciary branch, the police force, and government-linked companies), and puts the culture of excellence at the core of its administration. Only then, would Malaysia get the microeconomic incentives right, get the macroeconomic balances right, and get the governance institutions right in order to transition to a knowledge-based economy.