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THE LESSONSOF EAST ASIA

MalaysiaGrowth, Equity, and StructuralTransformation

Ismail Muhd SallehSaha Dhevan Meyanathan

The World BankWashington, D.C.

Copyright © 1993The International Bank for Reconstructionand Development/THE WORLD BANK

1818 H Street, N.W.Washington, D.C. 20433, U.S.A.

All rights reservedManufactured in the United States of AmericaFirst printing October 1993Second printing September 1994

The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s)and should not be attributed in any manner to the World Bank, to its affiliated organizations, or tomembers of its Board of Executive Directors or the countries they represent. The World Bank does notguarantee the accuracy of the data included in this publication and accepts no responsibility whatsoeverfor any consequence of their use. Any maps that accompany the text have been prepared solely for theconvenience of readers; the designations and presentation of material in them do not imply the expressionof any opinion whatsoever on the part of the World Bank, its affiliates, or its Board or member countriesconcerning the legal status of any country, territory, city, or area or of the authorities thereof orconcerning the delimitation of its boundaries or its national affiliation.

The material in this publication is copyrighted. Requests for permission to reproduce portions of it shouldbe sent to the Office of the Publisher at the address shown in the copyright notice above. The World Bankencourages dissemination of its work and will normally give permission promptly and, when thereproduction is for noncommercial purposes, without asking a fee. Permission to copy portions forclassroom use is granted through the Copyright Clearance Center, 27 Congress Street, Salem,Massachusetts 01970, U.S.A.

The complete backlist of publications from the World Bank is shown in the annual Index of Publications,which contains an alphabetical title list (with full ordering information) and indexes of subjects, authors,and countries and regions. The latest edition is available free of charge from the Distribution Unit, Officeof the Publisher, The World Bank, 1818 H Street, N.W., Washington, D.C. 20433, U.S.A., or fromPublications, The World Bank, 66, avenue d'1ena, 75116 Paris, France.

ISSN: 1020-0924

Ismail Muhd Salleh is assistant director-general at the Institute of Strategic and International Studies inKuala Lumpur, Malaysia. Saha Dhevan Meyanathan is senior industrial economist in the World Bank'sEconomic Development Institute, Finance and Private Sector Development Division.

Library of Congress Cataloging-in-Publication Data

Salleh, Ismail Muhd.Malaysia: growth, equity, and structural transformation / by

Ismail Muhd Salleh, Saha Dhevan Meyanathan.p. cm. - (The Lessons of East Asia)

Includes bibliographical references.ISBN 0-8213-2610-41. Malaysia-Economic policy. 2. Malaysia-Economic conditions.

I. Meyanathan, Saha Dhevan, 1948- . II. Title. III. Series.HC445.5.1833 1993338.9595-dc2O 93-23261

CIP

CONTEN73

FOREWORD ....................... vACKNOOEDGEMENS .................. viiEXECUTIVE SUMMARY' ......................................... ix

1. INTRODUCTION IDevelopment S uu.e s. IInitial Conditions 2Development Phas e..3

11. SECTOR ANALYSIS ......................................... IInvestment and Trade .8Public Sector ........................................... 15Human Resource Development ................................ 23Infmstructure ........................................... 27Agriculture ............................................ 27Finance .............................................. 31

m. INSTITUTIONAL CAPACrY .................................. 34

IV. EVALUATION AND LESSONS ................... 38LeoMns: .............................................. 47

BBLIOGRAPHY ............................................... 49

MALAYSIA: ECONOMIC AND POLITICAL TMEL E .... 4................ 4

iii

FOREWORD

Policymakers everywhere are searching for lessons from East Asia's enormous success ineconomic development. A number of recent cross-country and thematic studies have sought to identifyand analyze the policies behind this success. Among them is 7he East Asian Miracle, a recent WorldBank publication, which draws in part on the Lessons of East Asia project. Study teams, including in-country nationals, examined in some depth the experiences of the highly successful East Asian economiesand the public policies underpinning them.

Several clear contributions emerge from this set of country studies. The research:

* Highlights considerable variation in approaches within the group of East Asianeconomies. For example, some economies chose a substantial degree of governmentintervention; others did not. The studies dispel the notion that there is a single oruniform East Asian model of success.

* Demonstrates that a core set of good economic policies -- such as macroeconomicdiscipline, outward orientation, and human resource development -- laid thefoundation for East Asia's success. Pragmatic policymaking -- understood as beingnonideological and reversible -- seems to be at the heart of these policies and meritsreplication.

- Dispels some of the myths about the more idiosyncratic interventions, such as"picking winners" in industry, which sometimes produced the desired result andsometimes did not. Because presence or absence of institutional features seems tohave affected the outcomes of these interventions, applications to other regionalcontexts must be approached cautiously. A dominant finding of the studies is thatserious diversions from macroeconomic equilibrium were largely avoided, even bystrong interventionists. At the same time, the later generation of industrializers weremore successful when they avoided these industrial policies.

A question not easily answered is why East Asian governments adopted fundamentally soundpolicies and were apparently able to achieve better results from their active policies and to incur lowercosts from errors. In this connection, the studies touch on such dimensions of policymaking as the roleof the state, leadership, and the bureaucracy. It is one thing to describe the institutional featuresaccompanying a successful episode, however, and quite another to know why and how those featurescame about. For instance, why did East Asian leaders apparently hold themselves more accountable foreconomic performance than has been the experience elsewhere? How did the governments manage togain sufficient national consensus to put difficult policies into effect? These aspects of political economycannot be ignored. Our analytic tools, however, are severely limited in penetrating these issues, inassessing their impacts, and in assigning credit to them. These country studies are only one step,although a significant one, in deepening our understanding of the experience of East Asia. It is hopedthat they will prompt additional work on the institutional foundations of rapid growth.

Gautam KajiVice President

East Asia and Pacific Region

v

ACKNOWLEDGMENS

This paper and all the papers produced as part of the country studies project have benefitedfrom the insights and observations offered by discussants and commentators at a conference held at theEast-West Center in Honolulu, November 19-21, 1992. The participants included the following regionaland country experts: Duck-Soo Han, Hal Hill, Chalmers Johnson, Wolfgang Kasper, Hyung-ki Kim,Paul Kreisberg, Chung H. Lee, Manual Montes, Seiji Naya, Takashi Nohara, John Page,Tambunlerthchai Somsak, Wanda Tseng, Wing Thye Woo, Ippei Yamazawa, and Zainal Aznam Yusof.The papers also benefited from a Bank-wide review of the project in August, 1993.

The country studies team included Amar Bhattacharya, Leung Chuen Chau, ScottChristensen, Carl Dahlman, David Dollar, Kim Kihwan, Saha Dhevan Meyanathan, Mari Pangestu, PeterPetri, Ismail Salleh, Ammar Siamwalla, Teck-Wong Soon, C. Suan Tan, and Vinod Thomas. Thecountry authors would like to acknowledge fruitful dialogue with our country counterparts and theanalytic work prepared in World Bank country departments as part of Bank economic and sector work.The country studies were edited by Rupert Pennant-Rea. The project assistant was Jason Brown. Thisproject was undertaken with the support of Lawrence H. Summers, Nancy Birdsall, John Page, andGautam Kaji, Callisto Madavo, Marianne Haug, and Vinod Thomas.

Danny M. LeipzigerCountry Studies Director

vii

ACRONYMS

DPM - Deputy Prime MinisterEPB - Economic Planning BoardFDI - Foreign direct investmentFYR - Five Year PlanGDI - Gross Domestic InvestmentGDP - Gross Domestic ProductGIE - Government-invested enterprisesGTC - General Trading CompanyHCI - Heavy and Chemical IndustriesHUD - Harvard Institute for International DevelopmentKDI - Korean Development InstituteKEPCO - Korea Electric Power CorporationKIET - Korea Institute of Economics & TechnologyKIST - Korea Institute of Science & TechnologyKNR - Korean National RailwayKOTRA - Korean Trade Promotion CorporationKTA - Korean Traders AssociationMOF - Ministry of FinanceNIF - National Investment FundODA - Official Development AssistancePOSCO - Pohang Steel CompanyREER - Real effective exchange rateVAT - Value-added taxWDR - World Development Report

viii

EXECUTIVE SUMMARY

Development Strategy and Macroeconomic Performance

Over the past three decades, Malaysia has achieved growth, equity and structural transformationin an ethnically diverse society. Between 1960 and 1990, real GDP increased sevenfold, at an annualgrowth rate of 6.8 percent. In the course of this expansion, Malaysia has been transformed into a modernindustrial economy, where manufacturing now accounts for 29 percent of GDP and 60 percent of exports.Moreover, rapid development has been associated with reduced inequality in the distribution of income,particularly between ethnic groups. Absolute poverty has now all but disappeared in Malaysia.Underlying this process has been a strong record of macroeconomic stability and an aversion to inflation.

Development strategy in Malaysia can be separated into three broad phases. From independencein 1957 to the late 1960s, the state pursued market-based policies for industry but intervened to promoterural development and to provide social and physical infrastructure. Agriculture accounted for the largerpart of state development expenditure, and domestic manufacturing received only light protection.Growth was stable during this period and was based largely on the export of primary products. Neverthe-less, there was little improvement in the level of absolute poverty, particularly among the indigenousBumiputera population. Ethnic discontent led to communal rioting in 1969 and prompted a radicalrethinking of policy.

Between 1971 and 1985, Malaysia's development strategy was guided by the New Economic Policy(NEP) and its twin objectives of eradicating poverty and restructuring society to redress economicimbalances between ethnic groups. In particular, the NEP was designed to improve the economic positionof the indigenous Bumiputera population and allowed for a considerable increase in state intervention toachieve this goal. Nevertheless, economic policy has evolved through a series of stages ... thin thecontext of the NEP. During the 1970s, the focus was on distributional objectives. The state attemptedto increase Bumiputera involvement in modern commercial and industrial activities by introducingemployment and ownership quotas. Under the Industrial Coordination Act 1975, all manufacturingenterprises with 25 or more employees required an operating license. The award of these licenses wasmade conditional on the enterprise's conforming with NEP ownership guidelines. Commercial bankswere required to fulfill lending quotas at subsidized rates to priority sectors (including Bumiputera-ownedenterprises). The state also set up new enterprises and bought out the equity of foreign-held companiesto increase Bumiputera access to managerial positions.

Although its control over economic activity increased, the state continued to encourage the growthof private enterprise during the initial phase of the NEP. A series of incentives was introduced topromote manufactured exports, including investment credits, tax exemptions and credit subsidies. Freetrade zones were created to attract foreign direct investment (FDI) and were particularly successful in theelectronics sector.

In the early 1980s, frustration at the pace of economic development prompted a state-led attemptat industrial upgrading buttressed by the increase in oil and gas revenues. In 1981, public expendituremeasured 58.4 percent of GDP as the state invested in a range of capital-intensive manufacturingactivities, most notably through the Heavy Industries Corporation of Malaysia (HICOM). HICOM wasintended to promote industrial diversification, creating modern manufacturing activity outside the FTZenclaves and fostering backward linkages. The state provided HICOM's start-up capital and guaranteedthe organization access to subsidized loans. By 1988, it had set up 9 companies, often in the form ofjoint-ventures with foreign investors, and had a workforce of over 4,000.

The inefficiencies associated with the state-led drive to industrial upgrading are illustrated by therecord of HICOM's best-known project, PROTON, the national car manufacturer (a joint venture withMitsubishi). PROTON has recorded large losses, until recent years, and operates at well below theminimum efficient scale for car plants. The poor performance of PROTON has been matched by a

ix

number of other state-owned enterprises (SOEs). According to the most recent data, the SOE sector hada net operating deficit of M$1 billion in 1988. While previous periods of intervention had involvedrelatively small distortions - Malaysia's protection rates remained slight compared to other developingnations - industrial policy generated significant costs in the early 1980s. There were sharp increases incapital-output ratios and a decline in industrial productivity growth.

The third phase, in 1986-90, has been one of adjustment and liberalization. This was promptedby a sharp recession in 1985, highlighting the costs of the drive toward industrial upgrading and the largeexternal debt it had generated. Licensing requirements were relaxed and new investment incentivesintroduced in an attempt to stimulate private enterprise and increase FDI. State expenditure has beenrestrained and now concentrates on infrastructure provision. The new emphasis on growth and efficiencyis reflected in the National Development Policy, successor to the NEP, and in Prime Minister Mahathir'sVision 2020, which establishes the goal that Malaysia should become a "developed nation" by the year2020. These policies have been successful; Malaysia has recorded rapid economic growth since 1986 andis now a favored location for FDI among the Asian NIEs.

The state has continued to emphasize educational development throughout the post-independenceperiod but with mixed results. In the 1960s, the focus was on increasing primary and secondaryenrollment. Although the policy was successful, adult literacy rates remain below those of other EastAsian nations. Under the NEP, education policy became concerned with equal access to highereducation, causing many non-Bumiputera students to study overseas. More recently, the government isusing the education system to address skill gaps in the economy and is promoting the study of technicaland scientific subjects. Nevertheless, international comparisons suggest that Malaysia enjoys lower-than-expected benefits given the relatively large amount that it spends on education.

Institutions and Governance

The ability of the Malaysian government to engineer fundamental changes in development strategyhas been partly a function of political will and institutional strength. A coalition of ethnic-based politicalparties, in which the Malay grouping (UMNO) is the dominant partner, has retained power since 1955.The notion of national unity has been used to fend off challenges both internal and from other politicalforces. In part, political stability reflects a social contract between the ethnic groups, allowing Malaysto dominate the governance of the country while Chinese business interests remain intact. Prime MinisterMahathir remains the dominant figure in policy-making; he was responsible for the industrialization driveof the early 1980s, the "Look East" strategy, which increased Malaysia's trade with other Asian nations,and Vision 2020, which is publicized widely in the media and used to motivate people to the cause ofsustaining rapid growth.

The Economic Planning Unit (EPU), an agency in the Prime Minister's office, has been the keyinstitution for development planning. Staffed by technocrats, it prepares the government's medium- andlong-term plans and mid-term plan reviews. Also working out of the Prime Minister's office, theImplementation and Coordination Unit (ICU) ensures that policies are consistent and executed inaccordance with national and local plans. More generally, Malaysia inherited an effective bureaucracyand a firmly entrenched legal code which gave the government a reliable basis for policy implementationand administration. The Malaysian civil service has always worked closely with the political leadershipand has enjoyed strong support in return.

x

- 1 -

I. INTRODUCTION

Over the past three decades, Malaysia has achieved growth, equity and structural transformationin an ethnically diverse society. What was the role of the government versus markets in this process?What were the forms of government intervention? What were the costs and benefits? Could theMalaysian government have acted in other and better ways?

In evaluating government actions, the right emphasis is not on a simple state versus marketapproach but on the closeness of fit between strategy, circumstances and institutional capability on onehand, and development goals on the other (Klitgaard, 1991). This paper will use this approach toilluminate the nature, causes and results of state intervention. It is divided into 5 sections. First, adefinition of development success; then an examination of the conditions Malaysia faced at the time ofIndependence and its major development since then. Section 3 will then analyze the state's role indevelopment, paying particular attention to trade and investment, human resources, agriculture,infrastructure, state owned enterprises, and the financial system. Section 4 takes a brief look atMalaysia's institutional capacity for implementing reforms, and Section 5 assesses the role of governmentintervention in Malaysia's development and draws some lessons from its experience.

Development Success

Although national development includes economic, social, cultural, and political elements, thisstudy treats economic development as the core concern. Except for the severe 1985-86 recession,Malaysia has had relatively uninterrupted and rapid growth since 1957. Between 1960 and 1990, realGDP increased seven-fold, at an annual growth rate of 6.8 percent.' Per capita real GDP multipliedthree-fold, rising (in 1980 ringgit) from M$1,634 (US$534) to $5,301 (US$1,960), at an average 4.0percent per annum (IMF, 1991).?

Aggregate growth is not the only measure of economic welfare; equity is another importantconsideration. Figures shows that inequality in income distributionhas been reduced particularly betweenethnic groups. The incidence of poverty fell among all ethnic groups, with those in the rural sector(where the Bumiputera population predominates) showing large gains. There was also some success inchanging the ownership of wealth. In 1970, the Bumiputeras owned an estimated 2.4 percent of corporateequity; by 1990 their share had increased to 20.3 percent (Malaysia, 1991c).

The government adopted the goal of universal education in the 1960s, and by 1990 about 96percent of all students managed to complete at least six years of primary schooling. Health services, too,have expanded considerably. The ratio of population per doctor declined from 4,302 in 1970 to 2,594in 1990, and the number of hospitals and government clinics expanded from 1,838 to 2,784 (Malaysia,1991). The results have been striking. Life expectancy among men has increased from 62 to 70 years

The recession of 1985/86, when Malaysia experienced negative growth, naturally lowers theoverall figure. During the period 1967-1974 the growth rate averaged 7.7 percent per annum, andfrom 1975-1981 it averaged 8.3 percent per annum (Bruton, 1992). Since the recession, thegrowth rate has resumed a steady 7 percent per annum rate.

2 These are computed point-to-point in 1980 prices. Since income levels over a long period are notstrictly comparable, these figures should be treated only as indicative of the magnitude of change.In deriving the 1957 figure, the deflator for 1960 was used based on the assumption that there waszero inflation in the intervening period.

-2 -

since 1970 and for women from 66 to 74 years. During the same period, infant mortality rates havedeclined from 41 to 13 per thousand births (Malaysia, 1991).

A third criterion for economic development is resilience - the ability of the economy to withstandinternal and external shocks. In the case of an open economy like Malaysia, resilience meansdiversification away from the production and trade of a few commodities. This structural transformationfrom a lower value-added, farm-based economy to a higher value-added, modern industrial economy(Kuznets, 1960; Chenery et al., 1986) is characterized by a decline in the share of agriculture and acorresponding rise in industry. This Malaysia has done: in 1957, manufacturing contributed less than10 percent of the GDP while agriculture made up more than 40 percent; by 1990, manufacturingaccounted for 27 percent of the GDP compared with agriculture's 19 percent, and 60 percent of totalexports compared with 10 percent for agricultural commodities. Structural transformation has notlessened the economy's involvement in trade. Exports increased from 56 percent of GDP in 1960 to 65percent in 1990; the ccrresponding figures for imports are 44 percent and 65 percent.

Initial Conditons

For more than eighty years Malaysia (then Malaya) was under British colonial rule. Achievingindependence in 1957 under a parliamentary democratic system, the country was bequeathed an economywith growth potential as well as weaknesses.

Economic Conditions. With a land area of 330,000 square Iam, and a population of 6.2 million,Malaya already enjoyed a fairly high standard of living relative to its neighbors. It produced rubber,coffee, other forest products and tin. About 35-40 percent of GDP came from agriculture in 1960, twicethe average for all developing countries (Bruton, 1992). Agriculture itself was strongly dualistic, withlarge foreign-owned plantations on the one hand and smallholder rubber and rice farming on the other.Almost 60 percent of the workforce was in agriculture and fishing. Industrial activity was largely devotedto the processing of raw materials. In 1960, industry and construction together accounted for only 11percent of GDP, with another 23 percent coming from trade and finance.

The external orientation of the economy meant that exports and imports constituted a highpercentage of income. In 1960, exports were equivalent to 55 percent of GDP and imports 42 percent.The country was therefore susceptible to terms of trade shocks, and has been ever since.

As described by Bruton (1992, p.2 33 ), maintenance of order was the primary British concernwhich also led to a strong sense of macroeconomic stability. Order would attract foreign capital, and itwas best served by a balanced budget, a strong balance of payments, low taxes, and zero inflation. Theincreased investments would boost government revenues, which would allow for additional socialservices, which would also contribute to the improvement of the estate economy. Infrastructure,particularly transport, was relatively well developed but concentrated around the plantations and mines.Thus, concern for macroeconomic stability was established at the time of independence.

Political and Social Conditions. There was significant immigration from China in the nineteenthand twentieth centuries. These immigrants contributed to the trading sector and the opening anddevelopment of tin mining.3 Their control was later diluted by British colonialists with access to superiortechnologies and greater capital.

3 The Chinese population in Peninsular Malaysia was estimated at 856,000 in 1921. It rose to 1.29million in 1931 and 1.89 million in 1947. By 1957 it had reached 2.33 million (Bruton, 1992).

Under the British, a large number of workers were imported from India as well, laying thefoundations for the multiethnic society. In 1957, 49 percent of the population were Malay, 37 percentwere Chinese, 12 percent were Indian, with others making up the remaining 2 percent. Some 81 percentof the Malays lived in rural areas compared with 27 percent of the Chinese and 59 percent of the Indians.Malays were by far the poorest of the three groups. Snodgrass (1980) estimated that 56 percent of theMalay households had a monthly income of less than M$120, compared with 13 percent for the Chineseand 20 percent for the Indians. The colonial legacy was also characterized by the concentration of wealthin foreign hands. Most fledgling industries were owned by foreigners and ethnic Chinese.4 In 1963,the Borneon states of Sabah and Sarawak joined the Federation. Although rich in timber, oil and otherresources, they added yet more ethnic and political diversity to the country.

Malaysia also inherited the British colonial institutions: strong central government, a small andefficient administration, and a parliamentary system. The firmly entrenched legal code would give thegovernment a strong base for implementing and administering its policies over the coming decades.However, these institutions also served to codify certain social disparities which have affected Malaysiaever since, particularly in the areas of education and health.

As colonial powers withdrew from the region after the Second World War, a campaign forindependence began in Malaya. A political group called the "Alliance" took power. It was a coalitionof the leading Malay (United Malay National Organization - UMNO), Chinese (Malayan ChineseAssociation - MCA) and Indian (Malayan Indian Congress - MIC) political parties, and it has remainedin government ever since. In essence, each of Malaysia's economic plans has been a "social contract"promising equitable growth to all three groups.

To sum up, then, the newly independent Malaysia found itself left with a valuable institutionaltradition and a coalition government willing to seek compromises. But this coalition faced a highlycomplex society which was troubled by an unbalanced economic structure, ethnic inequality, and largeinter- and intra-regional disparities. Providing economic growth for the entire society would prove tobe the government's greatest challenge, and the question was what role it should play in the economy.One standard justification for state intervention is some type of "market failure," resulting in a sub-optimal allocation of resources. In the case of Malaysia, inequality in general, and inter-ethnic inequalityin particular, was precisely one such market failure. Racial equity was necessary for political stability,itself a vital precondition for rapid growth. In many senses, this was something that the market,composed of individual units, could not fully value.

Developmnt Phases

Given the initial complexities, it is not surprising that public policy has continually evolved overthe past 30 years in response to changing social, political and economic conditions. To provide a contextfor policy, we distinguish three development phases, more or less according to the degree of stateintervention.

4 Another structural issue of importance in the rural context, was the heavy concentration of villagelevel enterprises in Chinese hands. A particular instance of this was the rice market which wasmonopsonistic at the purchasing and distribution level. Small-scale Malay rice farmers generallysold their produce to the local Chinese rice miller, who was in a dominant situation in the localmarket. These setups aggravated ethnic tensions and resulted in the govenmment devoting manyresources to rural development in the 1960s.

Market-led Development, 1957-70. In the first decade after independence, the governmentessentially continued the colonial laissez-faire policies for industry, but intervened extensively to promoterural development and provide a social and physical infrastructure. Its aim was to reduce the economy'sdependence on rubber and tin, so it sought to boost the infrastructure and amenities that would encourageother forms of private sector production.

However, the government biased its interventions towards the rural areas. Agricultural andinfrastructure projects, which accounted for 52 percent of spending in the first Malayan plan, were aimedlargely at the eastern part of the country. This was comparatively underdeveloped and also contained alarge proportion of ethnic Malays. Over the first three five-year plans (1956-1970), agriculture and ruraldevelopment accounted for 22.3 percent of spending, while industrial development received only 2.4percent (Bowie, 1991, p.69). The government's hands-off industrial policy was the implicit "socialcontract" arising from the political compromise reached after independence. That compromise gave theMalay party (UMNO) the leading role, while the Chinese political party (MCA) kept control over theindustry and commerce portfolios.

Although the government promoted import substitution during this phase, it did not pursue a strongprotectionist policy that would have boosted manufacturing at the expense of agriculture. Bruton (1992)attributes this policy stance partly to the continuing political influence of the large plantations. Apartfrom broadening the industrial base, the import substitution policies were also aimed at reducingdependence on imported consumer goods, promoting the use of domestic natural resources, and creatingemployment opportunities.

Instead of direct industrial intervention, the government chose to operate through the creation ofa favorable investment climate. It offered general financial inducements in the form of tax holidays,industrial estates, and the provision of supporting services and infrastructure, which were institutionalizedin measures such as the Pioneer Industries Ordinance (PIO) of 1958. In the late 1960s, governmentindustrial intervention was increased following the formation of the Federal Industrial DevelopmentAuthority (FIDA), a govermment body responsible for promoting and regulating industrial development.5

Macroeconomic Developments. Starting from around 1960, the Malaysian economy was on itsway to stable growth. During the 1960s the average GDP growth rate was 6 percent per annum. Duringthis and later periods, overall performance was largely determined by the achievements of exporters.Taxes on rubber, palm oil and tin exports provided the bulk of government revenue. The export sectoralso had an influence on the money supply, but the Central Bank (established in 1958) has always closelycontrolled inflation and the period was marked by an unusual level of price stability.

Investment averaged 14 percent of GDP, but the savings rate was twice as high. Savings, stronglyaffected by commodity prices, outstripped investment until about 1971. One explanation for the lowinvestment rate was the inherent caution of the entrepreneurial class (World Bank, 1985). Fiscalprudence was another cause. The country had a balanced budget and a balance in the external currentaccount, and its foreign currency debt was around 10 percent of annual exports (Bruton, p. 187). Thelabor market could not keep up with the growing number of new entrants, and unemployment by the endof the 1960s was reaching 7 percent.

Although economic growth during this period was impressive by developing countries' standards,there was relatively little reduction in the level of absolute poverty for many people, particularly the

Formed in 1965, it was renamed Malaysian Industrial Development Authority in 1968.

- 5 -

Bumiputeras.6 Widespread poverty coupled with relatively high unemployment and underemploymentamong the Bumiputeras contributed to discontent which, together with communal politics, resulted in the1969 ethnic conflict. This event was a watershed in Malaysia's social and economic policy.

State-led Development. 197;-85. The 1969 ethnic conflict prompted a major rethink in theMalaysian government's approach to development. The result was the New Economic Policy (NEP) of1971. In retrospect, the NEP can be seen as a response to the failure of the "trickle-down" effects ofmarket-led development to achieve a socially acceptable pace of income, employment and wealth betweenthe economically disadvantaged Bumiputeras and the other ethnic groups. In essence, this second phaseof Malaysia's development policies was the product of a second "social contract".7

The NEP's aim - growth with equity - was embodied in the twin objectives of eradicatingpoverty and restructuring society to redress economic imbalances between the ethnic groups. The NEPthus gave impetus to a more active and direct state role in resource allocation, production and trade,primarily through public enterprises. The aims of the Government were to establish new industrialactivities in selected areas and to create a Burniputera involvement in commercial and industrial life."The efforts to attain these objectives will, in turn, be undertaken in the context of rapid structural changeand expansion of the economny so as to ensure that no varticular group experiences any loss or feels anysense of deprivation in the process" (Malaysia, 1973) (emphasis added).

The government set two targets: the Bumiputera group would, within 20 years, manage and ownat least 30 percent (as opposed to 2.4 percent at the time) of total commercial and industrial activities;and employment at all levels and in all sectors, particularly the modem and urban sectors, must reflectthe ethnic composition of the population (Malaysia, 1970). To achieve its ownership target, thegovernment began a policy of velvet nationalization, basically buying out and restructuring the equity offoreign held companies through trustee companies, notably Permodalan Nasional Berhad (National EquityCorporation).

In the pursuit of growth, the government stressed the diversification of agriculture and moreintensive use of natural resources. It established regional development authorities to integrateagricultural, commercial and rural development in selected regions. The decline in rubber and othercommodities accelerated government programs supporting cocoa and palm oil cultivation as well asextensive forestry. Significant reserves of petroleum and natural gas were also discovered in the easternpart of Peninsular Malaysia and offshore Sabah and Sarawak, and the extraction and refining were takenover by the government. Malaysia became a net exporter of oil, with a surplus that grew from M$607million in 1976 to $3.4 billion in 1980.

This period also saw a shift from import-substitution to export-oriented policies. The latter aimedto encourage the production of light manufactures such as textiles, footwear and garments. Exportincentives, tax breaks and other indirect subsidies were given to 'pioneer' industries, particularly throughthe setting up of Export Processing Zones (EPZs) or Free Trade Zones (FTZs). These incentives,coupled with the availability of low-cost, semi-skilled, women workers led to the rise of the semi-conductor industry in Malaysia.

6 The term "Bumiputera" was coined to refer collectively to the Malays and other indigenous groupsafter the formation of Malaysia in 1963 when Sabah, Sarawak, Singapore and Peninsular Malaysiacombined as a federation.

7 The eventual structure of the 1957 Constitution, was the product of the first "social contract".

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During this period, both state and market forces were operating on the economy at the same time,though not necessarily always in contention. On the one hand, state interventions via licensing and quotas(principally through the Industrial Coordination Act - ICA) and regulated prices (e.g., controlled pricesfor state procurement through state-owned enterprises) acted to restrain the market. On the other hand,the government was encouraging private sector development through the promotion of investments inexported-oriented industries. The net effect was a mixed economy which was increasingly statedominated.

Macroeconomic Developments. During the 1970s, external demand accelerated and the prices andproduction of major commodities increased. However, import prices rose rapidly as well. This promptedsome tightening of monetary policy, so that inflation was held at about 4.5 percent a year. In 1980, afterthe second oil shock, the inflation rate rose to 9 percent. The commodities boom led to the familiarappreciation of the exchange rate ("Dutch Disease").8 In late 1984 speculation against the Ringgit washeavy, and was met by intervention by the Central Bank. The adjustment of the OECD countries to thesecond oil shock and the consequent recession led to a softening of the markets for Malaysia's exports.This resulted in a deterioration in the terms of trade, growth, and weakened domestic savings. Thegrowth rate dropped from around 8 percent in 1979 to 6 percent in 1982. The precipitous drop incommodity prices created difficulties for the conduct of fiscal and monetary policies, together with a buildup of external debt. As the government acted on a broad front to address the immediate financialproblems (through reductions in expenditure), the severity of external conditions persisted. By this timethe increasingly restrictive features of the ICA were also being felt, and investment fell. The economylunged to a negative 1 % growth in 1985.

The financing of investment in the country, which had relied largely on domestic savings prior to1980, shifted to external borrowing after 1980. As in other resource-rich countries, the weight ofprimary commodities in GNP made income, the major determinant of savings, sensitive to variations inprimary commodity prices. The commodity price boom of the late 1970s and the oil exports after 1977encouraged policymakers to lift their sights and spurred a vast expansion of the development effort.Gross national savings (as a percentage of GNP), which was 20.6% between 1971-1975, rose to 30%over the second half of the decade (Figure 1). But by the first half of the 1980s the fall in commodityprices and incomes had squeezed savings to 27% of GNP and the ambitious targets of governmentexpansion had to be financed largely by foreign borrowings. External borrowings swelled from M$4.86billion (or 9.46% of GNP) in 1980 to reach a peak of M$50.5 billion in 1986 (or 76% of GNP)9

During 1971-80, substantial structural changes took place. The share of agriculture in GDPdeclined from 30 percent in 1970 to 20 percent in 1980, and that of manufacturing increased from 13percent to 20 percent. Employment in manufacturing rose at 7.6 percent per annum, in construction at

8 It has been estimated that the exchange rate overvaluation was 12-20% (Ariff, 1991; World Bank,1985).

9 Prior to 1980, financing of investment was largely done from domestic savings, the bulk of whichwas contributed by private savings (18-25%) of GNP. A large part of this is accounted for by"contractual" or forced savings (5-7% of GNP) of the Employees Provident Fund (EPF), acompulsory provident scheme introduced in 1952. The rate of contribution increased progressivelyfrom 10% in 1952 to 13% in 1975, to 20% of wages by 1980. EPF is the biggest holder ofgovernment debt (60%). Public savings (current surplus of the public sector), on the other hand,ranged from 2.4% to 9.4% and has been contributed to by a few large and commercially viableNon-Financial Public Enterprises (NFPEs) in utilities, conunodities, and petroleum.

6.8 percent, and in utilities at 6.5 percent. The unemployment rate as a percentage of the labor forcefell from 7.5 percent in 1970 to 5.3 percent in 1980.

Figure 1

Gross National Savings

3 5-

3 0

~25 -_ _ _

Z 2 0 E...National SavingsCD

a, Public Savings

0

ZS X

1971-75 1976-80 1981-85 1986 -90

PeriodSource: Hebert, 1993

Adiustment and Liberalization, 1986-90. The 1985-86 recession triggered a second round ofmarket liberalization and a more active promotion of private sector growth. The shift was given newimpetus by the Promotion of Investments Act 1986, which provided incentives for manufacturing,agriculture and tourism. Many of the old methods were again used as instruments of change (e.g.,pioneer status, investment tax allowances etc), but they were made even more generous (Malaysia,1991a). The Industrial Coordination Act 1975 was amended to exempt companies with less than $2.5million shareholders' capital from the licensing and reporting requirements. The government also keptpublic spending under control, focusing on providing the infrastructure and conducive environmentneeded for private enterprise to thrive.

During this period, the nation's outstanding external debt was reduced by about M$9 billion toMS41.5 billion in 1990 through prepayments by both the public and private sectors. In addition, recourseto external borrowing was reduced in favor of foreign equity funding and domestic borrowing. Theperiod also saw the depreciation of the Ringgit, which provided a boost to manufactured exports.

Macroeconomic Develooments. The pattern of growth shifted during this period. Previously ledby the external sector, domestic demand became more important, in part due to the rise in consumerspending after the 1985-86 recession. The surge in private investment, however, can be largely attributedto the Promotion of Investment Act, 1986. The four years of sustained growth resulted in some problemsassociated with a successful economy. Towards the end of the 1980s there were signs of overheatingarising from labor shortages and rising inflationary pressures. Imports, concentrated largely inintermediates and capital goods, outstripped exports, and the balance of payments deteriorated.

H. SECTOR ANALYSIS

Investment and Trade

In the decade or so following independence in 1957, the government's import-substitution policy'°was motivated by a wish to encourage the development of local industry and promote employment. Insome senses, it may have been an intellectual fashion of the times as well. Relative to many otherdeveloping nations, however, Malaysia has had a fairly liberal trade regime. Compared with the sixcountries in the Balassa study (Power, 1971), the average effective rate of protection for manufacturingin Malaysia was 7 percent in the 1960s, whereas for the others it was between 21 and 92 percent. Still,the number of items on the tariff schedule increased from 25 in 1962 to 200 in 1963 (Lee, 1986, p. 106).

The effects of the import substitution policies are revealed in two studies on the sources ofmanufacturing growth. Hoffman (1973) found that import substitution accounted for 51 percent of thegrowth in manufacturing output during 1959-68. Applying the same methodology, Vijayakumari (1992)compared two periods, 1973-81 and 1982-85 and found that domestic demand expansion and, to a lesserextent, import substitution, were the main contributors to manufacturing growth during the earlier period.The results of the two studies, summarized in Table 1, show that import substitution was a much biggersource of demand than export expansion during the 1960s and 1970s even though export promotionpolicies took effect in 1968.

Under the 1968 Pioneer Industries Ordinance, the Minister of Commnerce and Industry wasempowered to grant pioneer status to any firm that could establish an economic rationale for assistanceand demonstrate that this was in the public interest. By acquiring this status, a firm received a taxholiday. This was an effective inducement only when firms made a profit, and it appears that only ahandful of firms actually did so. Given the 2 percent payroll tax levied until 1971 and the obvious capitalbias of the incentive scheme, it is not surprising that employment did not grow rapidly in pioneer firms(Bruton, 1992). Seventy percent of the value added of pioneer firms during this period came fromforeign-owned firms.

Table 1: Sources of demand for Manufacturing Output Growth

Sources of Growth 1959-68 1973-81 1982-85

Domestic Demand 39.6 143.5 -5.5

Export Expansion 9.5 -79.7 137.5

Import Substitution 50.9 36.2 -32

Source: Hoffman (1973); Vijayakumari (1992).

10 Another important fact is the contribution of import duty revenues for total government revenues,though this has declined over time. Import duties accounted for a total of 43 percent of inlandrevenues in 1960, falling to 23.3 percent in 1970 and 16 percent in 1980 (Lee, 1986, p. 105).

The Tariff Advisory Council (TAC) was set up in 1959 as an investigative and advisory body onmatters of tariff protection and exemptions, with its members drawn from the private sector. Followingthe departure of Singapore from the Federation in 1965 and the resulting loss of a significant part of theindustrial base, the Action Committee on Tariff and Industrial Development (ACTID) was set up in 1966.Its managers came from the senior ranks of the bureaucracy. ACTID was responsible not only forregulation and application of the tariff scheme; it also considered applications for pioneer status, andtherefore had control over many matters of industrial development. Over the next three decades, overallnominal and effective rates of protection declined in absolute terms across most sectors. Malaysiacontinued to remain a comparatively open economy." But although tariffs were relatively low, theyvaried widely across sectors. During the 1960s, the highest rates were for nondurable consumer goods,whereas some export activities had negative rates (Power, 1971).

By 1970, the domestic market was showing signs of saturation. Imnport substitution was notproviding enough employment opportunities, as it tended to encourage capital intensive industries usingmore skilled labor (Linnerman, 1987, p. 365).

In 1968, the Investment Incentives Act (IIA) shifted the basic structure away from importsubstitution. The incentives, administered by ACTID extended measures such as accelerated depreciation,reinvestment allowances, and investment credits for non-pioneer industries. Manufactured exports alsoreceived an ad valorem incentive. The major export incentives given to domestic firms have beenamended over the years, but their main content can be summarized in four points: 1) an export allowancethat provided a deduction of taxable income, the amount of the subsidy depending upon exportperfornance and domestic input content; 2) promotional expenses for exports were tax deductible; 3) anaccelerated depreciation allowance for companies that exported at least 20 percent of their output; and4) export financing and insurance facilities from the government, at preferential rates.

By the mid-1970s, however, these modifications appeared to be insufficient to meet the objectivesof the NEP. Despite government efforts, industrialization was not moving fast enough.'2 Foreigninvestment, chiefly from the US and Japan, was not providing satisfactory linkages to the domesticeconomy. The NEP's goal of 30 percent wealth ownership for the Bumiputeras by 1990 was clearly notgoing to be reached.

To push the economy towards these equity objectives, the government brought in the InvestmentCoordination Act (ICA) in 1975. It was aimed at controlling industrialization and enforcing the NEP'sgoals. Policy changed from attempting to increase the size of the pie (theoretically providing more forall) to determining the size of the slices. The ICA initially required all manufacturing enterprises with25 or more employees (or with paid up capital greater than M$ 250,000) to obtain a license to

" Relative to many other developing nations, the Malaysian government has had a fairly liberal tradepolicy. Tariff and other trade barriers were erected in the past, but effective protection rates haveremained fairly low. The average effective protection rate was only 4 percent in 1965, rising to39 percent in 1978 (Ariff, 1991). This compares, for example, with an average effectiveprotection rate in the Indonesian manufacturing sector in 1984 of 141 percent. When the variouspolicies implemented by the government are examined, these relative magnitudes should be bornein mind.

12 The NEP was, after all, a result of the perception that (following the disturbance of 1969) theprocess of redistribution was not proceeding fast enough.

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manufacture.'3 It made the granting of licenses conditional upon compliance with NEP guidelines. Itwas hotly contested by Chinese business groups, who feared it was a mandate for the minister todiscriminate in favor of the Bumiputeras. The Associated Chinese Chambers of Commerce and Industry(AACIM) called the ICA "a sword hanging over the private sector. . . Mhe ICA, if it remains, willconstitute a continuing threat to the private sector" (Bowie, 1991, p. 102). Private domestic investmentfell, and the strong local reaction no doubt affected foreign investors. Foreign direct investment (FDI)dropped from 6.3 percent of GNP in 1974 to 3.9 percent in 1975, and continued to slide to 2.9 percentby 1979.

The timing could hardly have been worse. The 1971 Free Trade Zone (FTZ) Act had beendesigned to attract multinational companies (MNCs) to produce for world markets (see Box 1). FTZsand Licensed Manufacturing Warehouses (LMWs) had played an integral role in Malaysia's shift fromimport substitution to export oriented manufacturing. FDI had grown from 0.9 percent of GNP in 1968to 6.3 percent (and 19 percent of GDP) in 1974, the year before the ICA was enacted.'4 Downturnsin both foreign and domestic investment would exacerbate external economic difficulties in the comingyears.

After the severe recession of the mid-1980s, pragmatism dictated another policy shift. Thegovernment introduced general liberalization to promote the private sector, and amended the scope of theICA. Only manufacturing companies with shareholder funds of M$ 2.5 million and above or engaging75 or more full-time employees needed to apply for a license (as opposed to the original M$ 250,000 and25), and, increasingly, exemptions were granted. The Promotions of Investment Act replaced the HAin 1986. It provided a wider range of incentives for investments in manufacturing, agriculture andtourism, and included small and medium scale enterprises (SMEs).

" Exemptions from the licensing requirements were given to rice and rubber milling, crude palm oilprocessing etc. (Malaysia, 1984).

14 A census in 1978 of firms located in FTZs found that 94 percent of them were foreign controlled(Linnerman, 1987, p. 366).

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BOX 1

Exvort Processinz Zones or Free Trade Zones

Under the FTZ Act of 1971 certain industrial estates were designated as FTZs. The official incentive package has fourmain components:

1. Duty-free imworts of raw material and cavital eauipment. FTZ Zone Act of 1971 defines the zones to be outsidethe Federation of Malaysia for purposes of customs duties and taxes. All imported raw materials, components, andcapital equipment which are directly related to production may therefore enter the zones without payment of customsduties or other taxes. The exemption does not cover imported capital equipment not directly related to production: forexample, office equipment, building materials, and vehicles. For these items, duty is, in principle, payable. Similarly,all goods manufactured in and exported from a FTZ are exempt from sales tax and excise tax. Goods may be movedfrom one FTZ to another without payment of duty or other taxes. Goods entering Malaysia and destined for one of theFTZs must travel from the port of entry to the zone by means of a bonded container truck. This vehicle is sealed byCustoms Department officials at the point of entry and its seal must be intact when it arrives at the FTZ customscheckpoint. Goods exported from the FTZ must be transported in the same manner. Goods purchased by FrlZ firmsfrom within Malaysia are treated as exports from Malaysia. The domestic seller is responsible for the payment of anyexport duty.

2. Streamlined Customs formalities. Imports into the FTZs and exports from them can be made with less customsdocumentation than normally applies to such imports and exports, provided that bonded vehicles are used for transportto or from the port of entry or exit. Sales within FTZs or between one FTZ and another can also be effected withminimum documentation. The streamlining of administrative formalities applies only to the Customs Department,however. The fact that Malaysia's FTZs were established and are still controlled at the state rather than the federallevel means that there is no federal body with overall responsibility for them. For FTZ firms, this meant they had todeal with the various federal departments individually. Elsewhere in Asia, a single body has typically been createdwith authority to intercede between FTZ firms and the various government agencies at federal, state, and local levels.The absence of such an authority in Malaysia has meant that delays do occur and that policy has tended to beuncoordinated.

3. Infrastructure facilities. Except for the customs policing of the zone perimeter, the infrastructure facilities availableto FTZ firms are similar to those provided in other types of industrial estates within Peninsular Malaysia. Most FIZfirms have constructed their own factory buildings, and the others have not been encouraged to occupy government-provided buildings on a long-term basis. Government-owned buildings are rented at or slightly below commercialrates, but the land within the FTZs is leased to zone firms at well-below market rates. This is the most significantsubsidy in the provision of infrastructure to FTZ firms.

4. Comoanv income tax incentives. A complex system of tax incentives has been established to grant relief from thenormal rate of company income tax in Malaysia. These tax incentives are not unique to the FTZ firms, but they are animportant component of the overil incentive package. Their stated aim is to encourage investment in export-orientedmanufacturing. There are three major systems of tax relief, known as Pioneer Status, Labor Utlization Relief, andInvestment Tax Credit. These three systems are mutually exclusive. The first two entail complete exemption fromcompany income tax for the specified period and the third involves an exemption which may be only partial. Only oneother tax incentive may apply in addition to these three, the Export Promotion Deduction. A fifth major category oftax exemption, the Locational Incentive, applies instead of Pioneer Status or Labor Utilization Relief if the firm locatesin a designated Locational Incentive area. These areas do not include any of the regions currently possessing FTZs, butsuitably located Licensed Manufacturing Warehouses (LMWs)* may be eligible for Locational Incentive status.

* In 1975, the 1967 Customs Act was amended to allow firms to be designated as Licensed ManufacturingWarehouses (LMWs) which in effect allows them to operate as firms located in FTZs.

Source: Warr, 1987.

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These reforms were rewarded with an upturn in FDI and economic growth. The growth of FDIin the late 1980s was markedly different from that of the 1970s, however. Whereas FDI in the 1970swas dominated by Japan and the US, important contributions are now being made by the "new wave" ofAsian NIEs, particularly Taiwan, China. It moved from a meager 0.3 percent of approved FDI in 1982to 36.0 percent in 1990 (passing even Japan in the process).

As for trade policy, two recent studies have revealed a decline in the effective rates of protection(ERPs) in the late 1970s and 1980s. The Malaysian Industrial Policy Study of 1984 found an averageweighted ERP value of 31 percent in 1979/80. The average ERP estimated by Edwards (1990) for 1987is 17 percent. In an earlier study, he found an average ERP value of 45 percent in 1969. The generalconsensus is that the ERP in manufacturing has been declining but dispersed since the early 1970s. Thisis consistent with the shift from import substitution to export promotion in the 1970s and with the tradeliberalization in the 1980s. One exception was an increase in the ERP for heavy industries (discussedlater).

The new wave of foreign investors has had a dramatic impact on the Malaysian economy. SMEsbeing the hallmark of Taiwan's industrial structure, it is not surprising that many Taiwanese investorsare setting up SMEs in Malaysia, and the same is broadly true of the other NIEs. This trend has begunto include Japanese investors as well. Partly due to Malaysia's investment incentives and partly due toindustrial restructuring at home, the newcomers are geared primarily to exports. Eighty-two percent offoreign projects in 1988-89 exported more than half their output (as opposed to 24 percent of such projectsin 1984-85), and 74 percent export more than 80 percent. Since many of these new SMEs are involvedin the component industries, they increased inter-industry and inter-regional linkages.

This is true within Malaysia, as well. Whereas most FTZs were initially on the west coast, newFDI projects have been more willing to move in-land and to the outlying areas. This is partly due totheir smaller scale of operation and partly due to recent infrastructural development. Some investmentzones now cater to a particular line of manufacturing. For example, the 80 hectare Olak Lempit furniturepark in Banting (Selangor) contains 59 firms, both foreign and local.

For the future to remain bright, foreign and domestic firms must play complementary roles.Though Malaysia continues to encourage FDI, it still holds to equity objectives through which"identification of race with economic function" will be eliminated. These goals help to create the politicalstability and infrastructure which make Malaysia a desirable place for foreign investment.

Another looming problem is the lack of product diversification. FDI in Malaysia is stillconcentrated on electronics and textiles (see Box 2). This weakness is coupled with a growing laborshortage, especially of skilled workers. Every move to establish new industries and modernize the oldones must be linked with programs to develop the skills of the workforce.

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BOX 2

Electronics Industr, in Malayisl

The electronics industry accounts for the largest share of manufacturing output, value added, exports and employment.During 1981-88, its output expanded rapidly from MS3.58 billion to $9.42 billion, an average increase of almost 15 percentper annum. Exports also increased rapidly; by 1987 electronics exports were Malaysia's top revenue earner, contributingM$6.9 billion to the national accounts. Most of this was due to the well established MNC semiconductor firms. Malaysianow has one of the largest installed semiconductor assembly capacities in the world and is a major testing location forsemiconductor devices. According to the 'Electronics Data Yearbook. 1987" published by Benn Electronics, the totalelectronics production of Malaysia in 1987 was US$2,772 million, some 0.9 percent of the world's total.

What were the factors that led to this development? The industry took a foothold in 1967 when a Japanese multinational setup a consumer electronics plant in Malaysia to take advantage of the domestic market. In 1971 the semiconductor businesswas started when an American multinational invested in Malaysia. Many other multinationals did the same following activegovernment promotion of foreign investment to develop labor-intensive industries. This was part of export-oriented strategiesadopted in the early 1970s. Initially feared to be a "footloose" industry associated with assembly-type operations in free tradeor export processing zones, electronics has developed into a major area of high technology investment and development. It hasbecome the main catalyst in the country's manufacturing and export-led growth. In the process, Malaysia has achieved thestatus of being the world's leading exporter of semiconductors and third-largest producer after Japan and the United States.

The Investment Incentives Act of 1968 and the establishment of free trade zones in 1972 encouraged the influx of foreigncompanies into the electronics industry. Beyond the general incentives to foreign investment, however, the electronicsindustry was singled out. In the early 1970s, as the U.S. semiconductor makers were relocating their labor-intensive assemblyoperations to the developing countries, the Malaysian Industrial Development Authority (MIDA) coordinated specificinvestment missions to attract their attention. Later, during the recession of the mid-1980s, as U.S. investment declined inMalaysia, MIDA aimed its efforts at the surrounding Asian NIEs. These countries, especially Taiwan, began to move theirplants to Southeast Asian countries due to rising labor cost and currency appreciation at home. Their reliance on SMEs andcomponent industries fits weD into Malaysia's entrenched electronics industry and has had a significant impact on the boom.

The electronics industry is characterized by high growth rate, rapid technological change that necessitates continual investmentin facilities and equipment, technology and skiDls transfer, and development of ancillary industries. In terms of growth, theindustry value added expanded by 28 percent in real terms between 1973-81 and 10 percent between 1981-88. Its contributionto GDP increased steadily from 2.12 percent in 1981 to 2.98 percent in 1988. Correspondingly, its share of manufacturedexports rose from 48 percent to 56 perment. During the same period, the industry employment increased from 16 percent to22 percent of total manufacturing sector employment. One of the key reasons behind the success of the industry was, in fact,the wealth of available labor and the efficient use that was made of that labor.

Malaysia has benefitted from the industry's rapid technological change and competitive nature. Over the two decades,continuing investments by the MNCs has transfonned the industry from a labor intensive opertion in the early 1970s to ahighly capital and technology intensive operation today. The investments have gone into upgrading equipment, expandingproduction facilities, developing backward and forward integration, establishing local research and development capability andimproving quality. These investments have resulted in a gradual progression of the industry into areas of higher technology,for example, automated assembly equipment, computer-aided manufacturing, device testing, robotics and computer-aideddesign. Consequently, there has been some success in the transfer of skils and technology. Many MNCs have establishedformalized apprenticeship program for precision tool engineering, local and overseas scholarship and skills developmentcourses. The equipment, materials and infrastructural suppor required by the electronics sector have resulted in the creationof ancillary industries. These linkages are gradualy being developed as the country's indusal base deepens.

The Penang Skils Development Center (PSDC) is a good example of the forward thinking that has propelled the industry.PSDC is a public-private sector joint venture. It was given tax exempt status while much of its equipment is donated by theindustry. It provides training courses not just to its members, but to the entire manufacturing sector. As a non-profitorganization, it has emerged as one o' the leading tnrining institutes in the country, becoming a model for other states tofollow.

Source: Salleh, 1992.: Meyanathan and Salleh (1993) l

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Heavy Industrv:'5 In !980, the new Prime Minister, Dr. Mahathir bin Mohamnad, launched astate-sponsored heavy industry project. The Heavy Industries Corporation of Malaysia (HICOM) wasincorporated in November 1980 with an authorized capital of M$ 500 million to "plan, identify, initiate,invest [in], implement and manage projects in the field of heavy industries" (HICOM, 1984, p. 10). Jointventures would be established between HICOM and foreign investors, relying heavily on Japanese capitaland know-how.

Mahathir had long been an advocate of the Look East policy for the industrialization of Malaysia.As the Minister of Trade and Industry in 1978-81, he had campaigned strongly for heavy industryinvestment. The HICOM projects were intended to push Malaysia into diversification, create modemmanufacturing activity outside the FTZ enclaves, and foster linkages between industries. Stateinvolvement was necessary to overcome private investors' caution about high-cost, high-risk ventures withlong gestation periods.

Initially, HICOM was provided with M$ 125 million under the Fourth Malaysia Plan 1981-1985.It was one of twenty public enterprises in which the Ministry of Finance was a major shareholder. Assuch, the Ministry appointed the Board of Directors of HICOM and had a direct say in the appointmentof the Chief Executive."6 It also provided HICOM with subsidized loans - generally 2-4 percent lowerthan market rates (Chee, 1992) - or stood as the guarantor of foreign loans. The Implementation andCoordination Unit (ICU) in the Prime Minister's Department is also responsible for monitoring andcontrolling HICOM. ICU is charged with reviewing HICOM's annual report, approving financing ofnew projects and conducting ex-post evaluations of projects.

By 1988 HICOM had set up 9 companies employing a total of 4,350 workers and involvinginvestments of about M$ 2 billion. Most were involved in manufacturing, and were set up in differentstates to try to correct the regional imbalances in industrial development.

The best known of the HICOM ventures was the national car project, or PROTON, a joint venturewith Mitsubishi. It ran into immediate problems which revealed many of the weaknesses of the HICOMexperiment. Financial arrangements were particularly favorable to the Japanese partners. HICOM wasrequired to provide 70 percent of the capital, which it financed mainly by foreign borrowings. ThePROTON venture's losses were largely due to forces beyond HICOM's control: world recession and therevaluation of the yen. Even so, for a project which was supposed to lessen Malaysia's dependence onworld markets, this was certainly ironic.

The limited size of the domestic market was also a factor. PROTON had an initial plant capacityof 80,000 units, with a plan to expand to 120,000 by 1988. Some economists questioned the viabilityof producing 80,000 units when the minimum efficient scale of production for a single plant was

5 The conventional definition of heavy industries covers products which are bulky and heavy, requireenormous capital, a high level of technology and skilled manpower. These industries include paperand paper products, chemical products, basic metals, fabricated metal products, shipbuilding,petroleum refineries, machinery and equipment. The Heavy Industries Corporation of Malaysia(HICOM) defines heavy industries as those possessing all or some of the following characteristics:(a) large scale in nature; (b) large investment outlays; (c) long gestation periods; and (d) rates ofreturn generally not attractive if measured purely by normal commercial standards and thus notattractive to domestic private investors (Chee, 1992).

16 The first Chief Executive was a former civil servant.

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considered to be 200,000 (Bowie, 1991, p. 121). In fact, production measured 100,000 in 1983, the yearPROTON was established, and dropped to 70,000 in 1985 and to 33,500 in 1987 before reaching 104,000in 1992. To recoup losses, HICOM shifted its policy and tried exporting the automobiles to foreignmarkets (e.g., the UK).

With the deepening world recession, Malaysia was faced with twin deficits in its fiscal and externalaccounts. Ultimately, government policy changed sharply, as the equity imperative seemed to slip inimportance to the growth imperative. In a stem rebuke of the project's management, Finance MinisterDaim Zainuddin said in 1988 "The recession is only part of the problem. If a company fails somethingmust have gone wrong. I am prepared to listen [to problemsl up to a point. Beyond that I don't wantto hear anymore. . . Either you perform or say goodbye." (Far Eastern Economic Review, Sept. 1988).HICOM officials said goodbye and were replaced by managers from one of PROTON's foreign partnerinstitutions. Again, the irony of the move was not lost on HICOM's critics.

Though HICOM turned out to be a loss-maker until recently, the Malaysian government did whatit could salvage the situation. Saga, an automobile produced by PROTON, has reached the 60 percentlocal content required to enter western markets, and exports (notably in the UK) have gone forward(Machado, p. 530). '' PROTON has turned around and has been making profits since 1990.

Public Sector

In contrast to the policy before independence, the public sector since independence has been gearedto the country's social and economic development.

Government Expenditure: During the 1950s and 1960s, the development strategy aimed to reducethe dependence of the economy on rubber and tin. The government launched a program to diversify andmodemize agriculture and promote industrial development. It also spent more on the infrastructures andamenities needed to facilitate private sector production.

Public spending changed in the 1970s, in response to the 1969 riots. As a proportion of GDP, itrose from 29.2 percent in 1970 to 39.9 percent in 1979 and peaked two years later at 58.4 percent. Thepublic sector deficit and public debt also increased during the same period (see Table 2). The growthof public enterprises was only one aspect of a general widening scope of the public sector. Three typesof enterprises were classified as public:

* Departmental enterprises that were required by law to maintain their financial accounts inaccordance with commercial standards, e.g. National Electricity Board, TelecommunicationsDepartment and Waterworks Department.

* Public corporations and bodies established by state and federal statutes. These were 100 percentgovernment-owned, and included the Federal Land Development Authority (FELDA) and theMalaysian Rubber Development Corporation (MARDEC).

* State-owned companies established under the 1965 Companies Act. Although wholly or partlyowned by the Govemment and accountable to parliament, they were involved in commercialactivities and competed with domestic or foreign enterprises. Included in this category are theHeavy Industry Corporation of Malaysia (HICOM), Petroleum Nasional Berhad (Petronas),

7 The local content in 1993 had reached about 80 percent (Business Times, July 9, 1993).

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Malaysian International Shipping Corporation (MISC), Malaysian Airlines System (MAS), andseveral other enterprises created by the federal government and the State EconomnicDevelopment Corporation (SEDC), the investment arm of the states.

The amount owed to the federal government by statutory bodies, government-owned companiesand state governments stood at M$1.2 billion in 1970, the equivalent of 24 percent of the federalgovernment's outstanding debt. By 1982 the figure was approximately M$17 billion, 37 percent ofoutstanding debt. Public enterprises were specifically defined in the Second Malaysia Plan (1971-1975)as one of the instruments for redistributing wealth and creating a Bumiputera commercial and industrialcommunity. The result was more regulation, affirmative actions and an increased share of governmentin production through a proliferation of public enterprises. This proliferation continued strongly through1975-85. At least 453 public enterprises (more than 50 percent of all that exist today) were createdduring this period.

This expansion of public expenditure coincided with a severe world recession. By the end of 1982,it was clear that it could not continue. The government started to curb its operating expenditure andsharply to reduce its development expenditure. It also checked the growth of public enterprises andannounced a master plan for privatization. "Malaysia Incorporated," as Mahathir called it, gave strongemphasis to an increased role for the private sector. Public spending as a proportion of GDP peaked in1982 at 38%, and then began a gradual but steady decline.

Non-Financial Public Enterprises (NFPEs): The government saw their expansion as being centralto the tasks of stimulating growth in areas where private sector participation is lacking, promotingregional development and social restructuring, ensuring political control, reducing bureaucraticconstraints, and "nationalizing" foreign-controlled companies through purchase of equity. Moreimportantly, NFPEs have been used as a policy weapon to improve the welfare of the poor and to raisethe relative economic position of the Bumiputeras.

For the government, there were a number of advantages in using the NFPEs as developmentagents. Firstly, they were free from normal government controls. Secondly, they were not subjected tothe same parliamentary scrutiny as a government ministry or department. Thirdly, they were empoweredto establish subsidiary companies. Lastly, their ownership structure could be easily varied to meet therequirements of the NEP. Thus, once a state-owned or state-controlled enterprise was financially viable,some or all of its shares could be transferred to private Bumiputera individuals.

Table 2: Consolidated Public Sector Finance as percentage of GNP

1970 1979 1981 1983 1985 1987 1989 1990

Revenue 24.6 30.7 32.9 33.2 36.5 32.61 31.49 30.40Operating expenditure 20.9 26.8 31.1 30.6 30.8 31.15 28.05 27.72Current surplus/deficit 3.7 3.9 1.9 2.6 5.6 1.45 3.45 2.68Non-Financial Public

enterprise surplus 0.8 1.2 5.1 6.6 7.8 4.78 3.91 3.86Total public sectorcurrent surplus/deficit 4.5 5.0 6.9 9.2 13.5 6.23 7.36 6.54

Development expenditure 8.3 13.1 27.3 26.2 18.3 11.29 13.36 14.84 General government 7.6 11.0 22.6 16.8 9.6 7.43 8.67 10.05 <

Non-financial publicenterprises 0.7 2.1 4.7 9.4 8.6 3.86 4.69 4.79

Total expenditure 29.2 39.2 58.4 56.8 52.4 42.44 41.40 42.56Overall surplus/deficit -3.7 -8.1 -20.4 -17.0 -4.7 -5.05 -6.00 -8.29(GNP growth) 5.8 22.6 8.2 9.2 -3.2 5.4 7.7 6.5(GDP growth) 6.2 9.3 6.9 6.3 -1.0 5.3 7.6 6.5

Source: Malaysia, Economic Report;Bank Negara Malaysia Annual Reportvarious issues

Table 3: Actual Malaysia Plan Develpment Expenditure

Sector Second First Malaysia Second Third Fourth Fifth Malaysia SixthMalaya Plan Plan (1966- Malaysia Plan Malaysia Plan Malaysia Plan Plan (1986- Malaysia Plan(1961-1965) 1970) (1971-1975) (1976-19111) (1981-1985) 1990) (1991-1995)*

Agriculture is 26 24 22 16 21 16

tndushy 2 6 19 IS 14 11 11

lnffanacture(inckduing -

Cmnnumicuions) 26 17 19 18 20 22 20

HumanuResources 19 16 17 17 22 25 25

Services 13 IS 5 9 10 10 9

Securty andAdminisuaion 22 20 16 19 Is 1 19

Proaected Figures

Source: Rcspetive Malaysia Plans

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The expansion of NFPEs has been financed continuously by an increase in public developmentexpenditure. During the First Malaysia Plan (1966-70) period, the allocation to NFPEs totalled M$1.4billion, or 32 percent of all public development expenditure. With the implementation of the NEP in1971, this figure increased to M$3.9 billion (40 percent) during the Second Malaysia Plan (1971-75)period, MS12 billion in the Third Malaysia Plan (1976-80), and M$27.7 (56.6 percent) in the FourthMalaysia Plan (1981-85) before declining to MS17.7 billion in the Fifth Malaysia Plan (1986-90) (SeeFigure 2).

Figure 2

Public development exrenditure on NFPEs by 6-year plan periods

30.0-l

25.0

15.0-

co10.0

5.0-

1966-70 1971-75 1976-80 1981-85 1988-905-year plan period

- 20 -

The NFPEs also relied heavily on loans from both the domestic and international markets, underfederal government guarantee. Outstanding loans due to the federal government by the various statutorybodies and NFPEs totalled M$40.7 billion in 1986, up from M$ 18 billion in 1982 and M$I.2 billionin 1970. The largest number of NFPEs were created in manufacturing and services, but they werepervasive throughout the economy (see Table 4).

Under the Fifth Malaysia Plan, 1986-90, many public enterprises were reclassified as NFPEs.Those with government equity ownership exceeding 50 percent and an annual revenue exceeding M$ 5million were included in the operational definition of the public sector. In view of the large impact thatpublic enterprises have on domestic investment and the balance of payments, an Inter-Agency Committeewas formed in 1984 to define the coverage of NFPEs for monitoring and reporting purposes. Thefollowing year, a Central Information Collection Unit (CICU) was formed and jointly operated by theTreasury and the National Equity Corporation (see Box 3) to monitor and analyze the nearly 900enterprises with government equity participation.'8

Table 4: Growth of Public Enterprises in Malaysia

Sector Before 1960- 1971- 19811960 1970 1980 onwards

Agriculture 4 6 73 59Bldg & construction 2 7 56 65Extraction industry 0 3 22 6Finance 3 14 61 44Manufacturing 5 35 172 102Other industrial 0 0 0 10Services 5 10 135 143Transportation 5 13 28 23

Source: Central Information Collection Unit, Perrnodalan Nasional Berhad.

Public holding corporations were another instrument of state intervention. For example, PERNASwas set up in 1969. As its capitalization under the NEP increased, PERNAS became the most successfulof the public holding companies. In late 1975 it employed about four thousand people and operated eightsubsidiaries in a wide range of activities, from trade and mining to property development and securitiestrading. The Urban Development Authority (UDA) had the principal responsibility of supplying Malaysin business with office space and other premises in urban areas. SEDC activities, like those of PERNAS,were wide-ranging, encompassing agriculture, manufacturing, the provision of business and officepremises, and wholesale and retail trading (Gale, 1981).

These and other institutions provided direct assistance to Bumiputeras to enable them to competewith non-Bumiputera capital. For example, to prepare more Bumiputeras for skilled jobs in manufacturingand commerce, many agencies offered training facilities. MARA, Bank Bumiputera, and to a lesser extent

Is A total of 141 agencies with at least 51 percent government equity and an annual revenue turnoverof more than $5 million were initially identified for monitoring purposes. Of these, 56 wereselected for initial scrutiny because they formed the bulk of the NFPE expenditures and borrowings(Salleh and Osman, 1991).

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Malaysian Industrial Development Finance (MIDF), extended credit to Malay businessman atconcessionary rates.

We shall assess the financial performance of NFPE's bearing in mind the shortcomings of theprofitability criterion because of the special treatment usually given to NFPEs in allocation of licenses,government contracts and other assistance. Table 5 shows the percentage of profitable companies in theNFPE sector. It varied between 55 and 60 percent during 1981-86. A large proportion of the profitablecompanies were in finance, transportation and extraction. Those in services and manufacturing fared verybadly. Those in agriculture were rather erratic, again due to a combination of international conditionsand management troubles.

The heavy losses continued up to 1988, the year of the latest available data. They show that ofthe total of 770 companies monitored, 378 reported accumulated profits of M$4.6 billion, while 383companies had accumulated losses of M$ 5.6 billion (Salleh and Osman, 1991). Most of the large lossescame from the large NFPEs involved in heavy industry.

The poor financial performance of the NFPEs has been attributed to various factors. One is thelack of accountability due to the absence of performance guidelines, overemphasis on social and politicalconsiderations, and lack of managerial skills and experience. This failure to develop strict guidelines,performance criteria and management training programs suggests that the Look East philosophy of Dr.Mahathir was never developed from theory into a detailed program.

Another factor was the easy access to funds, which meant that NFPEs were inclined to do littlein-depth pre-investment study, and did not prepare themselves to cope with the expansion. They also hada strong tendency to operate on high gearing ratios.'9 Puthucheary (1984) estimated that of the M$33billion invested in federal-owned companies in 1984, only M$2.5 billion was in equity capital. The resttook the form of outstanding loans that were easily borrowed from the commercial banks.

Table 5: Percentage of Profitable Companies in the NFPE Sector

1981 1982 1983 1984 1985 1986

No. of companies 498 576 631 676 702 574Percentage 61.6 55.5 56.7 58.0 54.8 55.2

Source: Ministry of Public Enterprises, cited in Salleh and Osman (1991)

'9 Ratio of debt capital to equity capital.

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BOX 3

The National Equity Corporation (PNB)

One of the major objectives of the New Economic Policy (NEP) of 1971 was to redistribute wealth. The Governmentset a target goal of 30 percent ownership for Bumiputeras by 1990. Since 1978, the Malaysian government has setout to distribute the capital stock purchased from British, Chinese, and other companies among the Bumiputeramasses. First, it wanted to prevent that stock from being concentrated in the hands of high ranking officials and richMalays. Secondly, it wanted to create an organizational device to prevent the shares distributed to Bumiputera frombeing resold to non-Malays (this had taken place earlier despite the efforts of the National Investment Company[NIC]). To meet these two objectives the Government came up with a unit trust scheme known as the AmanahSaham Nasional (ASN). This scheme had three implementing arms: 1) the Yayasan Peraburan Bumiputera (YPB) orBumiputera Investment Fund; 2) the Amanah Saham Nasional Berhad (ASNB), the National Investment TrustCorporation: and 3) the Permodalan Nasional Berhad (PNB), or National Equity Corporation. These institutionsworked with the Perbadanan Nasional Berhad (PERNAS), the National Corporation set up in 1969 to carry out theBumiputera policy by buying stock and forming joint ventures.

PNB was set up to accumulate and manage capital on behalf of the Malays. YPB worked as PNB's investmentplanning and decision-making body (with Prime Minister Mahathir serving as its head), while ASNB works as awholly owned subsidiary of PNB. Following YPB planning, and using YPB interest-free loans, PNB acquired at facevalue the stock of profitable companies from among the shareholdings acquired by the Ministry of Trade and Industryand from those held by public subsidiaries and affiliated companies. Then from April 1981, PNB began moving intothe investment trust business, working through the ASNB and aiming its efforts at Malays as individuals.

By 1981, the Government had invested over M$2,000 million in 674 companies. The plan was to sell the purchasedequity shares to Bumiputera within twenty years. The Government selected 21 companies out of the firms in which ithad invested and decided to sell M$660 million worth of their stock shares to Bumiputeras. Five hundred fifty-twomillion MS worth of these shares were transferred to PNB to establish the National Trust Fund, and the remainingMS 108 million were to be transferred to Bumiputera companies, their employees, and Bumiputera organizations.Ten of the companies chosen as equity share recipients were subsidiaries of PERNAS, including Malaysia MiningCorporation Bhd., Bank Bumiputera Malaysia Bhd., Kontena Nasional Sdn. Bhd., Malayan Banking Bhd., KomplekKewangan Malaysia Bhd. (MARAV's financing arm), and three subsidiaries of Bank Pembangunan Malaysia Bhd.(the Development Bank of Malaysia).

PNB has been able to borrow interest-free and non-collateral loans from the Government. Under such favorableconditions, PNB has been rapidly increasing its stockholding. Apart from the stocks acquired from the Governmentand public enterprises, PNB itself has used its borrowed government capital to make investments. These investmentsare concentrated in the mining, plantation, financial, and industrial sectors. The investment into plantations has beenaimed primarily at buying up British enterprises; most of that going into the financial sector has been for buying upmainly Chinese banks and enterprises"*. Both of these sectors have been strongly profitable, so are the mosteffective places to invest to raise the proponion of capital owned by the Malays.

Forty-four percent of the qualified Bumiputera population, as of 1990, had their money invested under the trustsystem, their total investment amounting to M$6,770 million. In 1985, Bumiputera's held 17.8 percent of totalMalaysian stock. It is fair to say that ASN has contributed greatly toward the goal of raising Bumiputera's equityownership to 30 percent.

* Council of Trust for Indigenous People.

* In the 1960s and 1970s all of Malaysia's local banks (with two or three exceptions) were synonymous with Chinesebusiness. Chinese-controlled banks have now diminished in importance and the banking business has become dominatedby government sponsored or privately-held Bumiputera capital. Chinese capital has not been a force in Malaysia'smanufacturing sector, but rather tends to be concentrated in real estate, hotels, finance, and commerce.

Source: Horii, 1991; Saruwatari, 1991.

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Privatization: The poor performance of the NFPEs led to the privatization policy announced in1981. By 1992, 40 NFPEs had been taken over by the private sector, and 14 projects involvinginfrastructure and utility construction had been privatized. At the state level, 120 smaller enterprisesbelonging to the various SEDCs were sold. Other divestitures involved transferring various entities to thePNB, the Bumiputera trust corporation (See Box 3). The aim of the whole process was "to increaseprivate sector involvement [in the economy] and, at the same time, reduce the financial and administrativeburden of the Government. " The Privatization Plan was, in fact, an admission that mistakes had beenmade during the second phase of Malaysia's development in trying to fulfill the goals of the NEP. TheMalaysian Airlines was the first to be sold, followed by several other prominent enterprises. AnInterdepartmental Committee at the Prime Minister's Office (supported by technical committees) isresponsible for the implementation of privatization. Public sector reforms to reduce and rationalize thesize of the civil service have been in force since 1985.

Privatization poses special problems for Malaysian policymakers because of the inherent tensionbetween the dual objectives of unleashing the energies and resources of the private sector on the onehand, and the desire to protect and promote Bumiputera interests on the other. It is still far from certainthat the privatization effort has achieved its stated objectives. Most of the enterprises selected forprivatization were natural monopolies (such as the airlines, the municipal water supply, the toll road,electricity, and the telecommunications company); selling them did not change their monopolistic status.

The broader social tensions can bhe seen clearly in the policies towards the employees of privatizedenterprises, who were protected by government regulations. They have been given the option of joiningthe new enterprise, retiring, or remaining in the public sector. While the benefits of stability areundeniable, this policy has raised concerns that the efficiency which privatization is intended to promoteis being stymied by excessive staff.

Human Resouroe Development

Malays had long insisted that the limited opportunities which they had experienced under colonialrule were largely due to the inequities of the British education system. It came as no surprise, then, thatthe first phase of Malaysia's development saw a focus on education as a means to economic and socialimprovement. Through the Education Ordinance of 1957, a national system of education was established.Malay was designated the national language, but the role of other languages continued. Malay andEnglish were made compulsory in all primary and secondary schools. In 1962, primary school fees wereabolished, and three years later, the school leaving age was raised to 15 to provide a minimum of 9 yearsof education for every child. This was in line with the National Educational Policy which waspromulgated after the passing of the Education Act of 1961.

Education was a primary concern of the early Malaysia Plans. In the 1960s, it was the third largestitem in the development budget, after land development and transport. Recurrent expenditures oneducation were also high, amounting to 20 percent of total expenditures in those early years (Bruton,1992, p. 246). Development expenditure on education rose from 9.4 percent of the total in the SecondMalaysia Plan to 16.1 percent in the Fifth Malaysian Plan, before dropping to 15.1 percent in the 6thMalaysia Plan.

20 Wahab, 1987.

- 24 -

Between 1956 and 1968 total primary enrollment increased by 60 percent. Enrollment in Malay-language schools increased by more than 50 percent and in Chinese-language schools by almost 30percent. English language instruction more than doubled. The statistics were even more dramatic in thesecondary schools. Total enrollment between 1956 and 1968 jumped by a factor of more than 5, and inMalay-language schools by a factor of 45. All evidence suggests that the poorest people believed in thepotential of education and wanted more education opportunities for themselves and their children.

Not only did enrollment show a rapid increase, but the adult literacy rate grew from 53 percent to60 percent between 1960 and 1975. This increase, though admirable, has been slower than many ofMalaysia's foreign competitors (see Table 6). The facts are disturbing; nearly all the other second tierAsian countries boast a greater success in tackling literacy. Korea and Hong Kong not only began withmuch higher adult literacy rates, but have shown a 20 percent increase over the same period. To somedegree, Malaysia's relative lack of success must be the result of the problems inherent in a multi-ethnicsociety. Compared with homogenous societies like Korea and Taiwan, it faced problems of language andculture which invariably lead to inefficiencies in the educational system.

Table 6: Literacy Among Asian Nations

Country 1960 1975 Total 1985Male Female

Malaysia 53.* 60 73 81 66Republic of Korea 71 93 - - -Hong Kong 70 90 88 95 81Singapore - 75.* 86 95 79Indonesia 39.* 62 74 83 65Philippines 72 87. * 86 86 85Thailand 68 84 e4 94 88India 28.* 36 57 57 39Japan 98 99

* Figures are for years other than those specified - generally not more than 2 years distant fromthose specified.

Source: Tan (1992b)

In the universities, by the late 1960s 3540 percent of the total students enrolled were Malays, apromising sign of social equity and a major objective of the Government. However, a new problem wasstarting to arise: "credentialism". Many investigators (for exarnple, Meerman 1979) began to argue thatthe strong bias to liberal arts by university students was a major handicap for an economy which neededto diversify technologically. The fear was that many students, and Malays in particular, merely wanteda degree (of any kind) because that was the principal requirement for a government job. By 1983, asurvey by the Institut Pengajian Tinggi (IPT), or Institute of Advanced Studies, found that 67 percent ofall university scholarship students went to work for the Government, and another 14.5 percent took jobswith statutory bodies. For Malays, the numbers were 70 percent and 16 percent (Mehmet and Yip,1986). As the government succeeded in increasing Bumiputera participation in higher education, it feltcompelled to guarantee those students a job in public service.

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Throughout the 1960s and into the 1970s, the population was growing rapidly.2 ' This put agrowing stress on the education system; many schools adopted morning and afternoon sessions to copewith the increasing number of students, but this made school administration difficult and exacerbated theproblem of finding adequately trained instructors. As the Malaysian educational system tried to absorbmore and more students, it suffered a drop in standards. By 1990, Malaysia had 13,855 untrainedteachers, 11.5 percent of all instructors in the country (Tan, 1992b). As Table 7 shows, Malaysia wasfalling behind its competitors at the secondary level as well.

If worrying trends were beginning to appear in the late 1960s, the Government's interventionistpolicies of the 1970s did nothing to help. In attempting to further the goals of the NEP, the Governmentpromoted Bumiputera participation in higher education. The Third Malaysia Plan was based on theassumption that there was a critical underinvestment in Malay human capital. It provided detailedoccupational and educational requirements through to 1990, and recommended "a sizeable expansion inthe production of scientific and technical personnel" and a "vast expansion of personnel and facilities foreducation at the secondary and tertiary levels of education in the sciences and technologies."

As a result of these forecasts and expectations, there was a rapid expansion in the Malaysianuniversity system, with five new universities opening during 1969-1980 and a fourfold increase inenrollment. At the same time, there was a vast expansion in government scholarships. The IPT/UMsurvey showed that two out of every three students in Malaysian universities in 1982 were on agovernment scholarship. Scholarships were granted on need, as opposed to merit, with informal quotasset to enhance Bumiputera participation. The 1983 IPT/UM survey concluded that the Malaysiangovernment was a virtual monopsonist of Higher Level Manpower (HLM); almost none of the HLMcoming out of the universities had an impact on the private sector. Fully 90 percent of the 1982/3graduates on scholarship were under bond to the Government, two-thirds of these were committed to 7years' service.

Overseas education increased dramatically during this phase, particularly among non-Bumiputerastudents who felt pushed out of the Malaysian universities. During the mid-1970s, overseas enrollmentnearly equalled the enrollment in Malaysia's universities. By 1987, there were some 65,000 students atthe tertiary level within Malaysia, compared with 40,000 students studying overseas, mostly non-Bumiputeras (Klitgaard, 1991). These statistics naturally raised the question of a "brain-drain."

The 1980s have seen a changing approach to this complex situation. In 1983, scholarships werechanged from a need to merit basis. Furthermore, if students fail to perform well, their scholarships aretreated as loans that must be repaid. This change has provided hope that market forces would ease theproblem of a skills mismatch, and that the Government scholarships would begin producing more trainedtechnical and professional manpower and fewer "generalists". In addition, the government decided toshift the cost burden of overseas education (which had led to a large outflow of foreign exchange). Asa result overseas enrollment dropped from 39 percent in 1980 to 29 percent in 1990.

21 Urban population increased from 26 percent in 1965 to 29 percent in 1980 up to 42 percent in 1989.

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Table 7: Educational Achievement in Secondary School

Average Schooling Years*

1960 1970 1980 1988

Korea 0.81 1.67 2.75 2.86

Philippines 1.18 1.67 2.39 2.68

Indonesia 0.12 0.34 0.62 0.73

Malaysia 0.61 1.05 1.49 1.79

Taiwan, China 1.03 1.33 1.96

All Developing 0.34 0.52 0.95 1.1

OECD 2.59 3.03 3.79 3.94

*Defined as the average number of years of secondary schooling attained by the total population.

Source: Barro and Lee (1993).

Another encouraging sign in the 1980s was the increasing role of the private sector in education.The enclave nature of some MNCs located in FTZs has caused training to be limited to in-plantexperience. In general, however, the human capital in advanced integrated circuit (IC) design andmasking has been far superior in Malaysia to that of any other country in Southeast Asia. A growingnumber of private sector institutions have begun to offer tertiary education to make up for what theyperceived to be a "government failure" during the 1970s and early 1980s. Also, the rapid pace ofindustrialization and the growing diversification have led to a growing demand for middle-leveltechnicians, with higher wages. As a result, more children and young adults seem willing to getvocational training for these "blue-collar" positions that traditionally Malaysians have shunned.

These changes are welcome, and badly needed. Tan and Mingat's (1992a) recent study of 15Asian countries showed that Malaysia had lower than expected post-basic enrollment ratios, given its GNPper capita of about $2,300 and a high share of GNP spent on education (6 percent). This study showedthat as a percentage of GNP per capita, recurrent unit costs were 25 percent above the average for Asiancountries (at all levels of education) and 39 percent, 12 percent, and 24 percent above respectively forprimary, secondary, and tertiary education. At the same time, Kharas and Bhalla (1988) show that thequality of the labor force has increased at the rate of 1 percent per annum since 1973. At all levels, thetrend is clear: Malaysia is spending more on education than countries such as Korea and Taiwan, China,and getting relatively less out of it.

The same could be said of the government's efforts to create a Bumiputera entrepreneurial class.After more than 20 years of credit provision, training, advisory services, quotas and price allowances insupplies and works contracts, the issuance of licenses in local authority areas, allocation of shares in newcompanies and the provision of buildings, the Government still laments the lack of a vibrant Bumiputeraentrepreneurial class - a class that can venture out without political crutches. Many Bumiputeraentrepreneurs fell into financial difficulties during the recession in the mid-1980s; the Government laterset up a fund to help out some of them. Many of the successful small Bumiputera entrepreneurs have

- 27 -

been the ones with skills in their own trades, know the market, and have a good sense of managementand thrift. Recent efforts include establishing joint ventures between Bumiputeras and non-Bumiputeras,and between successful and aspiring Bumiputera entrepreneurs (Meyanathan and Salleh, 1993).

At the same time, there have certainly been gains in other types of Bumiputera employment. In1990, Bumiputeras made up 30 percent or more of all doctors, veterinary surgeons, surveyors, andengineers, with respectable contingents of lawyers, dentists and architects as well.

Infrastructure

One of the reasons for Malaysia's success in the past three decades is its steady support ofinfrastructure. Every Malaysian Plan has devoted about 20 percent of its expenditure toward the build-upof the country's infrastructure. This farsighted approach has paid many dividends.

In the first decade after independence most of the Government's concern with infrastructurefocused on the agricultural areas. It invested in drainage and irrigation facilities to promote ricecultivation among the predominantly Bumiputera rice farmers and to maintain the price of rice. Theseprojects went hand-in-hand with other land development projects. The 1956-1960 Plan devoted M$38.3million to drainage and irrigation alone, about 4 percent of total expenditures. The 1961-65 Plan spentM$108 million on these projects, also about 4 percent of total expenditures. Building the ruralinfrastructure was also vital to the goals of poverty reduction and the development of a Bumiputeraownership class. The Bumiputeras made up the bulk of poor land workers, and the land developmentscheme, was a concentrated effort to set up Bumiputeras as smallholders, particularly in the rubber andoil palm industries.2

In the 1970s this concern began to change. When, with the 1968 Investment Incentives Act (IIA),the government had begun to court foreign investment, an efficient infrastructure became one of the mostpowerful incentives in the package. The government built up roads for the transportation of equipment,materials and goods, and they created the FTZs. Although the government did not encourage any firmsto occupy a government-provided factory building on a long-term basis, government-owned factories andbuildings were rented to firms at or slightly below commercial rental rates, and the FTZ land was leasedto firms at well-below market lease rates.

The infrastructure shift towards industry has continued ever since, even during the recession ofthe mid-1980s. It is a tribute to the planners that they kept the long-range benefits of building andmaintaining infrastructure firmly in mind during this period, rather than give in to any temptation to saveon immediate expenditures by cutting down infrastructure development. Malaysian planners have beenastute in anticipating the future need for infrastructure and have avoided the creation of severe supplybottlenecks. Consequently, as the new FDI began to take shape in the late 1980s, there was no time lagneeded to prepare the way.

Agriculture

At the time of independence, agriculture accounted for about 70 percent of total exports and almost60 percent of the labor force. Despite this, Malaysia had a trade deficit in food and could not reach self-sufficiency in its main food crop - rice. By 1980 agriculture's share in GDP had fallen to 22.2 percent

22 Another major thrust of this early phase was the building of schools (see above).

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(while manufacturing had risen from 13.4 percent in 1970 to 20.5 percent in 1980) and agriculturalemployment was down to 40.6 percent 13 of the total (Meyanathan and Sivalingam, 1986).

The need for economic diversification was recognized even before independence. In the DraftDevelopment Plan of the Federation of Malaya covering 1950-1955, the dependence of the economy ona limited range of products (i.e. rubber and tin) was highlighted. Similarly, in the First Malaya Plancovering 1956-1960, economic diversification was listed among the priority objectives.24 It called fordiversification in agriculture "... by providing more land, by diversifying and intensifying production, bysupplying better planting material, encouraging the use of fertilizers and off-season cropping, byimproving cultivation techniques, extending cooperation and fisheries and the practice of poultry rearingand animal husbandry."

After independence, the government began to implement a range of policies designed to widen theagricultural base. They included measures to influence prices, subsidies on agricultural inputs, theprovision of extension services, and technological and research support. These policies influenced theflow of factors to the production of different commodities by modifying the private rates of return. Theprovision of protection against imports, together with fiscal incentives or taxes, also influenced thedifferential rates of return between commodities. This effect was particularly strong on rice production,which was officially supported in the 1960s and 1970s. Import subsidies were also introduced foragricultural machinery and fertilizer, to encourage double cropping. As a result, wet rice fields rose,from 2 percent in 1960 to 57 percent of the total cultivated area in 1975 (Young, et al, 1980). Thecontribution of off-season crop also rose from 2 percent to 40 percent of total annual rice production.Increases in rice yields were also achieved as a result of improved inputs, and provision of extension andcredit services.

The earliest institution set up by the Government to implement land-use development programs wasThe Rural Industrial Development Authority (RIDA). Along with the Malaysian Agricultural Researchand Development Institute, RIDA worked to extend the amount of land that could be put to use (mainlythrough drainage programs) and to help smallholders and non-landowners buy this land. Due to the rapidincrease in the rural population, the Federal Land Development Authority (FELDA) was established in1956. Its main objective was to resettle farmers with uneconomical farm sizes into new land schemes,thereby increasing their incomes and alleviating overcrowding in traditional farms. In fact, FELDA wasusing policies to favor smallholders, in an attempt to increase Bumiputera land ownership.

To avoid confiscating land from large private estates, the government chose to develop unusedfringe land. Through the efforts of these land schemes, private estates gradually decreased both inabsolute and relative terms from 1960 to 1980; and smallholders, both traditional and organized,increased dramatically (by 34 times) over the same period. The development of new land schemes wasconsidered as more socially and politically acceptable as a redistributive scheme than land reforms(Tamin, 1990). The NEP then provided new impetus for pursuing land development schemes on largetracts of undeveloped forest lands. To develop the targeted regions, various regional statutory bodies wereestablished: Johor Tenggara Regional Authority (KEJORA) in 1972; Trengganu Tengah DevelopmentAuthority (KETENGAH) in 1973; and Kelantan Selatan Development Authority (KESEDAR) in 1978.

23 As discussed in the HRD section, this was, in part, due to large scale demographic changes inMalaysia's population.

24 The First Malaya Plan was based on a 1955 World Bank report entitled The EconomicDevelopment of Malaya.

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Following the NEP, state intervention extended deeper into agriculture. The Agricultural Bank(Bank Pertanian) was founded in 1969 to provide greater access to credits for agricultural development.The activities of the Federal Agricultural Marketing Authority (FAMA), which was established in 1965,were expanded. The National Paddy and Rice Authority (LPN) was created in 1971 to manage the pricesupport system for rice farmers. The Rubber Industry Replanting Board was established in 1952 torejuvenate the industry by providing money for replanting with new high-yielding clones. As theagricultural diversification drive intensified in the 1960s and 1970s, the rubber replanting fund wasapproved for smallholders to plant approved crops, particularly oil palm (See Box 4).

The achievements of the land development agencies, particularly those of FELDA, highlight thesuccess of state intervention in agricultural and rural development. As shown in the Table 8, both FELDAand RISDA have contributed significantly to the expansion of oil palm cultivation. FELDA and theagricultural research institutes have been quite successful in bridging the productivity gap between theprivate plantations and the smallholdings that it manages. Table 9 shows that FELDA's averageplantation yield in 1988 was almost level with the private estates.

Table 8: Oil Palm Hectarage in Peninsular Malaysia

Year FELDA RISDA Estates Others Total

1970 7,219 438 68,289 0 75,9471980 307,530 16,185 495,412 87,465 916,5901988 477,502 98,661 782,877 168,503 1,527,543

Source: Malaysia, 1988

Table 9: Average Oil Palm Yields of FELDA and Other Estates (tons/ha)

Year Estates FELDA

1975 19.27 13.931980 17.58 15.201988 18.92 18.09

Source: As in Table 8

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BOX 4

The Oil Palm Industry

Malaysia's oil palm industry has grown phenomenally over the past three decades. Since 1965, Malaysia has been theworld's largest exporter of palm oil products and, since 1972, the largest producer of palm oil. In 1984, it producedover 60 percent of the world's palm oil and accounted for more than 80 percent of the global exports of palm oil. Overthe past three decades, total planted hectarage grew 36 times, expanding from 55.000 hectares in 1960 to about 2 millionhectares in 1990. During the same period, crude palm oil production rose from about 100,000 tons to about 6 milliontons. It is now the leading crop in the country, contributing 5.4 percent of total export earnings in 1990 compared with4.0 percent for rubber.

Until the establishment of processing facilities in 1975, only crude palm oil was exported. By 1984, more than 98percent of the crude palm oil was processed locally into various products. The output of processed palm oil and otherproducts grew at an average rate of 30.5 percent per year in that period. This impressive growth sums up the success ofthe crop diversification efforts and the trade and investment incentives given by the government to stimulate the growthof the processing industry in the 1970s.

(i) Industry profile: The composition of private-public ownership of oil palm plantations has changed tremendouslysince 1960. Then private sector estates accounted for the entire oil palm plantings. By 1990, the federal and stategovernment agencies controlled 46 percent of the total planted area, compared with 45 percent in private sector estatesand the rest in smallholdings. There has also been an increase in ownership by Malaysians. Of the total of 1,668 oilpalm estates in 1990, 93 percent were owned by Malaysians, compared with 81 percent out of a total of 975 estates in1980.

(ii) Intervention and effects: An account of the state's role in the development of the oil palm industry can be drawnfrom the various Malaysian five-year development plans. These plans contained numerous policies and programs thatdirectly or indirectly supported the development of the industry. The major policy motivating the industry's growth wasencapsulated in the diversification effort to reduce the economy's dependence on two commodities, rubber and tin. Intandem with the diversification effort was the rural development program to resettle and absorb the expanding rural laborforce, and to reduce rural-urban migration. Among the major implementation agencies set up to spearhead the programwere the Federal Land and Development Authority (FELDA), Federal Land Consolidation and Rehabilitation Authority(FELCRA) and Rubber Industry Smaliholders Development Authority (RISDA). In 1990, FELDA managed about588,000 hectares or 67 percent of public sector holdings, FELCRA about 12 percent, RISDA about 4 percent, and thevarious state land schemes comprising the rest. FELDA also worked towards reorganizing the smallholders into efficientproduction units. RISDA, on the other hand, provided smallholders with replanting grants to convert their rubberholdings into oil palm.

While the economic diversification policy stimulated rural land development, the industrialization policy provided theimpetus for the development of palm oil downstream activities. Incentives were already provided under the 1958 PioneerIndustries Ordinance to set up processing activities. These incentives were boosted by the Investment Incentives Act of1968 which geared the industries towards exports. The incentives enjoyed by the palm oil reftning industry include thepioneer status, investment tax credit (ITC) and export incentives. As of 1984, 70 percent of the total 54 refineries weregiven ITC, 17 percent were operating under pioneer status, and the rest were without incentives. Of the total of 51 palmkernel mills, 18 percent were given pioneer status, 20 percent were accorded ITC and the rest were without incentives.

Since 1980, the government has been reforming the commodity export tax structure to alleviate the incidence ofproducer taxes on smallholders. An export duty scheme, featuring different rates of duties on crude and processed palmoil, was introduced in 1976 to encourage further value added processing. An export duty exemption is also granted toprocessed palm oil according to the level of processing.

Currently, Malaysia is the world's largest producer of palm oil with half of the acreage under the control of publicsector authorities. The government set up the Palm Oil Research Institute of Malaysia (PORIM) which suggestedutilization of Cameroon weevils as a pollinating agent for increasing yield productivity (standard agriculturaltechnological externality). The Malaysian Industrial Development Authority (MIDA) promoted local refineries throughtax and other incentives such as exemptions from the licensing requirements of the Industrial Coordination Act.

Source: Meyanathan, 1989; Malaysia 19 91a.

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However, there have been notable failures of government intervention as well. FELCRA'sobjective in taking over the Fringe Alienation Scheme in 1962 was to give landless peasants ten acreseach, and boost all smallholders up to ten acres. This was converted into the Land Rehabilitation Schemein 1966 under which FELCRA assumed the responsibility of management for the land by controlling thesales of products and taking over the farmers' debts to the government. By 1970, when FELCRA begana renamed Fringe Alienation Scheme, some farmers were denied ownership, because they had merelyheld and not developed their uncultivated land. This scheme was called the "sharing system," sinceparticipating farmers were given part shares in the land, with FELCRA acting as a trustee. They wereguaranteed equitable wages from FELCRA until they could pay off their debt.

The National Agricultural Policy (NAP) of 1984 clearly states that estate type management ispreferable in the future for rubber, oil palm, and rice farming. However, present policy clearly limitscapital expenditures on land development and promotes the conversion of FELDA estates into industrialland. This has brought instant wealth to some farmers.

Finance

The financial system in Malaysia is fairly sophisticated compared with those of other countries ata similar stage of economic development. Financial deepening and innovations have proceeded rapidly,especially since the second half of the 1970s (Ahmad, 1990). The financial system covers a broadspectrum of institutions and markets, including the Central Bank, the commercial banks, the financecompanies and the merchant banks. By 1990, the number of bank branches had risen to 1000, makingan average population-to-bank-office ratio of roughly 18,000:1.

Other than the state's role in maintaining a stable monetary system, it was involved in three mnaintypes of intervention: a) ownership structure of banks; b) directed credit; and c) the export creditrefinancing scheme.

Ownership: In colonial times, foreign banks accounted for the bulk of deposits and loansadvanced. By March, 1980, however, domestic banks took about 66 % of the total deposits and advancedabout 55% of the total loans. By 1990, out of a total of 38 commercial banks, 22 were domesticincorporated banks.

Three banks with large government shareholdings (Malayan Banking, United Malayan BankingCorporation, and Bank Bumiputera) have become very active in collecting deposits and advancing loans.Although Bank Bumiputera was established in 1965, it has expanded rapidly with strong governmentsupport, and is now the second biggest domestic bank (after Malayan Banking). It is wholly owned bythe government, with the objective of promoting Bumiputeras in the banking industry. From 1970onwards, Bumiputera equity stakes in the country's commercial banks began to increase. By thebeginning of 1982, they had increased to 77% of the entire banking industry.'

One reason for the increased ownership by Bumiputeras (and the Government) in the banks hasbeen profitability. Another has been the desire to shift the pattern of lending. The government has astrong influence on the financial system through its stakes in the major banks and development financeinstitutions which were established in the 1970s. Bank Negara's guidelines on lending and the regulationof interest rates shaped the direction and cost of credit throughout the country.

25 In 1992, there were nine banks under Chinese management (Hara, 1991).

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Directed credit: Following the NEP in 1971, the Central Bank changed its approach towardsbanking in order to fulfill the social and restructuring objectives of the government (Yusof, et al. 1992).It required banks to provide designated priority sectors with ready access to credit at a reasonable cost.It first issued guidelines for bank lending in 1975, directing commercial banks and finance companies toprovide at least half of their increase in net credit during the year to the priority sectors. It also imposedceilings on the interest rates that could be charged to certain types of priority borrowers. The list ofpriority sectors, which was modified yearly according to development needs, originally included theBumiputera community, small-businesses, food production, housing loans (including low-cost houses of$25,000 or less), manufacturing, and other sectors such as agriculture, fishing, forestry, building,construction and property development (Yusof, et al., 1992).

Although the Central Bank administered these guidelines flexibly, it ensured compliance bypenalizing those who failed to meet them. The delinquent institutions were required to deposit with theCentral Bank an amount equal to the shortfall for one year at an interest rate to be determined by theCentral Bank. These deposits would then be on-lent to institutions which had the capacity to lend to theprivate sector. In 1976, the directive was made more specific: 25 percent of the loan increase had tobe channelled to manufacturing industries, 20 percent to Bumiputera borrowers, and 10 percent to foodproduction. The stringency of the guidelines has been reduced progressively in the 3rd phase ofdevelopment as more targets have been met. Although it is not possible to separate the effects of organicchange from the govermment's scheme, the direction of bank lending, shown in Table 10, does reveal abalanced distribution of loans to the various sectors.

The guidelines also covered the implementation of schemes like the General Guarantee Scheme(GGS) and the Special Loan Scheme (SLS) administered by the Credit Guarantee Corporation (CGC).CGC was set up in 1972 to guarantee cover for loans by the commercial banks to small-businesses.Between 1973 and 1990, the cumulative loans by CGC to Bumiputeras numbered 81,270, with a totalvalue of $1,007 billion. Non-Bumiputeras received a total of /5,572 loans amounting to $2,217 billion.According to Yusof, et al. (1992), the priority lending guidelines did not seriously distort the capitalmarket because the Central Bank ensured that the fixed interest reflected the actual cost of funds to thebanking institutions.'

The other form of priority lending is directed government credit. This involves the provision ofloans by the federal governnent to various government agencies, statutory bodies and corporation inwhich the government owned equity. The interest rates charged depended on the purpose of the loan.For instance, no interest was charged for loans to anti-poverty projects. Restructuring, infrastructural,strategic and other similar projects carried an interest rate of 2 - 5 percent, while conmnercial projectswere charged the full cost of the funds to the government (Yusof, et al., 1992). Thus far in the 1990s,the government has charged an interest rate at half the cost for anti-poverty program loans, while loansfor other social restructuring programs may be charged up to the full cost of the funds to theGovermnent. The funding of commercial projects at subsidized rates has been stopped. This moremnarket-minded approach shows up in the figures: in 1975, total governmnent loans amounted to 22percent of the total banking system loans, but the proportion declined to 16 percent in 1980 and to 9.8percent in 1989.

26 After 1987, it was linked to the Base Lending Rate of the banking institutions, subject to marketlevels (Yusof et al., 1992).

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Table 10: Direction of Commercial Bank Lending(millions of ringgit and percentage of total)

Sector 1970 1980 1990

Agriculture 240 (10.2) 1,648 (7.8) 4,238 (5.2)Mining & Quarrying 51 (2.2) 211 (1.0) 833 (1.0)Manufacturing 466 (19.7) 4,694 (22.3) 18,742 (23.2)Electricity na na 279 (1.3) 202 (0.2)General Commerce 756 (32.0) 4,644 (22.1) 11,642 (14.4)Real Estate, Bldg. and Construction 207 (8.8) 3117 (14.8) 14,599 (18.1)Housing na na 2,323 (10.6) 9,587 (11.9)Transport & Storage 17 (0.7) 400 (1.9) 1,342 (1.7)Financing, Insurance,

& Business Services 80 (3.4) 1,297 (6.2) 9,105 (11.3)Other 543 (23.0) 2,509 (11.9) 10,473 (13.0)

TOTAL 2,360 (100.0) 21,031 (100.0) 80,763 (100.0)

na: not available. Totals may not add up due to rounding.

Source: Malaysia, Bank Negara Malaysia, Quarterly Economic Bulletin and Annual Report, various issues.

After the NEP four major institutions were created specifically for development banking: BankPembangunan Malaysia Berhad (BPMB), Malaysian Industrial Development Finance (MIDF), BankIndustri Malaysia (BIM), and Bank Pertanian Malaysia (BPM). These institutions have concentrated onfurthering NEP equity goals in various parts of Malaysia's economy. BPMB has been involved inimplementing a World Bank-assisted program for the development of SSEs. MIDF concentrates on thedevelopment and modernization of manufacturing. Bank Industri Malaysia works on stimulating export-oriented high-technology industries. BPM deals mainly with agriculture.

With the exception of Bank Industri Malaysia (see Box 5), these institutions have been hamperedby the poor performance of many of their debtors. BPMB, for instance, has had a failure rate of about30 percent, with an additional 20 percent of the SSEs experiencing severe financial troubles. To somedegree this has been the result of a shortage of viable projects, and even viable projects have not properlyprepared their business proposals. Recently, the development institutions have widened their sectoraltargets, accepting more applications from non-Bumiputeras (Asian Development Bank, 1990).

The debt problems caused by the promotion of heavy industries and NFPEs in the early 1980s hada major impact on the financial sector and forced some changes in policy. Bank Negara has tried tostrengthen the financial system by imposing capital adequacy ratios, single customer limits, and provisionsfor non-performing loans. Rescue operations were conducted to assist ailing financial institutions. Asthe economy began to recover from the recession of 1985/86, structural charges took place in thefinancial sector. A number of institutions have been consolidated through mergers and acquisitions,forming more resilient units. New legislation has strengthened insurance companies and cooperatives andimproved their supervision. Finally, Bank Negara has encouraged increased competition within thebanking system by removing entry barriers between the various financial markets.

ExRort Credit Refinancin,: The ECR has promoted Malaysian exports since 1977, by providingexporters with easy access credit at preferential rates for both pre-shipment and post-shipment costs. The

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ECR's object is to promote the export of manufactured goods and agricultural products which have highvalue-added and local content and the government approves the selection of goods according to thesecriteria. The minimum amount of ECR financing is M$10,000 and the minimum drawdown is M$2,000.

ECR is very popular among exporters, and its utilization has risen from M$140 million in 1977to $9.6 billion in 1989. The sharpest rise came after 1986, when the scheme was restructured so as tosimplify its administration and clarify the procedure for bankers and exporters. In 1977, when thescheme was initiated, only 3 percent of gross manufactured exports used ECR. By 1989, the proportionhad risen to 22.5 percent, well up from 1988's figure of 16.3 percent. Another important feature of therecent restructuring of the scheme was a shift towards pre-shipment financing. This benefits Malaysiamore directly, by providing the exporter and his suppliers with finance for "bridging." (Meyanathan andSalleh, 1993).

BOX 5

Bank Industri Malaysia

The success of the Bank Industri Malaysia can be attributed to its strict attention to details. Even though it is willingto finance high-risk projects which commercial banks will by-pass, it still has had a good success ratio with its loanprojects.

Bank Industri has a thorough research team on which it relies heavily. It has adopted a target market approach, andthe research staff plays the key role in identifying and evaluating new areas of the economy for the Bank to penetrate.The researchers undertake very detailed industry studies, looking at all aspects of a potential project in order to gainfamiliarity with its strengths and weaknesses and gain market intelligence on the opportunities and threats awaiting it.

Once it has approved a project, Bank Industri insists on being an active partner. It stays jointly involved in thefinancial management with its partner, often operating joint bank accounts with the clients which requires the Bank tocountersign all checks for payment of expenses. Bank Industri is vigilant in monitoring the progress of its clients,frequently visiting the business site, and is quick to provide financial management advice.

Source: Asian Development Bank, 1990.

m. INSTrTUTIONAL CAPAClTY

As the previous sections have shown, the Malaysian government increased its intervention in theeconomy during the second phase of the country's modem development, then shifted back again duringthe third period. Its ability to make these changes is partly a function of political will, and partly ofinstitutional strength and pragmatism.

Political will: Malaysia inherited, at independence, a parliamentary democratic system along withthe administrative, legal, and legislative systems of the British. The Constitution provides for a King,who is himself elected by rotation from among the nine sultans for a term of 5 years. It has a bicameralparliament consisting of the upper house (senate) and the lower house (house of representatives).Members of the lower house are elected for 5 years. The federal government is headed by the PrimeMinister, whose cabinet consists of ministers who are members of either house. The cabinet comprisesleaders of the governing coalition of ethnic-based parties. The distribution of cabinet posts by political

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parties is based on the number of seats secured by each party in the coalition during the elections, andalso on the need for equitable representation for the coalition parties.

Parliament is not the sole repository of legislative power. The Constitution (in 1957 and 1963)provided for the legislative assemblies of each of the thirteen states to make laws for their respectivestates. Federal-state relations are therefore an important factor in the role of the government in fosteringdevelopment. The Federation was intended to have a strong central government, with some autonomyfor the states based on their control over local government and land matters. However, the FederalGovernment is constitutionally empowered to enact legislation through parliament to provide foruniformnity of law and policy. In particular, it has the power to acquire states' land for nationaldevelopment and national interest projects. More importantly, the Federal Government has been able toinfluence the activities of the states through its spending and its control over their borrowing.

Since the beginning of modem politics in Malaya and Malaysia, the concept of a coalition ofethnic-based political parties has been a successful one. This coalition, the Alliance party - representingMalays (UMNO), Chinese (MCA) and Indians (MIC) - has been in power since 1955. After 1969, theAlliance was broadened to include several other parties and became the National Front. The Allianceand the National Front have been replicated in the political life of the various states. UMNO isrecognized as the dominant party in the coalition, but tensions among the partners are not unknown.Even so, the notion of unity at the highest level of government, has been used to fend off internal andexternal challenges from other opposition parties (Ahmad, 1982).

The strength of the coalition lies in its ability to achieve national goals based on continuingdevelopment and modernization for all, while still favoring the economically disadvantaged but politicallydiominant Malay group. Although Malaysia is a secular state, with Islam as the major and officialreligion, the country still harbors the potentially explosive forces of religious extremism and narrowcommunalism. In the light of these forces, the importance of the government's pro-development stancecannot be over-emphasized.

Except for the 1969 elections, the coalition has won a two-third majority at each of the eightelections (from 1955 to 1989). This majority has allowed it to pass legislation as well to enjoy thecredibility needed for policy reform. The pragmatism displayed by the goverrunent in implementing theNEP policies has been a major contribution to political stability. In a virtuous cycle, political stabilityfacilitates economic growth which in turn contributes to political stability. Specifically, the growingBumiputera middle-class is seen as a stabilizing force which has helped to create the more stable politicalclimate and racial relations of the 1980s.

Has political leadership and vision been a factor in explaining the turning points in Malaysianpolicy? Clearly, the answer is yes. The ruling party's political dominance has allowed for strongpolitical leadership, particularly by the Prime Minister. The first Prime Minister, Tungku Abdul Rahman(1957-70), who led the country to independence, is usually identified with the forging of national unityand a preference for the functioning of markets; the second Prime Minister, Tun Abdul Razak (1970-76),is associated with rural development and modernization and the third, Tun Hussein Onn (1976-81), with

- 36 -

stability and clean govermnent. The present Prime Minister, Dato Seri Mahathir Mohammed, isidentified with strategic vision, heavy industrialization, the work ethic, public sector reforms and themove towards attaining "developed nation" status.2"

Institutional Strengths: Since Malaysia's experience with colonialism was a relatively fortunateone and independence was gained without violence, it began its development with an outward-lookingrather than inward-looking view of the world. It had no inhibitions about trading with and accepting aidfrom the West, and made good use of capital and technical assistance from both unilateral and multilateraldonors (Higgins, 1982). The Office of the Prime Minister, particularly its Economic Planning Unit(EPU), has been the key institution for development planning. The EPU, which was established in 1961and took over the planning function from the Treasury,' is staffed by capable technocrats who producethe long-term (20 years in the case of OPPI and 10 years in the case of OPP2) and medium-term plans(five-year plans), as well as the mid-term reviews. It has a wide range of other responsibilities: advisingthe Government on economic matters; drawing up detailed development plans; economic analysis; thereview and evaluation of projects; and programming and coordinating technical assistance.

The annual budget is prepared by the Treasury in cooperation with the EPU. The Treasuryallocates operating and development budgets and the EPU appropriates development allocations acrosssectors and states. Also working out of the Prime Minister's department, the ICU ensures thecoordination and implementation of government policies, programs and projects at the national,intergovernmental, and federal and state levels. The Prime Minister is also assisted by a specialcommittee of ministers for socio-economic development. He advises the cabinet before any planningdocument is approved for tabling in Parliament. The National Development Planning Committee, whichconsists of senior civil servants appointed by the Govermnent, also has a big say in the formulation ofdevelopment plans; it undertakes periodic reviews and suggests adjustments in accordance with changingcircumstances. While the EPU's focus is on macroeconomic planning, the National DevelopmentPlanning Committee's main concern is the effective implementation of projects and programs (Ariff,1991). From the mid-1980s, there has been a tendecy for think-tanks, academies and other private sectororganizations to have a greater input into the policy formulation process.

27 This personal influence extends beyond the Prime Minister. One of the strongest and most

controversial personalities in the government was the former Finance Minister Daim Zainuddin.A product of the private sector, he was willing to face head-on the growing problems ofgovernment expenditures and debt. While some say he is antagonistic to the Bumiputera cause,there is no doubt that the liberalized policies of the late-1980s are partly Daim's doing (Far EasternEconomic Review, 1988).

28 The Prime Minister's Department consists of the EPU, Implementation Coordination Unit (ICU),the Public Services Department, Manpower Planning Unit (Mampu), MicroElectronics Instituteof Malaysia (Mimos), the Islamic Center, and the National Security Council.

Table I1: Allocation and Actual Expenditure, Malaysia Plans (M$ million)

11 -ucrto( (B) (C) (D) 1E) I1 AL LOCATION EXPN314n IjRC DIFFERElNCE AlLOCAT1ON EXPENDmIRE m3 FEkRINCE

1___971-75 1971-75 J A-I (S) 1976_0 _ JU 391P6-0 D-Es

L. ECO)NOMIC

A AGM0k 11.T33IiE AND RiRAl. DLVEI OPIENTr .277822 1.793.53 21% 6.464.31 4.672.41 25%

D. MINERAL RESOIIRCES DEVEI.IENT 0 69 0.56 19% 21.29 IS 70- 26%

C. COMMERCE AND INI)l3TRY 1.658.62 1.433.32 14% 4.25.96 3,.24621 24%

| D. TRAN91roT 1.562.06 1.233.92 21% 4.462.99 2A42.75 36%

E. CouuTreCAlnONS ISS.42 174.91 (13%) 1.252.73 1,15206 is

F. ENERGY ANI) tiu C ImTIES 378 07 285.36 24% _.913L9 1.5a22 I1%

| G FEAsINUurY maM 43.69 3442 21% 91.56 5393 35S

H.~~ ..D,..I ..

A. EbINCATION AND TRAINING 1.43 695.92 21% 2.1352.79 13Q.3146 26%

a tIFALni ANIt KWIAT,IH 21 82 133.25 36% 529.42 3.40 42%

C. NOMATION AND UROAICASrNG 3M.30 .5.23 17% 110.20 6930 37%

NIWIUNG 37.06 1466. 4% O313 1.2" 04 24S

SEWERAGE 12.60 9.60 32% 170.95 .90 d0os

aCItXRE iOmM AND sMTOs o3916 1290 315 93.5 4. 42%

LOAL COUSLS, WELFARE AND 0.04 21.36 293 23" 11501 49%

COMMINUTY SEEVICES

KAMPOIG AND CUNITY 30.34 H33 33S m.3 24

nMPIaAsE OF IAND 402 o3. a3s

Dt-3+WM 0 5.em s I 13% 4.969 43 2,67.36 46%

INTIRNAL SEOIWITY 321.33 363.13 2% 1.339 157.4 36%

GENEtAL SERVICES 1 73.94 13560 22% 1_.2m | 417.15 46%

HMSMY OF R*EIGN AFFAR 36.33 laJS 9% 54.14 | 2a7 4s

wirce: lIiIij~si a bird and Fourth Malaysia Plans, Mid-Tern Reviews.

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Implementing development plans and monitoring their progress has proved to be far more difficultthan the actual planning itself, due to coordination problems inherent in the multiple levels of government(federal, state, local) and the multitude of ministries, departments, agencies, etc. (Ariff, 1991). Thehighest form of coordination occurs at the political level. Below this, fairly good coordination has beenestablished by Inter-Agency Planning Groups and technical working groups established by the EPU forpreparing plans and formulating policies. At the state level, the need for coordination is more extensive,as the government must deal with many organizations and the state planning committees.

Malaysia inherited the legacy of a closely administered political structure and a highly effectivebureaucracy. They have made the implementation of policies easier (including the National Front'smodernization policies), but, paradoxically, they could also destroy the regime's credibility throughinefficiency and incapacity (Ahmad, 1982). However, the evidence indicates that the bureaucracy, thoughnon-partisan, is highly committed to achieving the Government's goals. The bureaucracy occupies acentral position in the policy process in terms of formulation, evaluation, analysis, periodic reviews, andadjustments. The Malaysian civil service has always worked closely with the political leadership and hasbeen well paid, especially compared to the faster growing NIEs.

Despite this institutional strength, policy miscalculations were made in the second period.Implementation capacity, in particular, suffered. One example was the difference between allocation andexpenditure in the 3rd and 4th Malaysia Plan (see Table 11). Although a small lag was noticeable inimplementing the allocation of the 3rd Malaysia Plan, this increased tremendously during the next term.In short, the government's reach exceeded its grasp.

Another instructive comparison is between Malaysia and Korea. While Malaysia's public capitalexpenditure increased from 18.5 % of total government spending in the 1970s to 22.4% in the 1980s,Korea's dropped from 20.7% to 14.8%. While Malaysia spent about 30% of its total governmentexpenditure on wages and salaries in the 1970s and 1980s, Korea kept its personnel expenditures downto about 15% (dropping, in fact, from 15.8% in the 1970s to 14.5% in the 1980s) (IMF, GovernmentFinance Statistics). As the next section will show, Korea's relative efficiency was accompanied by strongeconomic growth.

IV. EVALUATION AND LESSONS

Evaluating the results of policies is fraught with difficulties. Even when a defined set of criteriaexists, it is difficult to arrive at a definitive conclusion where effects are not measurable or, as is the casewith Malaysia's tension between growth and equity, where there are policy trade-offs. Anothercomplicated problem is the issue of attribution - to what extent can the observed changes be attributedto a particular policy? And, finally, the issue of "What might have been" can only be guessed at, neverknown. Our approach is to use a macroeconomic framework and compare the actual conditions withaverage patterns, or with the patterns of neighboring countries; and sometimes to compare the results withthe position before a policy went into effect.

Before evaluating the role of government in Malaysia, it is important to distinguish "intervention"from "distortion." Government intervention concerns a government's attempt to influence economicperformance through strategic expenditures. Distortion has to do with a government arbitrarily maskingthe signals which its economic performance sends (e.g. through price or currency controls). In Malaysia,there has been a great deal of government intervention, particularly in the 1970s when the NEP boosted

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public expenditures and programs. But there has been relatively little distortion. Malaysia's ERP hasalways been low relative to other Asian countries. Also, the exchange rate has not been used as anexplicit policy instrument. Malaysia's experience is, therefore quite different from Korea's. Datacompiled by Thomas and Wang (1992) show that whereas Korea's price distortion index is higher thanMalaysia's and its total expenditures much lower, as a proportion of GDP, its growth and Total FactorProduct Growth (TFPG) have been higher. Japan also used distortion of the real value of the yen as anexplicit economic policy. Clearly, no blueprint for development success exists. The issue comes downto efficiency: How well does government strategy fit the existing circumstances of the country and howefficient is goverrnent spending in implementing that strategy? These questions ultimately matter farmore than the actual amount of spending.

Equity: When it comes to evaluating government intervention, the issue of equity is fairlystraightforward. Given the events of 1969 (particularly with the memory of Indonesia's troubles in 1966fresh in the mind), the Malaysian government had every reason to make equity a primary strategic goal.Despite the economic strains which the NEP caused, it also brought bentfits. Poverty has been reduced.Although there is still an unacceptable regional disparity in income, all states have shown a markeddecline in the incidence of poverty over the past 15 years (see Table 12). Of particular note has beenthe drastic reduction hard-core poverty, down to 2% in Malaysia and Sarawak, and 1.7% in PeninsularMalaysia. The incidence of poverty itself has been cut significantly in most regions; between 1976 and1990, incidence of poverty fell in Malaysia from 46.4% to 17.1% (Malaysia, 1991a and 1991b). Interms of annual income growth, the Bumiputera recorded the highest rate at 6 percent compared with 3.5percent for the Chinese and 1.4 percent for the Indians during 1970-1987. At the start of the NEP in1970, the average Bumiputera household had substantially lower income per capita than either Chineseor Indian households; both gaps had narrowed by 1987. Still, by 1987 the average Bumiputera(M$2,246) and the average Indian (M$2,640) had below average incomes (M$2,761). The goal of 30percent Bumiputera ownership was not reached, but Bumiputera wealth ownership did increase from 2percent in 1970 to 20.3 percent by the early 1990s. This allowed the government to compromise, usingPERNAS and PNB gradually to buy more wealth for the Bumiputeras through the rest of the century.The Gini coefficient, which was calculated at .42 in the late 1950s, rose to .50 by 1970 and continuedto rise until 1976 (to .53). Since then it has shown a steady decline. In the late 1980s it was nearly thesame as it had been thirty years earlier.

Critics of NEP equity strategies can make a good case for themselves, however. AlthoughBumiputeras have benefited most from Malaysia's successful growth, the average Bumiputera householdhas not caught up with the other ethnic groups, especially the Chinese. Also, despite heavy spending oneducation, Malaysia still lags behind other Asian countries when it comes to literacy.

The final judgement is inevitably a compromise. On equity, success was achieved. Moreimportantly, the government created the perception that this issue was of prime importance, therebyfostering policies of the past six years to be implemented without undue social disturbance and cries of"foul play." Still, in tackling the issue of equity, a government may choose between equality ofopportunity or equality of outcome. Malaysia chose to focus on equality of outcome in the 1970s and1980s, and this had many negative ramifications. It now seems that the government is ready to focus onequality of opportunity, while building up human skills so that all Malaysians will be able to takeadvantage of opportunity when it comes.

40-

Table 12: Incidence of Poverty by State, 1976 and 1990

AchievedState 1976 1990

(%) (%)

Johor 29.0 10.1Kedah 61.0 30.0Kelantan 67.1 29.9Melaka 32.4 12.4Negeri Sembilan 33.0 9.5Pahang 38.9 10.3Pulau Pinang 32.4 8.9Perak 43.0 19.3Perlis 59.8 17.2Sabah 58.3 34.3Sarawak 56.5 21.0Selangor 22.9 7.8Terengganu 60.3 31.2Wilayah Persekutuan 9.0 3.8

Source: Sulaiman, 19.

1 1 T__Io: How do Malaysia's rates of structural transformation compare withthe pattern of modem econonmic growth first defined by Kuznets (1960) and expanded by Chenery andSyrquin (197S)? Using the results from the updated study by Syrquin and Chenery (1989) for 108economies in 1950-83, Malaysia's GDP shares of agriculture, manufacuring and services were comparedwih the predicted pattern. The results, presented in Table 13 and in Figures 3-7, show that Malaysia,by virtue of its abundant natural resources, has a GDP share of agriculture that is 5-10 percentage pointshigher than other countries at the same income level. The gap narrows as income rises. Moreimpontly, the pattern of agriculture's share of GDP decline mirrors the path of successfultrnsformation undergone by other countries (Fig. 3). Of course, the agriculture share would have fallenanyway, as a consequence of growth with or without state intervention. Growth, however, can beachieved without suctural transformation. The fact that growth in Malaysia was achieved with structuraltransformation, and that the period of trformation was fairly short, suggests that policies have playeda major role.

A more dramatic achievement was made in nfacturing (Fig. 4). In 1960, its GDP share was11 percentage points below the predicted value. It levelled by about 1980, and by 1990 it exceeded thepredicted value by 3 percentage points. This rapid "catch up" in manufacturing strongly reflects thesuccess of the industrialization policies pursued by the government.

Similarly, agriculture's share of the labor force (Fig. 5) follows the predicted general decline butat a faster rate. By 1990, the agricultural labor share was 10 percentage points lower than the predictedshare. This implies that thure has been a successful transfer of labor from fanning to industry andsies. In both industry and services Figures 6 & 7), the labor shares generally follow the predictedupward trend; however, dtey had higher actual shaes of total employment compared with their predictedvalues at latew stag of development (much higher, in the case of services).

- 41 -

The improvements in the structure of the economy as compared with the average patterns indicatethe effectiveness of the policies being pursued. This achievement is reinforced by what happened inindustry. The increase in its share of GDP was accomplished alongside a strong performance fromagriculture. As shown by the growth performance of other resource-rich and primary-exportingdeveloping countries, transforming into an industrial-based economy amidst resource abundance isdifficult without prudent management. Moreover, the "Dutch disease" syndrome, caused by large capitalinflows (arising, for example, from resource booms), results in real exchange rate appreciation. Thisdiscriminates against the traditional exporters - a fate which Malaysia has successfully managed throughvigorous promotion of private sector investments.

One area in which structural development has not been successful, however, is in overcomingregional disparities. There is still a wide margin of difference in the incidence of poverty between states,one that essentially follows rural/urban lines. A similarly stark difference exists in the distribution ofGDP between states. While Selangor accounts for 18.4 percent of GDP, Perlis accounts for slightly lessthan 1 percent and Kelantan and Melaka less than 3 percent. This disparity is mirrored in the FederalGovernment Development Allocation by state, where urban or industrial regions like Selangor (7.8percent), and Wilayah Persekutuan (8.4 percent) get the lion's share of development allocation, whilesmaller rural states like Perlis (0.9 percent) and Melaka (1.7 percent) are left wanting (Sulaiman, 1992).One cause of this imbalance is a lack of coordination and cooperation between the policies of the Federalgovernment and those of the states (some of which are controlled by opposition parties). It is at thisfederal/state intersection that Malaysia's spirit of political compromise seems most often to break down.

Growth: Though Malaysia has seen steady growth since independence (apart from the recessionof the mnid-1980s) it cannot compare to the success stories of Taiwan, China or Korea. According to theWorld Development Report (1992), Malaysia's GNP per capita growth rate from 1965-1990 was 4.0percent a year, compared with an average of 6.0 percent for Asian NIEs. To a large degree thisdifference can be explained by the inefficiencies which were allowed to proliferate in many parts ofMalaysia's economy.

The inefficiencies in its education system were exacerbated by its political structure. From thetime of independence on, Malaysia's government consisted of a basically unopposed bureaucracy which,in the 1970s and 1980s, was willing to employ large numbers of college graduates who were nottechnically trained. The combination of these circumstances led to a weak managerial class in Malaysiaand poor standards of accountability. As Malaysia's public sector grew to massive proportions in the late1970s and early 1980s, this weakness was a major factor in the failure of many public enterprises, andthreatened to be a serious problem for Malaysia's privatization efforts as well. Only when the economycollapsed in the mid-1980s did the government face the problem of managerial accountability.

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Figure 3

Actual versus Predicted GDP Shares (Agriculture)

0.50

0.40 1

c 0.30 - Z Actual

X 0.20 -- Predicted

0.1 0

0.00

1960 1970 1980 1990

Year

Figure 4

Actual versus Predicted GDP Shares (Manufacturing)

0.50 -

0.40 -

o 0.30 Actual

0.20 Predicted

0.10 -

0.00-

1960 1970 1980 1990

Year

- 43 -

Figure 5

Actual versus Predicted Labor Shares (Agriculture)

0.65

c 0.60'

E 0.55

EL 0.50- E \ Actual-a 0.45

Z 0.40 -0-- Predicted (C-S)0.4

* 0.35

0" 0.30

0.25 l1960 1970 1980 1990

Year

Figure 6

Actual versus Predicted Labor Shares (Industry)

0.50

0.40

0.30 - - Actual

0.20 -0--- ~~~~~~~~~~~~~~~~Predicted (C-S)

.9 0.10

.0.00

1960 1970 1980 1990

-44 -

Figure 7

Actual versus Predicted Labor Shares (Services)

0.50

E0.40 -

06E 0.30 - Actual

: 0.2tl- Predicted (C-S)

.v 0.10

0.00

1960 1970 1980 1990

Year

Table 13: Comparison wth Economic Structure Predicted by Chenery-Syrquln's Average Pattems, 1960-90

1960 1970 1980 1990VARIABLE C-S Act. Dlff. C-S Act. Dlff. C-S Act. Dlff. C-S Act. Dlff.

(a) (b) (b(a)a ) ) (b) (bHa) (a) (b) (b)X(a) (a) (b) (bxa)DEMAND (Share of GDP)Private consunption 0.69 0.62 -0.07 0.67 0.62 -0.05 0.64 0.51 -0.13 0.62 0.45 -0.17Govemmer consumptiorn 0.13 0.13 0.00 0.13 0.16 0.03 0.13 0.17 0.04 0.13 0.11 -0.02Investment 0.23 0.13 -0.10 0.24 0.20 -0.04 0.25 0.30 0.05 0.26 0.27 0.01Expots 0.26 0.56 0.30 0.26 0.46 0.20 0.26 0.58 0.32 0.25 0.65 0.40Imports 0.29 0.44 0.15 0.27 0.44 0.17 0.26 0.55 0.29 0.24 0.65 0.41

PRODUnON(Shae GDP)Aiufue 0.27 0.34 0.07 0.22 0.32 0.10 0.17 0.23 0.06 0.14 0.19 0.05Mining 0.09 0.07 -0.02 0.10 0.06 -0.04 0.11 0.10 -0.01 0.11 0.10 -0.01

0.16 0.05 -0.11 0.18 0.12 -0.06 0.21 0.20 -0.01 0.23 0.26 0.030.06 0.03 -0.03 0.07 0.04 -0.03 0.07 0.04 -0.03 0.07 0.03 -0.04

Saov. & Udkies 0.48 0.45 -0.03 0.38 0.46 0.08 0.49 0.43 -0.06 0.43 0.42 -0.01

EMPLOYMENT Shm of Totl)0.60 0.57 -0.03 0.52 0.51 -0.01 0.44 0.37 -0.07 0.38 0.28 -0.10

Indoky 0.14 0.17 0.03 0.18 0.18 0.00 0.22 0.22 0.00 0.25 0.27 0.02Sarvices 0.26 026 0.00 0.31 0.32 0.01 0.35 0.40 0.05 0.39 0.48 0.07Notes: C-S + Chersy-Syuin's regesons; Act. - Actual; Diff. - DienceSes:1. Predcked shares basd on actualptpalai siees of 8.10 10.39,13.70 rd 17.86 mElons; and per capkal GNP n 1980

U.S. dolars of 712, 1085,1663 ad 2247 jbr th fotur seled yars usin Chone,y-Syrquins average regressbns for1950-83. as giva In Syrq and Ctheny (199).

2 Acdla donid a b on NW. 1991.Pmdocon and Effwnms d shas boan Maydsa Pls.- -

- 46 -

Table 14: Sources of Malaysia's Growth

1971- 1976- 1981- 1986-75 80 85 89

(a) GDP at factor costOutput growth 6.50 7.72 5.71 5.93Contribution by:

Capital 0.81 2.62 3.49 1.36Labor 2.52 2.44 2.47 2.57(labor quality) 0.40 0.43 0.65 0.96Structural change 0.09 0.10 0.11 -0.07Residual (TFP) 3.03 2.56 -0.35 1.76

(b) GDP excl. government and housingOutput growth 5.94 7.84 5.22 5.86Contribution by:

Capital 0.94 3.49 4.04 1.41Labor 1.98 2.15 2.49 2.76(labor quality) 0.44 0.41 0.65 0.89Structural change 0.03 0.04 0.05 0.00Residual (TFP) 2.99 2.15 -1.37 1.68

(c) GDP excl. government, housing, andresource rents

Output growth 5.96 7.43 4.96 5.21Contribution by:

Capital 0.75 2.31 3.01 1.02Labor 2.29 2.51 2.97 3.34(labor quality) 0.51 0.48 0.78 1.20Structural change 0.03 0.05 0.06 -0.01Residual (TFP) 2.88 2.06 -1.08 0.86

Source: World Bank, 1991.

A look at Malaysia's Total Factor Productivity (TFP) growth for the entire period sinceindependence shows Malaysia (2.2) operating at acceptable standards, albeit at a lag behind Hong Kong(4.7), Taiwan, China (3.9) and Korea (2.4).29 When we break this down further, however, the 1980sshow themselves to be a most inefficient period. Table 14 gives some indication of the economy-wideeffects of public policies between the 1970s and the 1980s.

The problem seems to have been the inefficient use of capital. Based on data computed by theMalaysian Institute of Economic Research, Malaysia's incremental capital output ratio (ICOR), whichmeasures the efficiency in the utilization of capital, rose from 3.65 in 1971-1980 to 7.21 in 1981-85before dropping to 4.7 in 1986-1990. The ICOR computed for the public sector increased from an

29 Thomas and Wang, 1992.

- 47 -

average of 6.75 in 1971-1980 to 15.51 in 1981-1985, while the corresponding figures for private sectorinvestment were 2.27 and 3.87. Malaysia invested heavily, but did not have the human capital to useit properly. Monitoring and implementation capacity within the Government failed to keep pace with therapid growth of the public sector programs. Financial control and economic appraisal of projectssuffered. The government spent heavily on "social infrastructure" and for "commerce and industry".These are areas which make extensive demands on design and appraisal skills, and on administrativecapacity.

The drastic deterioration of efficiency in the 1980s was in direct contrast to what happenedelsewhere. Hong Kong and Korea were both able to raise their TFPG substantially from 1960 to 1970(Hong Kong growing from 2.4 in the 1950s to 4.3 in the 1960s, while Korea's TFP rose from 2.0 to 4.1during the same periods) and have managed to maintain fairly stable TFP ever since. Taiwan, China hasmaintained a TFP consistently over 3 since the 1950s. They also differed from Malaysia in their decisionto promote small industries and enterprises. Industrial parks and districts were set up in Taiwan for smallcapitalists and entrepreneurs. Consequently, between 1966 and 1976, the number of manufacturing firmsin Taiwan increased 150 percent, while the average size of the individual enterprises increased by only29 percent. Their success in this endeavor stands in stark contrast to Malaysia's experiment in heavyindustry.

lessons

We have emphasized that although Malaysia's statistical results can be compared with other NIEs(e.g. Taiwan, China and Korea), it is difficult to compare their developmental success because Malaysia'ssocio-economic environment and objectives were so different. Malaysia's circumstances demanded acomplex strategy and efficient implementation. It did not always succeed in this. However, it hasprovided some clear lessons that others can learn from.

The flexibility of Malaysia's government has been a crucial factor. Despite having a monolithicstructure, the government has repeatedly shown itself willing to adapt to changing conditions. It has hadto walk a tightrope of compromise between growth and equity concerns and, while shifting conditionshave caused it to shift its emphasis from time to time, it has resisted the temptation to drop eitherobjective. It has even been willing to pronounce certain policies and their implementation as outrightfailures. What success Malaysia is now enjoying is primarily due to this characteristic.

Beyond this virtue, Malaysia did have some advantages to start with. Unlike Taiwan, China andKorea, it began with a wealth of natural resources. This enhanced its ability to draw in foreigninvestment, and continued to provide a sense of economic stability. This gave it some freedom toexperiment with other policies. If some of these experiments were unsuccessful (e.g. HICOM), otherswere tremendously successful (e.g. the oil palm and electronics industries).

Malaysia also benefitted from institutional strength. Having a legal and political structure in placehas paid dividends in terms of the speed with which strategy is converted to policy. Built-in checks, theopenness of the economy, and low levels of distortion all help to create strong institutions which havebeen able to achieve stability quickly. The successful structural transformation and the benefits Malaysiahas reaped from developing its infrastructure are, in no small part, due to this institutional strength. Thesame can be said of the recent growth which has resulted from the liberalizing policies of the late 1980s.This strength does have a drawback, however, for it suggests that the policies of the NEP, howeverextravagant, should have been implemented with a greater degree of efficiency than we have seen. Thispoints to the insufficient development of human resources in the 1960s and 1970s as a crucial reason forthe economy's poor perfonnance in the 1980s.

-48 -

Finally, and most importany, the Malaysian story highlights the importance of politicalsuwtainability. The country is engaged in a long-range plan which it is pursuing with flexible short-termobjectives. The benefits of this kind of thinking can be seen most clearly in the way the government hasalways insisted that economic performance be considered as a means to social enrichment rather than asan end in itself. Malaysia's development policies were, for a long time, considered sui generis. Today,with the end of the Cold War, the Balkanization of nations and the ensuing ethnic conflicts, the Malaysianexperience starts to seem highly relevant to the rest of the world.

- 49 -

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MALAYSIA: ECONOMIC AND POLITICAL TIMELINE

Phase I

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