4 Two caveats are in order. First, our analysis accounts only for resource misallocation _within_ sectors. There may be other, possibly large, resource misallocation _across_ sectors.<sup>6</sup> If so, closing those gaps could boost TFP and GDP growth even further. Second, as will be clear later, because of the lack of quantity data on both outputs and inputs, the Hsieh and Klenow framework makes assumptions regarding demand, such as constant elasticity of substitution (CES) aggregation and equalized markup across firms in the same sector. Because of these assumptions, what we attribute to misallocation in this paper could be partly caused by different markups, which in turn could be driven by differential quality and/or demand for the firms’ products. To the extent that there is no substantial variation in quality or demand for firms’ products within the same narrow industry, the Hsieh and Klenow approach provides a good approximation of resource misallocation. In subsequent papers, we will try to disentangle improvements in physical productivity with other quality and demand factors, thanks to newly obtained data on outputs and material inputs for Malaysian manufacturing firms.

This paper is organized as follows. Section 2.0 provides an overview of the Malaysian economy, particularly the manufacturing sector. Section 3.0 reviews literature on the role of misallocation as a source of productivity differences across firms. Section 4.0 discusses Hsieh and Klenow’s (2009) estimation framework, and describes the profile of firms in the three census periods and the data treatment for the estimation procedure. Section 5.0 discusses the findings. Section 6.0 concludes by discussing a few broad policy options.

# **2.0. Background**

The manufacturing sector is one of Malaysia’s engines of growth, registering an average growth of 7.8% and contributing approximately 1.5 percentage points (ppts) to overall GDP growth during 1988–2016. This is higher than the average growth in gross domestic product (GDP) of 6.1%. Development of the manufacturing sector first focused on import substitution. Then, from the mid-1980s, increasing openness to foreign investment drove export-led growth. The shift was made as the government saw the importance of technology embodied in FDIs as a way to develop and shape the country’s industrial base. In this regard, the Promotion of Investment Act (PIA) 1986 was instrumental in attracting foreign direct investment (FDI) through a spectrum of tax incentives, particularly in areas of services, manufacturing and agriculture.<sup>7</sup> Consequently, the manufacturing sector’s share of GDP increased steadily from 16.5% in 1988 to 21.2% in 1995, peaking at 26% in 2006. The growth of the manufacturing sector facilitated the diversification of Malaysia’s economic base by reducing the economy’s dependence on the agriculture and mining sectors. The share of manufactured exports to total gross exports increased from 22% in 1973 to 82% in 2016.

The growth in the manufacturing sector was disrupted by three major events: the Asian – – Financial Crisis (AFC) in 1997 98; the burst of the U.S. technology bubble in 2001 02; and the global financial crisis (GFC) of 2007-08 (figure 1). During each of these downturns, the manufacturing sector registered a sharper decline compared to the overall economic growth.

> 6 See, for example, Restuccia, Yang, and Zhu (2008); McMillan and Rodrik (2011).

> 7 Tax incentives such as the Pioneer Status and Investment Tax Allowance were aimed at promoting the export sector.  At the same time, the government had also undertaken measures to liberalize the equity requirements for foreign investment to support the objectives outlined in PIA 1986.