Malaysia’s Middle-Income Trap

January 26, 2011

By Herizal Hazri, Nina Merchant-Vega

Many first-time visitors to Kuala Lumpur are quickly impressed by the large highways, ultra-modern shopping malls and, of course, the twin Petronas Towers that dominate the city’s skyline. However, some do not realize just how impressive these overwhelming signs of economic progress are – especially considering Malaysia’s recent history. As recently as 50 years ago, half of Malaysians lived in absolute poverty with a GDP per capita of around $260 (MR 788).

As recently as 50 years ago, half of Malaysians lived in absolute poverty with a GDP per capita of around $260. Today, Malaysia has been among the best-performing economies in the world since World War II.

Today, just 4 percent of Malaysians live in poverty, and GDP per capita has reached $8,100 (MR 24,300), almost doubling each decade. Malaysia has been among the best-performing economies in the world since World War II, consistently achieving an average of 7+ percent GDP growth between 1980 and 1997. Indeed, Malaysia has transformed from a poor, colonial plantation economy into a modern, upper-middle income country in the span of one generation. This represents one of the strongest records of economic and human development in recent memory.

In spite of this remarkable development, many economists fear that Malaysia is getting farther from its goal of becoming a fully developed country by 2020. They contend that Malaysia is in the so-called “middle-income trap,” in which a country gets stuck at a relatively comfortable level of income but cannot seem to take the next leap to developed nation status. The reasons for getting “stuck” are relatively simple. At low levels of income, it’s easy to take advantage of cheap labor for low-skilled manufacturing exports that facilitate the transition from low to middle income. However, making the leap from middle to high income is much more difficult. As incomes increase, so do costs, which means countries like Malaysia must “move up the value chain,” by exporting more technologically advanced products. In addition, they must innovate and use capital and labor more productively. This means having a better-educated workforce and an innovative domestic private sector that invests in research and development.

Ironically, the same policies that put Malaysia on its path to success 50 years ago may be holding it back today. Although the Malaysian economy has moved from being a raw commodity exporter to a manufacturing exporter, it has done so by relying heavily on foreign direct investment. While this is not a bad thing, only Malaysian domestic investors are going to develop innovative Malaysian businesses and products that can move the country to high-income status. Unfortunately, Malaysian domestic private investment is even lower today than it was before the 1997 Asian economic crisis, making prospects for a Malaysia-led development path even dimmer.

In addition, Malaysia’s 40-year-old New Economic Policy (NEP) – originally designed to help Bumiputera (a Malay term used to describe the indigenous people of Malaysia) compete more effectively in the economy through educational and ownership quotas – has instead hampered growth by preventing the full mobilization of human resources (particularly of ethnic Chinese and Indian minorities). Critics claim that it has also scared off some foreign investors who believe that the NEP represents too much government interference in the economy. While the NEP rightly focused on expanding opportunities for and redistributing wealth to poorer Malaysian communities when it was created, many Malaysians, including Bumiputera who have benefited from the policy, believe it is now an outdated model that discourages Malaysia’s best and brightest (from whatever ethnic background) from innovating.

In February 2010, the government announced the introduction of the New Economic Model (NEM) as part of its 10th Malaysia Plan. The NEM aims to stimulate economic growth by improving worker productivity across all sectors of society, in part through an improved need-based system of affirmative action. The government believes that the NEM will help create a knowledge-based economy, re-position Malaysia farther up the value chain, and propel Malaysia to developed-country status by 2020.

With the advent of the NEM, the government is positioning itself as an enabler or facilitator of economic development rather than a strict regulator. The primary proponents of the NEM believe that excessive government interference in the economy is dampening investor sentiment and holding back Malaysian industry. They believe that by giving private business better incentives to invest in innovative projects, it will set Malaysia on a higher growth path. Many believe that the new policy appears to have similar ideological underpinnings to the Washington Consensus or The Lisbon Treaty, expounding the virtues of deregulation and reduced state presence.

Nevertheless, this move, seen by the government as the “secret ingredient” to double Malaysia’s economy, is debatable. Many economists wonder if the timing is right. In the current global economic situation, where many governments are strengthening regulations and adopting fiscal measures to avert banking crises, Malaysia seems to be moving against the current. The grave lesson of the global economic crash of 2008 – that sometimes under-regulated capitalism can have severe consequences – seems to have had minimal impact on Malaysia’s new policies.

In addition, the NEM also propagated a “better quality of life” for Malaysian citizens with the creation of a high-income group and the reduction of the income disparity between the rich and the poor. However, evidence from many high-income countries over the years (U.S., UK, Germany) points to an emergent pattern of increased income inequality without redistributive efforts from the government. Therefore, questions must be posed about whether the NEM is sufficiently geared toward addressing these issues.

On the other hand, some critics think that the NEM does not go far enough in loosening government regulations and reforms. To date, the details of the policy have not been articulated, which some critics point to as a sign that the NEM is just political rhetoric. In addition, some wonder what the government is going to do to curb growth-killing graft and corruption and improve education to buoy the workforce. While the government has put together an Economic Transformation Programme and a Government Transformation Programme to address these critical issues, some remain skeptical that progress will be made.

Clearly, the government of Malaysia is serious about moving the country out of the “middle-income trap” and onto a higher growth path. However, in moving forward with NEM and Vision 2020, Malaysia will have to consider not just growth, but how it is going to tackle the serious challenges that could ultimately stall the progress toward development. The government will have to improve efforts to combat entrenched institutional problems like corruption. These issues will not be easily solved. But if the history of Malaysia over the past 50 years is any indication, it can, with careful policies and political will, make progress on these fronts.

Nina Merchant-Vega is The Asia Foundation’s assistant director for the Economic Reform and Development program and Herizal Hazri is program director in the Foundation’s Malaysia office. They can be reached at [email protected] and [email protected], respectively.

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