manufacturing sector among Malaysia’s overall exports and lower inflows of foreign direct investment (FDI) into the sector since the early 2000s, this has led some observers to characterize Malaysia as experiencing relative deindustrialization (Tan 2014).

In contrast to common perception, this study finds that Malaysia’s impressive growth in output per capita over the last three decades can largely be attributed not to structural change but instead to sustained growth in within-sector labor productivity. This is true over the entire observation period from 1987 to 2018 and all relevant sub-periods. During the time of most rapid growth from 1987 to 1997, labor productivity grew by an annual average of 9.1 percent in business services, 8.4 percent in trade services, and 6.1 percent in manufacturing. In contrast, structural change contributed a relatively small share of overall growth in output per capita, with the most sizeable contribution during the period of rapid industrialization from the mid-1980s to the early 2000s when labor was reallocated from agriculture to the manufacturing sector. Similarly, the relative deindustrialization of Malaysia since the early 2000s has led to productivity-reducing structural change, that is, a negative contribution of structural change to growth in output per capita. But again, the main reason underlying the slowdown in aggregate economic growth has been a slowdown in within-sector labor productivity growth. Excluding the mining sector, annual average within-sector productivity growth was 4.8 percent from 1987 to 1997, 2.4 percent from 1997 to 2007, and 2.1 percent from 2007 to 2018.

Accordingly, the main policy challenge for Malaysia going forward will be to reverse, halt or at least moderate the decline in productivity growth within sectors. The country’s incipient convergence to high-income status will make sustaining high rates of economic growth more and more challenging; World Bank (forthcoming) projects that by 2050 annual GDP growth will have fallen to 2.4 percent. Nevertheless, there are promising policy areas to at least moderate the decline in economic growth. These include overcoming skills gaps, maintaining the high quality of infrastructure, building innovation capacity, addressing distortions in output markets, improving management quality, and fostering the reallocation of production factors within sectors (World Bank 2016; Chuah et al. 2018; World Bank 2020). Though gains from sources of growth other than within-sector productivity are likely to be more limited, productivity-enhancing policies should nevertheless be combined with efforts to spur the more productive reallocation of labor across sectors. Finally, it will also be important to positively affect the employment rate by further increasing labor force participation especially among women, and better using the productive potential of older persons in the face of a rapidly accelerating aging process.

In terms of methodology, this study follows Martins (2018) and uses the Shapley decomposition method to decompose growth in output per capita into within-sector labor productivity growth, between-sector labor productivity growth, employment growth, and changes in the demographic structure. This study also utilizes the canonical decomposition method in World Bank (2019) that decomposes between-sector labor productivity growth into changes that can be attributed to the static and dynamic reallocation of labor. Regarding data, the study utilizes detailed output, employment, and population data collected and published by the Department of Statistics Malaysia (DOSM). Both output and employment data are compiled at the one-digit sectoral level. All sectoral data have been standardized to match Malaysia’s national accounts sector classification.

Based on this approach, the study provides one of the first quantitative and integrated analyses of structural transformation and labor productivity growth in Malaysia. In the process, it highlights detailed patterns of output and employment growth as Malaysia has shifted from being an agriculture-, to a manufacturing-, and subsequently service-based economy, as well as the underlying sources of these shifts. The resulting findings provide insights that are of relevance for how Malaysia can restart its productivity growth engine. In addition, they hold important lessons both for low-income countries that aim to emulate Malaysia’s successful structural transformation from an agricultural economy to one with a strong manufacturing sector and for middle-income countries that, like Malaysia, struggle to maintain high rates of labor productivity growth.

3