3 This paper attempts to measure allocation efficiency across firms operating in narrowly defined manufacturing industries in Malaysia,<sup>2</sup> and the potential productivity gains that can be made by removing distortions that impede allocation efficiency. We find that distortions in both the output and capital markets lower the productivity of Malaysia’s manufacturing sector. If resources were being allocated “perfectly,” such that all marginal revenue products across all firms in the narrowly defined industries were equalized, Malaysia’s manufacturing productivity would be higher by as much as 94% in 2010. If we benchmark Malaysia against the level of allocative efficiency in the United States in 1997, hypothetical productivity gains are estimated to be 36%.

This paper contributes to the literature in three ways. It is the first attempt to measure the extent of resource misallocation in Malaysia using firm-level census data. Previous studies of Malaysia have tended to focus on the traditional drivers of aggregate productivity,<sup>3</sup> as well as the role of capital accumulation in growth and development. From a firm-level approach, we find that Malaysia’s productivity loss of 94% is comparable to that of China, an upper middleincome country, but lower than that of India, which is perceived to experience larger market distortions.<sup>4</sup> We also extend the analysis to investigate the misallocation of resources within 2-digit industry groupings.<sup>5</sup> We find misallocation to be rather significant in the food and beverage industry, but less apparent in the export-oriented industries, such as textiles, wood and wood products, and the machinery, electrical, and electronics industries.

Second, the availability of the three periods of census data allows us to examine trends in resource misallocation. We find that the allocative efficiency gap between the United States, the benchmark economy, and Malaysia worsened during these census periods. This suggests that the catching up process, particularly with respect to the United States, remains a challenge. Decomposing the sources of misallocation, we find that distortions in the output market appear to have a stronger effect on productivity compared to distortions in the capital or labor markets.

Third, we simulate three possible growth paths based on the magnitude of the realization of productivity gains. A realization of a 10% gain resulting from moderate reforms can lift growth by 0.4 percentage points over five years. More aggressive and purposeful market reforms can increase the realization of productivity gains and further lift growth. This is an important source of growth for Malaysia because we expect TFP to be the single most important contributor of future growth. Higher productivity growth is essential to accommodate the impact of demographic changes, to boost competitiveness, and to enable Malaysia to escape the middleincome trap that is afflicting many emerging economies.

> 2 The focus is on the manufacturing sector because we have access only to data on manufacturing firms in Malaysia. This does not mean that resource misallocation does not exist in other sectors such as services, construction, or agriculture. 3 See Sarel (1997); Ahmed (2009); and Anand et al. (2014). 4 See Hsieh and Klenow (2009).

> 5 The estimation of productivity gaps for industries is based on the 2-digit Standard Industrial Classification (SIC) of industries, while productivity gaps for the overall manufacturing sector is based on the 3-digit Malaysia Standard Industrial Classification (MISC) codes.  Both are harmonized to ensure consistency.   A 2-digit level classification of industries will define industries less narrowly compared to a 3-digit level classification.  For example, the 2-digit level classification “36” represents firms in the electronics, computers, and electrical equipment industry.  The 3-digit representation will breakdown the electronics industry into electronic components, computers and peripherals, consumer electronics, and so on.