Reversing the structural regression in Malaysia manufacturing

Published on Thursday, 03 December 2015

Published by Jayant Menon and Thiam Hee Ng on Thursday, 03 December 2015

The iconic Petronas Towers in Kuala Lumpur, Malaysia.
The iconic Petronas Towers in Kuala Lumpur, Malaysia.
When the Federation of Malaya gained independence from the UK in 1957, economic conditions were ripe for rapid and sustained growth, and the new country’s primary export sector showed immense potential for expansion.
 
A legacy of its colonial past, primary commodities—particularly tin ore and natural rubber—accounted for a third of Malaysia’s gross domestic product (GDP) and over 75% of exports by 1970. Manufactured exports accounted for less than 10%, raising concerns that heavy reliance on a few commodities left it vulnerable to terms-of-trade shocks from swings in commodity prices. There was little economic diversification up to the 1980s, with undersized manufacturing focused on little more than processing agricultural and mining output. 
 
In fact, several terms-of-trade shocks in the early 1980s—followed by global recession a few years later—ballooned fiscal and current account deficits, setting the stage for radical reform. A new National Development Policy was introduced, easing the affirmative action strictures of the pro-ethnic Malay New Economic Policy (NEP), and placing wealth creation ahead of wealth redistribution. The Promotion of Investment Act of 1986 extended generous incentives for private investors, and regulations on foreign direct investment (FDI) were relaxed, allowing 100% foreign ownership of export-oriented companies. Massive FDI inflows ensued. This opened Malaysia’s gates to the global production network, and the country succeeded in developing a vibrant and competitive electronics sector. Manufacturing grew sharply from about 12% of GDP in 1970 to over 30% by the mid-1990s.  
 
Although Malaysia had an early start in electronics, it could not build on its technological advantage and move up the value chain. As wages started to rise, skills remained weak. And then the Asian financial crisis struck in 1997. FDI in Malaysia never recovered, and domestic investment slumped as well. Since 2006, Malaysia has been a net exporter of capital, a process many suspect is driven more by capital flight than outward FDI. Although a net labor importer, it remains a net skills exporter, with growing numbers of professionals migrating to Singapore and other welcoming industrialized countries. With these developments, Malaysia’s fortunes have reversed in recent years, both in manufacturing and across the economy. 
 
Like in its early post-colonial phase, Malaysia is moving back to processing its agricultural and mineral resources. The only difference is that the commodities themselves have changed – rubber and tin have shifted to palm oil and petroleum. Petroleum refining accounted for almost 19% of manufacturing output in 2012, and palm oil processing 12%, each now bigger than electronics. While developing countries are often encouraged to process agricultural or mineral output before export to increase value-added content, Malaysia appears a rare example of an upper middle-income country—aspiring to high-income status—stunting or even reversing its previous success.
 
This manufacturing retrenchment has been associated with an overall contraction in the sector’s share of GDP, which fell gradually over the years to 24% in 2008, and has remained so ever since. Malaysia may be experiencing “premature deindustrialization,” as Turkish economist Dani Rodrik has recently warned. But unlike many other countries with similar experience, Malaysia’s case appears more driven by policy than by technological disruption, or trade and globalization.
 
But why should we care about these structural shifts within manufacturing, and its aggregate contraction? The main concern about petroleum refining and palm oil processing is that they are capital-intensive  and generate few jobs. Despite their importance in overall output, just 14,400 workers are employed in petroleum refining, compared to nearly 200,000 in electronics. Furthermore, agro- and petrol-processing industries generate relatively low-productive, low-skilled jobs, and so wages are also low. The largest share of manufacturing workers are plant and machine operators with an average annual salary of around $4,000, when per capita incomes average $11,000. 
 
If Malaysia is to realize its aspirations and enjoy living standards associated with high-income countries, it must arrest,  then reverse this structural regression, and improve the business environment to revive private investment in manufacturing. But regenerating manufacturing is unlikely without an overhaul of current policies. There is growing recognition that many of the country’s problems—including the slump in private investment—are rooted in the distortions resulting from the design and implementation of the NEP and its subsequent incarnations. Government-linked corporations spawned to serve racial economic redistribution now crowd out private investment in most sectors of the economy, including manufacturing.  
 
While Malaysia may still reach the technical threshold of high-income status in a few years—assuming an economic crisis can be averted till then—it still means little to the welfare of most workers in manufacturing if it continues its journey backwards.
 
This blog was first published in the Malaysian Insider.