December 23, 1998

Malaysia in Turmoil: Growth Prospects and Future Competitiveness

Dwight Heald Perkins and Wing Thye Woo

Harvard University and University of California at Davis

These are extraordinary times in Malaysia. In an unprecedented departure from its long tradition of macroeconomic orthodoxy, Malaysia imposed comprehensive capital controls on September 1, 1998. This sharp policy break has as its background an equally sharp economic collapse. Output in 1998 is expected to contract by more than 6 percent, a drastic change from the average annual growth rate of 8.7 percent in the 1990-97 period, where the lowest growth was 7.7 percent in 1997. Furthermore, a quick rebound from the collapse does not look likely. In mid-December 1998, Prime Minister Mahathir Mohamad predicted that the 1999 growth rate would be 1 percent. Many private observers are considerably more pessimistic, the Economist Intelligence Unit (EIU), for example, has predicted that growth would be negative 2.9 percent in 1999 and 0.7 percent in 2000. Such pessimism about Malaysia's economy is unprecedented.

Equally unprecedented events are also occurring on the political front. At the end of June 1998, Mahathir substantially reduced the scope of economic management by Deputy Prime Minister Anwar Ibrahim, who was also the Minister of Finance, by appointing Daim Zainuddin, a former Minister of Finance, to take charge of economic development. Then on September 2, 1998, Mahathir dismissed Anwar from the government on the grounds that Anwar was morally unfit to be a political leader. Anwar is now in court facing charges of corruption and sodomy. Mahathir has also accused his once-designated successor of treason. There have been numerous demonstrations by Anwar's supporters since September, some of which turned violent. All of these actions are unprecedented in the political succession process in Malaysia, where external collegiality had been the norm.

Both extraordinary events are the products of many factors, and there is causation between the two events. The foremost contributing factors are the political struggle for power between Mahathir and Anwar, and their differences in economic policies. Furthermore, Mahathir had foreseen that Anwar's expulsion would lead to violent street demonstrations that would, in turn, induce large capital outflow given the extreme nervousness among investors in the midst of the Asian financial crisis. Hence, the imposition of capital controls preceded the firing of Anwar.

If the capital controls were not already in place when the street demonstrations began, the Malaysian Ringgit (MR) and the Kuala Lumpur stock market would most likely have gone into a free fall in the manner that the Indonesian Rupiah and the Jakarta stock market did in May 1998 just before Soeharto stepped down from the presidency. Such a free fall, as we shall explain, would have bankrupted many powerful groups within the United Malay National Organisation (UMNO) -- the dominant party within the governing Barisan Nasional coalition -- and weakened Mahathir's grip on UMNO.

The fact that capital controls might also allow the government to undertake expansionary fiscal and monetary policies to boost employment and the stock market without worsening the balance of payments significantly was another important reason why they were adopted. The short-term interest rate has dropped from 11.06 percent on June 10, 1998 (when Anwar was in charge of economic matters) to 6.58 percent on December 16, 1998; and the stock market index has risen from 489.9 to 543.0 over this period.

These two extraordinary events in Malaysia raise the need for a fresh look at two questions that have usually been answered optimistically:

(1) What is the short and medium-term outlook for Malaysia's economic growth?

(2) What is the underlying international competitiveness of Malaysia's economy at

the present, and how is it likely to evolve in the future?

To answer these two questions adequately, it is necessary to keep in mind that nearly three decades ago, Malaysia’s political leaders took a large gamble. The gamble was that the nation could simultaneously restructure its economy to increase the ownership share of Malay-Malaysians (bumiputras) in the industrial and modern service sectors, and continue to enjoy rapid increases in per capita income for all. By any reasonable standard this gamble was won. The economy achieved a large degree of restructuring and growth continued at an annual average per capita rate of between four and five percent per year over two and a half decades. If per capita GNP (measured in Purchasing Power Parity) in Malaysia continues to grow at four percent per year, Malaysia by the year 2020 will have a per capita GNP nearly equal to that of the United States in 1993

Success in the past, however, does not guarantee success in the future. The achievements of the 1970-1996 period were partly due to effective national leadership, but there was also a substantial element of luck involved. Malaysia had an unusually rich natural resource base on which to begin its restructuring, and, just as the restructuring got underway, that resource base got even richer with the development of the offshore extraction of petroleum and natural gas. With petroleum and timber channeling large funds into government and private coffers, Malaysia could make mistakes and still do well. As it turned out, Malaysia did not make that many mistakes so it did very well. Natural resources, however, are not going to carry the Malaysian economy into the future because its share in output and in exports has shown a clear downward trend in the last fifteen years.

To answer the questions of what are Malaysia’s growth prospects; and whether the Malaysian industrial and modern service sector will remain internationally competitive into the future, we turn to examine the economic policies, business organizations and business leaders that have produced the past successes.

State Ownership from the Race-Based Economic Policies of the 1970s and 1980s

In many ways, the breakthrough from import substituting industries to the export of manufactures occurred with the establishment of free trade zones, first in Penang in 1970 and then around Kuala Lumpur in 1971. The subsequent arrival of many Japanese and American firms was not so much the result of actions taken by the Malaysian government as it was of external factors. Japanese and American firms could no longer stay competitive in much of their electronic assembly work relying on high cost labor at home. The issue was not whether to go abroad but where to go. Malaysia was an attractive choice; it was stable politically, was a nice place for foreigners to live (one could even drink the tap water), and welcomed foreign investment (unlike Taiwan or South Korea).

The other major development of the first half of the 1970s in the industrial and mining sphere was the discovery and development of petroleum. At one level petroleum, like electronics, was just another new industry developed for the most part with foreign investment and technology.

It was in the context of this booming economy that Malaysia began to implement policies to achieve 30 percent bumiputra ownership of modern sector assets. Up to the mid-1970s, the path chosen to raise the bumiputra ownership share was the creation of state owned enterprises. These efforts, however, had only a limited impact.

To accelerate the rise in bumiputra ownership, the government in 1975 introduced the Industrial Coordination Act (ICA). ICA required that all enterprises with equity over a certain limit had to sell 30 percent of their shares to bumiputras. There were loopholes. The most important one was that firms that exported over 80 percent of their output were not subject to the bumiputra ownership requirement. None of the Kuala Lumpur and Penang electronics firms, therefore, felt any impact from the ICA. The Chinese-Malaysian and foreign businesses complained vociferously about the ICA from the outset. These complaints did gradually lead to modifications in the legislation, mainly the raising of the asset limit and the lowering of the export requirement.

Table 1 presents data on ownership of modern sector firms in Malaysia in 1974 and 1993, and it shows that the ethnic makeup of the Malaysian owned companies has changed dramatically in the two decades.


Table 1: Market Capitalization of the Top KLSE Companies by Ownership Category


Nationality or Ethnicity


Percent Share 1974


Percent Share 1993


Foreign Controlled*






Malaysian Controlled






Government A**









Chinese (Private Local)***






Bumiputra (Private Local)






Indian (Private Local)












Unit Trusts


















*Foreign controlled in 1974 excludes Singapore controlled companies. If Singapore companies were included, the foreign share would be 61.1% of a larger total. Singapore companies were excluded because of complications connected with the way Singapore (and Malaysian) companies were cross listed in the early years in both Singapore and Kuala Lumpur.

**Government A companies were those under government control in 1974. Government C companies were those under foreign control in 1974 but taken over by the government by 1977.

***Private local ownership in 1974 was almost entirely Chinese.

Sources: The 1974 data were derived from Tan Tat Wai, Income Distribution and Determination in West Malaysia (Kuala Lumpur: Oxford University Press, 1982). The 1993 data were constructed by Ms. Veena Loh under the supervision of Tan Tat Wai.


While half of the share capital of the top 80 firms in 1974 was in the hands of foreigners (excluding Singaporeans from the "foreigner" category), foreigners owned only 10.7 percent of the shares of the top 100 firms on the Kuala Lumpur Stock Exchange (KLSE) in 1993. In the mid-1970s, the private local ownership was mostly Chinese. By the early 1990s, Chinese-Malaysians controlled only 13.9 percent of the top 100 company shares and Indian-Malaysians a minuscule 0.1 percent. Bumiputra direct ownership in the 1993 was 6.3 percent, but the unit trusts, which were primarily designed to provide bumiputras with share ownership, accounted for another 17.6 percent bringing the bumiputra total to 23.9 percent in the 1993. The Malaysian government directly controlled 40.5 percent of the market capitalization of these firms in the 1990s as contrasted to only 6.3 percent in 1974. The race-based economic policies had caused the Malaysian government to dominate "the commanding heights of the economy" -- an economic ownership pattern that is similar to that of state socialism!

A major question from the outset was how to distribute the bumiputra shares. Few bumiputras had any experience with corporate shares, and the number with the money to buy them was equally small. The initial approach was for the Ministry of Trade and Industry to draw up a list of names to whom the shares should be distributed. Typically, the chosen individuals bought the bumiputra shares at a significant discount from the other shares in the same company. Share allocation, therefore, became a vehicle for political patronage.

However, if the favored bumiputras were to always realise their profits quickly by turning around and selling off the discounted shares that they had just received (an action engaged in by quite a number), then the 30 percent target of bumiputra ownership would be very difficult to achieve. So, over time, a large part of the discounted bumiputra corporate shares were given to the unit trusts set up by Permodalan Nasional Berhad (National Equity Corporation or PNB). PNB’s first unit trust, Sekim Amanah Saham Nasional (ASN), was formed in 1981. The ASN unit trust was a quick success because it had a number of special features. PNB, using funds allocated to it by the government, guaranteed each share of MR$10 a bonus of MR$90 but the MR$90 could not be withdrawn until regular earnings had accumulated to an equivalent amount. A rate of return of 10 percent was guaranteed, plus there were bonuses if investments did better than that. As things turned out, ASN paid an average annual rate of return of 18 percent.

By the early 1980s, therefore, Malaysia was well into the process of restructuring the race ownership of the modern sector of the economy. The commodity price boom of the late 1970s not only ameliorated the disincentive effects of ownership restructuring, it also helped lay the groundwork for a government led effort in the 1980s to change Malaysia’s industrial structure by establishing a number of heavy industries. The core of the plan was a new cement plant (Kedah Cement), a new steel mill (Perwaja Steel), and an automobile plant (Proton Saga). These heavy industry projects were financed to a large degree by a new state-owned corporation, HICOM, which undertook massive external borrowing to do so.


Privatization in the 1990s

By the 1990s large numbers of Malaysians including many government leaders had become increasingly disillusioned with state owned enterprises as vehicles for achieving both growth and social goals. Many of the state owned enterprises made sustained losses even though private enterprises in the same lines of business were doing well. Government oversight of the state owned firms was so weak that the government itself did not even know how many firms there were!

The first step toward changing the ownership structure of many of the large state owned enterprises was corporatization, which started in the mid-1980s with the listing of Malaysian International Shipping (MISC) and Malaysian Airlines (MAS), but did not get underway on a broader basis until the 1990s. The second step was the privatization of new infrastructure projects (e.g. the North-South highway, cellular phone projects) through a process that awarded the contract on what was called an invited bid or involuntary bid process, which usually meant that the contract went to the first proposal. The awarding of these contracts has been controversial from the outset, not because of the ethnic makeup of those who won the contracts, which was reasonably balanced, but because the process was not transparent, only a limited number of firms was involved, and the terms of the contracts were widely perceived as being overly generous to the recipients of the contract. For example, Renong Berhad, which used to be the main investment vehicle for UMNO and now controlled by Halim Saad, has won eight of the thirteen large national projects that Malaysia has awarded since 1992.

The third step was the outright privatization of existing large state firms. The scope of the effort was broad and by 1993 even HICOM was sold. Privatization in Malaysia, however, has involved objectives not found in similar efforts elsewhere such as in Margaret Thatcher’s Great Britain. Privatization in Malaysia was only partly driven by considerations of efficiency. In an important respect, privatization was the continuation of UMNO’s social redistribution policies in another form, and a means of strengthening bumiputra loyalty to UMNO. Since most of these companies were already corporatized, share prices were already determined by market forces so that the price at which shares were sold was not a major issue. On the other hand, the government did issue a controlling block of shares to favored individuals, generally allocating 32% or less of the total number of shares because any higher percentage, according to the law, required a general offer.

The entrepreneurs who received these shares such as Tan Sri Yahya Ahmad, who took control of HICOM, and Tan Sri Tajuddin, who took control of MAS were mainly bumiputras and members of UMNO. Realistically speaking, given the political background of many of these firms, it is doubtful whether anyone other than a bumiputra entrepreneur could have done the vigorous cost cutting that was required, and in the cases just cited, vigorous cost cutting did follow privatization. Who else could have cut the bloated staffs (mostly bumiputras) of these companies or have removed inefficient bumiputra vendors from their lists?

It must be noted here that while the acquisition of assets by UMNO members strengthened their allegiance to the top ministers, it also rendered their support of the existing UMNO leadership to be disproportionately influenced by the state of the economy in general, and by the state of the stock market in particular. This second implication of the massive asset redistribution program, we shall see, lies at the root of the two extraordinary economic and political events mentioned at the beginning of this paper.


Enhanced Vulnerability to Financial Panics and High Interest Rates

It turns out that the headlong plunge to accelerate bumiputra ownership of the corporate sector made the bumiputra business community particularly vulnerable to financial downturns. The financial vulnerability was created by, one, the government’s lax regulations on collateral-based loans, and, two, by the government’s directions to the state banks to extend investment loans to bumiputras. The generous flow of bank loans enabled, one, the bumiputra community to buy the discounted shares and to invest in the more profitable unit trusts, and, two, the politically connected bumiputra entrepreneurs to buy controlling shares in state companies. The newly purchased assets, in turn, constituted a large proportion of the value of the collateral that the bumiputra borrowers pledged for their bank loans.

The high economic growth of the 1990s, supplemented by large foreign capital inflows, caused the stock market to boom. The Kuala Lumpur Stock Exchange Composite Index went from 506 in 1990 to 1238 in 1996. The rise in the share prices allowed Malaysians to borrow more from the banks to acquire more assets. The outcome was that the domestic debt/GDP ratio in Malaysia in mid-1997 stood at 170 percent, which is among the highest in the world.

The reversal of foreign capital flows in mid-1997, and its acceleration at the end of 1997, exacerbated the decline of the Malaysian stock market that had started at the end of 1996. Besides crashing the stock market, the capital outflow also depreciated the Ringgit significantly against the US$, from MR2.5/US$ in 1997:2Q to MR3.9/US$ in 1997:4Q, and then to MR4.2/US$ in 1998:2Q.

Anwar, who was in charge of economic affairs up to almost the end of June 1998, reacted to the acceleration in capital flight in the final months of 1997 by implementing an IMF-style high interest rate policy to stabilise the exchange rate. The annualised growth rate of reserve money went from over 25 percent in all four quarters of 1997 to negative 6 percent in 1998:1Q and then to negative 15 percent in 1998:2Q. As a result of the significant tightening of credit in early 1998, the lending rate, which had been inching up since the start of the Asian financial crisis in July 1997 from 8.9 percent in 1996:4Q to 10.0 percent in 1997:4Q, jumped to 12.2 percent in 1998:2Q. The high-interest rate policy could not halt the decline of the Ringgit however. Worse yet, it reduced investment spending further and contributed to the downslide of the stock market index to 455 in 1998:2Q from 1238 in 1996:4Q.

In Anwar’s defense, it could be argued that the efficacy of his high interest rate policy was undermined by Mahathir’s occasional excoriation of conspiratorial speculation by foreigners. The Ringgit would fall sharply after each outburst by Mahathir, possibly because jittery investors interpreted his strong condemnation as the prelude to the imposition of capital controls. One should note, however, that similar high interest rate policies in Indonesia, Thailand, Korea and Russia had also failed to stop their currencies from falling further after an initial sharp devaluation, despite the absence in these countries of denunciations of foreign speculators by high government officials.

The collapses in the domestic stock market and the foreign exchange market were also accompanied by a large decline in aggregate demand. Private consumption and private investment, especially housing investment, plunged because of the abrupt withdrawal of foreign funds, the high interest rates, and the pessimism about quick economic recovery in East Asia. Furthermore, the positive effects from the depreciation of the Ringgit were more than offset by the depressed demand conditions in the region, making exports in the first half of 1998 (US$35 billion) to be lower than in the first half of 1997 (US$39 billion).

The fall in profits and in share prices rendered many large bumiputra conglomerates financially illiquid or insolvent. The decline in their share prices reduced the value of the collateral pledged against their bank loans, and the drop in profits caused by the economic slowdown made them unable to service their bank loans.

Possibly, the most well known rescue attempt of a politically-connected conglomerate in 1997 was the November 17 announcement by United Engineers Berhad that it had just used borrowed funds to acquire 32.6 percent of the shares of its parent company, Renong Berhad. United Engineers had done this without consulting its minority shareholders. Furthermore, the government had to issue a waiver to exempt United Engineers from having to make a general offer for Renong shares that it did not own. Because United Engineers’ move was widely seen as bailing out the indebted majority shareholders of Renong to the detriment of minority shareholders in both companies, the share prices of both companies plummeted after the announcement of the acquisition.

As matters turned out, the continued general downslide in profits and in share prices required that Renong be bailed out a second time. In October 1998, Renong defaulted on its debts, and the government paid off MR10.5 billion of Renong’s short and medium-tern bank debt by issuing an equivalent amount of long-term bonds. Renong promised to repay the government from its future earnings.

Most large bumiputra conglomerates shared Renong’s financial difficulties over the last year. Quite a few of them, especially the politically connected ones, also received state assistance to weather the financial storm. The difficulties of Malaysia’s conglomerates (both bumiputra and non-bumiputra owned) in servicing their large bank debts appeared to have severely damaged the balance sheets of Malaysia’s banks. An estimate by Lehman Brothers in October 1998 put the extent of Malaysia’s problem loans to be at the median of key Asian market economies experiencing banking crises. The proportion of problem loans in total bank loans was 13 percent for Japan, 33 percent for Malaysia and South Korea, 48 percent for Thailand and 61 percent for Indonesia.

Bank Bumiputra, a state bank, was pushed into bankruptcy for the third time since its establishment in 1966. The government had to put in at least MR2 billion as capital in order for Bank Bumiputra to meet the minimum risk-weighted capital adequacy ratio. Sime Bank and RHB Bank, two banks with strong ties to UMNO members, merged in mid-1998 and received an infusion of MR1.5 billion from Danamodal, a state company recently established to recapitalise troubled banks. The steady deterioration of the bank sheets of Malaysia’s banks has led Standard & Poor to predict that gross non-performing loans (NPLs) would exceed 30 percent of total bank loans at the end of 1999 and that the amount of required recapitalisation would exceed 40 percent of GDP.


Would Reflation Work?

It was clear by the end of June 1998 that the forecast of 2.5 percent growth in 1998 released in May by the IMF was too high. Salomon Smith Barney predicted in June that 1998 growth would be negative 3 percent, while the Economist Intelligence Unit (EIU) predicted 0.8 percent growth in its 1998:2Q issue. It was in this atmosphere of deepened pessimism, and after Mahathir’s political leadership was indirectly challenged by Anwar at the annual UMNO meeting in June, that Mahathir appointed Daim Zainuddin to formulate an alternative to Anwar’s high interest rate policy.

Reflation through lower interest rates in July 1998 was a risky policy however, because the unsettled global financial markets made the outcome uncertain. There was a chance that a significant lowering of interest rates would stimulate aggregate demand to rise substantially to raise output, restore corporate profits, and renew confidence in the underlying strength of Malaysia’s economy. The culmination of this positive scenario would be the repatriation by domestic investors of their overseas holdings to undertake capacity expansion, the return of foreign capital to the stock market, and the stabilisation of the Ringgit.

On the other hand, there was also the chance that lowering interest rates considerably would worsen the July 1998 situation. Instead of stimulating private spending, the lower interest rates would end up stimulating capital flight. Speculators would borrow Ringgit at the lower rates, and buy foreign currencies to bet against a further depreciation of the Ringgit. A massive substantial injection of money would thence set the Ringgit on a downward spiral, that would bankrupt even more Malaysian banks and businesses that had foreign debt.

Given the uncertainty of the outcome from lowering interest rates, and the ongoing capital flight from the region, a "wait-and-see" policy emerged by default, along with a small reduction in interest rates. The short-term interest rate on August 26, 1998 -- one week before implementation of capital controls -- was 10.0 percent, down from 11.1 percent on July 1, 1998. Output, the stock market, and the Ringgit continued to fall in July and August. It soon became clear that GDP had fallen an annualised 6.8 percent in the second quarter of 1998, and that the decline in the third quarter would be even greater. Incremental adjustments on the policy front was no longer acceptable, either politically or economically.

Malaysia put on capital controls on September 1, fixed the exchange rate at MR3.8/US$, started reducing interest rates substantially, and announced an expansionary government budget on October 23. Infrastructure spending was increased to raise the budget deficit to 6.1 percent of GDP in 1999, up from 3.7 percent in 1998. Mahathir and Daim announced that bailouts of troubled firms would increase; and urged banks to boost their lending. After all, there were two new state agencies, Danaharta and Danamodal, that would, respectively, take over the bad bank loans and recapitalise the banks. The central bank even imposed a mandatory target of 8 percent growth for bank loans in 1998.

Would Malaysia’s reflation work?

It is still too early at this point in time (early December 1998) to tell if the reflation is reviving the economy. The signals are mixed. The fact that industrial production in October is likely to have dropped 10 percent (annualised) as in September may only show the extreme downward momentum in the economy -- GDP had declined an annualised 8.6 percent in 1998:3Q!

The injection of liquidity, with leakage minimised by capital controls, has lowered the short-term interest rate to 6.6 percent on December 9, 1998, compared with 11.1 percent on July 1, 1998 (after Daim just took over), and with 7.5 percent on July 2, 1997 when the Thai crisis began. The stock market has stopped its downward slide and recovered some. The stock market index stood at 522 on December 9, 1998 up from 471 on July 1, 1998 but this is still way below the pre-Asian crisis level of 1085 on July 2 1997. While it is difficult to be confident about the message from these movements in the stock market, they are consistent with the signal that the economy would soon bottom out.

Overall, it is likely that the reflation would have a positive effect on the economy in 1999, as would be predicted by a standard macroeconomic model. The strongest argument for the net positive effects is the obvious fact that the output decline in 1998 was caused by a reduction in aggregate demand and not by a loss in production capacity.

However, a cautionary note - even about short-run growth – may be in order. The positive effects from the reflation could be offset by decline in domestic private spending caused by negative expectations about the future. Would the "race card" be invoked in the Mahathir-Anwar contest such that each side would compete to redistribute even more from the Chinese-Malaysians to the Malay-Malaysians? Would the use of capitals controls, even if temporary, turn foreign investors permanently away from Malaysia to the many developing countries that are now welcoming foreign capital as never before, and hence lower future growth in Malaysia?

While the short-run consequences of higher state spending and lower interest rate in a capital control environment are likely to be positive, the more important long-run consequences are harder to gauge. Given how dependent Malaysian growth and competitiveness has been so dependent on foreign direct investment (FDI) in the past, the long-run response of foreign investors to the temporary use of capital controls is absolutely crucial. The continued high inflow of foreign direct investment (and hence technology) may be necessary to maintaining the high trend growth rate of the last two decades. We think that the extensive Latin American experiences with capital controls provide grounds to be optimistic that foreign capital would return after the lifting of controls, albeit possibly with a higher risk premium being paid by Malaysia for several years. Of course, the return of foreign capital is fundamentally conditional on the underlying social stability in Malaysia not being affected by the current Mahathir-Anwar political fight. Another long-run issue, which matches the importance of the foreign investors’ response, is the use of bailouts in the reflation. If the bailout focuses mostly on bumiputra firms that were rendered illiquid by the financial panic (e.g. unable to roll over short-term debt), then the underlying growth of the economy is unaffected. But if the bailout covers mostly bumiputra firms that had their insolvency hastened forward by the high interest rates and lower aggregate demand, then the survival of these low-growth potential firms would lower the trend growth rate. Furthermore, these inefficient firms are also likely to weaken the future fiscal situation by requiring more subsidies, and to raise the costs for downstream firms by obtaining increased import protection in the future.

In conclusion, reflation would reduce the output loss inflicted by the Asian financial crisis provided that the present political conflict would not escalate to dampen private spending, and to reduce foreign investment. Reflation has to be accompanied by the restructuring of the industrial and financial sectors to weed out the less efficient firms in order for Malaysia to maintain its high trend growth rate.


International Competitiveness: The Picture Sector by Sector

We now turn to the microeconomic level to examine the international competitiveness of each sector of Malaysia’s economy. We group Malaysian industries into four categories:

  1. manufactured export industries;
  2. manufactured import-substituting light industries;
  3. heavy industries; and
  4. modern service industries


Manufactured Export Industries

Malaysia’s manufactured export industries have had two characteristics in common that are important to achieving international competitiveness. First, ethnicity oriented ownership policies have played only a minor role in these industries because most have been exempted from the ownership requirements of the ICA. Second, the great majority of firms in this sector are foreign owned in whole or in controlling part. The ICA ownership policies played little role because the government recognized early on that there are few rents to redistribute in the export of manufactures. International competition largely eliminates rents in this sector and profits thus reflect returns to business skill and entrepreneurship. Any effort to divert a substantial share of these profits to those not contributing to their creation kills the incentive to develop the business in the first place. Where foreign ownership is involved, it is a simple matter for the owner to decide to set up business in some other country.

Malaysia’s electronics sector, by far the most important manufactured exporting sector in the country, illustrates how Malaysia’s manufactured exports have developed to date. Basically the electronics sector is really two quite distinct groups of industries, both of which sell most of what they produce outside of Malaysia. The semiconductor, computer, and peripherals industries are dominated by large American firms such as Intel and Hewlett-Packard. These firms are not listed on the Kuala Lumpur Stock Exchange, so the precise size of their Malaysian operations is not public information, but several firms, notably Intel, have investments in Malaysia more than US$1 billion. What started as footloose firms employing cheap labor have become enterprises with a wider range of activities in Malaysia. Furthermore management and the technical staff of these plants has been largely localized. Ownership, on the other hand, is entirely foreign.

The other part of the electronics sector produces consumer electronics, ranging from television sets and VCRs to air conditioners and refrigerators. Brand names matter with these products and most of the firms in this sector are wholly owned by large Japanese conglomerates such as Matsushita, Sony, Hitachi, and Sanyo. Japanese firms differ from those of the Americans and Europeans in that top management in Malaysia is almost always staffed by Japanese who rotate in and out from their home offices in Japan. These plants are not really footloose since they involve substantial investments and have been in Malaysia a long time, but they are less firmly rooted than the semiconductor manufacturers and one should not overstate how firmly rooted are the semiconductor firms given the rapid pace of technology change in that industry.

If Malaysia’s future is like its past, future manufactured export growth will depend on:

But can foreign direct investment alone carry an economy that is no longer generating much growth from its rich natural resource sector? Singapore and Hong Kong have experienced FDI-led growth for long periods, but these are much smaller countries or territories than Malaysia and they have an unusually strong financial and commercial infrastructure. Malaysia is more comparable in size and infrastructure to Taiwan, and Taiwan’s manufactured export industries were led by Taiwanese with FDI playing only a small role. There is at least a plausible basis for concern that foreign direct investment alone will not be able to carry Malaysian manufacturing to ever higher levels of production and exports sufficient to sustain rapid GDP growth.


The Manufactured Import-Substituting Light Industries

Most of the firms in this category are small and medium sized. Of the three companies listed in the top fifty on the Kuala Lumpur Stock Exchange that fall within this category, two are foreign owned (Nestle, Rothman) and only one is local, Perlis Plantations (the Robert Kuok group) which includes sugar manufacturing among its diversified activities. In the next fifty firms listed by size, there are only six more in this category and they too are largely foreign (R.J.Reynolds, Guiness, Carlsberg) or local franchises of foreign operations (Kentucky Fried Chicken). The exception is Federal Flour, also part of the Robert Kuok group.

The great majority of the firms in this category are owned by Chinese-Malaysians. Some of these firms will no doubt grow to a point where they are suppliers to more than the Malaysian domestic market, but few outside of textiles played such a role in the mid-1990s. As they grow larger, however, they become subject to the rules of the Industrial Coordination Act and if they do not become larger, they are not likely to be able to export. But if many of these local light industry firms do not grow up to international status, which firms will? The incentive structure rooted in the ownership legislation thus inhibits the development of an export capacity among import substituting light manufacturers. This situation is common to many developing countries and is a particular problem in the Philippines, for example. Very small firms often prosper and grow out of sight of government regulatory and tax authorities until they reach a size where they are noticed and are suddenly faced with a raft of government interventions. Those firms with foresight often avoid this problem by staying small.

In short, light manufactures currently in the import substituting sector do not appear to be promising sources for the export oriented entrepreneurs of Malaysia’s future, and this is in part because the ICA discourages non-bumiputra-owned firms from expanding the scale of their operations.


Heavy Industries

Malaysia currently has proven oil and gas reserves plus the realistic prospect of future discoveries of new fields that will allow the country to extract substantial rents from this source for several more decades. The sector, however, is not a dynamic source of future growth either in domestic value-added terms or in terms of exports. If domestic demand for petroleum and gas continues growing at current rates, Malaysia will eventually become a net importer of these products.

Petrochemicals are dominated by Petronas, the state company which controls all the oil and gas fields, and receives most of the rents from them. In the mid-1990s worldwide profit margins in petrochemicals were extremely low. Petronas’s downstream efforts may also have had low or no profits, but there is no way for an outsider to know because profits from downstream activities are not separated out publicly from the profits (and rents) to the company as a whole. The Malaysian situation is further complicated by being next to a Singapore which got into the industry early and made itself the petroleum and petrochemical center for all of Southeast Asia and has been prepared to defend that position with vigorous price cutting and similar measures in order to prevent or cripple the rise of potential competitors.

Cement is an industry where transport costs provide significant natural protection for what, in most countries, is an industry oriented toward the domestic market. Scale economies can be achieved at one or two million tons of output per year, and the Malaysian market in 1996 was already around 12 million tons, more than big enough for Malaysia’s six major producers. The largest producer is APMC, a joint venture between the MUI group of Khoo Kay Peng and the Blue Circle Group of the U.K. Most of the other cement firms have close ties to the government.

Because infrastructure and concrete products (as inputs) affect the cost of export products only in a small and indirect way, the question of whether or not local Malaysian produced cement is fully competitive with imported cement only becomes an issue if the domestic plants are extremely inefficient, which Malaysia’s are not. Malaysia, in fact, might well become an exporter of cement, particularly to Singapore which regularly imports several million tons a year, but the export market for cement is neither large nor growing rapidly in part because it is a favorite target for developing country import substituting industrial policies.

Steel is very different from cement. The technology is more complex, scale economies are important in the case of some products and steel is both a potential export product itself and a major input into other actual and potential exports, notably automobiles. The Malaysian government has tried to take the lead in the development of a modern steel sector but with decidedly mixed results. Malayawata was the government’s first try. The government’s second try (Perwaja Steel) resulted in large financial losses. The 30 percent tariff rate on steel products has produced two prosperous private steel mills, ASM and Southern Steel.

The case of the car manufacturer, Proton Saga, is complex. Proton has a large advantage in the Malaysian market in that, unlike its domestic competitors, Proton does not have to pay either the excise tax or the 40 percent duty on the import of completely-knocked-down (CKD) kits. Informed guesses put the Proton price at about 20 percent above that of comparable automobiles on the unprotected world market, not a particularly high percentage as developing country auto production costs go, but not an internationally competitive price either.

If one takes a longer view to the year 2020, the case for Proton may prove to be a stronger one. All late developing automobile sectors, including that of the Japanese, take a long time to become competitive. If Proton’s costs do not come down, the consoling thought is that expensive cars do not generally raise the costs to other manufacturers the way expensive intermediate inputs do. But the car industry would have been a drag on overall economic performance nonetheless.

The engineering firms connected with the automobile sector are not yet capable of standing on their own as exporters of auto components as is the case, for example, of many auto parts manufacturers in Taiwan.

On the whole, even an optimist would agree that it will be several years before Malaysia’s heavy industries can realise their potential to be internationally competitive.


The Modern Service Sector

The short answer is that Malaysia’s service sector has a long way to go before it is capable of playing a leadership role in the economy and becoming a major source of foreign exchange earnings. Malaysia’s banking sector is a clear case in point. The large scale banking sector, if one excludes the foreign owned banks, is either owned by government or by large bumiputra interests with close ties to government. The private Chinese-Malaysian banks are small and getting smaller. This latter decline did not come about because of government coercion. For the most part it was mismanagement by the banks’ founders that got the banks into trouble with the central bank being forced to step in. Once the government stepped in, however, the eventual result was often the sale of the banks’ assets to bumiputra interests. Restrictions on the opening of new branches by existing smaller banks have had a similar effect.

Among the bumiputra banks, there are strong institutions such as the Arab Malaysian Bank of Tan Sri Azman Hashim. But there are others considerably less successful, notably Bank Bumiputra. The problem with banks such as Bank Bumiputra with close ties to government is that the competitiveness of these banks is undermined from two directions. On the one hand, they are expected to lend to government supported enterprises even when those enterprises are in deep trouble as was the case with Perwaja Steel. On the other hand, these banks have good reason to believe that, because of their close ties to government, they will be rescued if they make mistakes. Banks with this set of constraints and incentives are never likely to be internationally competitive.

There is also tourism, hotels, gambling and related services. Malaysia is already a major international presence in the hotel business with such notable international chains as Shangri La and Equatorial even if the headquarters of the former has now moved to Hong Kong. Malaysia does not have the historical sights of Bali or Thailand, but it has other major tourist assets which it is well along in developing.

Some portions Malaysia’s service sector do have the potential to become internationally competitive. But a service sector capable of supporting broad and sustained growth of the economy and of foreign exchange earnings is some time in the future



We have reviewed the history and current state of Malaysia’s industrial policy and evolving industrial structure as part of an effort to identify where one might expect to see where future competitiveness and growth may lie in the manufacturing and service sectors. We found that the internationally competitive parts of the manufacturing sector are mostly dominated by foreign owned and controlled firms. Scattered domestically owned and controlled firms have also become successful exporters of manufactures and even a few services, and their numbers increased in the mid 1990s all be it modestly, but most manufactures and services are oriented toward the domestic market and many still require some protection from international competition. The size of the Malaysian domestic market is not particularly large, however, so growth based solely on that market will not be able to take advantage of many economies of scale. Furthermore, industries that depend indefinitely on protection from foreign competition tend to work more at maintaining that protection than at raising their own productivity. Import substituting growth, therefore, is likely to be slow growth over the long haul. If Malaysia is to continue to enjoy continued rapid GDP growth, many of these import substituting firms will have to become exporters of goods and services.

There is nothing really unusual about this future challenge that Malaysia faces except for two special features of the Malaysian economy. The first special feature is the richness of Malaysia’s natural resource base. This natural resource base has made a major contribution to Malaysia’s growth in the past and has played a central role in helping fund some of the country’s industrial and social experiments. But Malaysia’s natural resources are a steadily declining share of GDP, of exports, and of government revenue, and will soon be minor actors in the Malaysian growth story much as first tin and now rubber have become relatively minor sectors of the overall economy.

The second special feature of Malaysian industrial and service sector development has been the emphasis on ownership restructuring and income redistribution. In the view of Malaysia’s leaders and even from the perspective of many who had to help pay for this restructuring and redistribution, the change was necessary in order to ensure a stable society where benefits were widely shared and occupations were not identified with ethnicity. Ownership restructuring has been by any reasonable standard highly successful. By the mid-1990s it was not possible to identify many large sectors of the economy as belonging to one ethnic group or another whatever the precise ownership percentages might be.

Ownership restructuring, however, has not been without costs. Malaysia’s internationally competitive manufacturing sectors are precisely those sectors that have been exempted from the ownership requirements and are dominated by direct foreign investors. Local firms, as is usually the case in most countries, have started by concentrating on the domestic market and hence have been subject to ownership restructuring throughout their history. Some have grown and prospered under the requirements of laws such as the ICA, but the number of these firms that have grown to be truly international is not large.

Probably the least successful part of the ownership restructuring is that part that relied on state ownership to implement its objectives. The government itself realized some years ago that state firms tended to be inefficient, and undertook privatisation of most of them. Privatization, however, generally meant sale to bumiputra, not sale to the highest bidders, in order to create a group of bumiputra billionaires. But the goal of creating bumiputra billionaires is being achieved in part by giving selected individuals exclusive licenses to build key elements of Malaysia’s infrastructure. In some cases, the license has mainly generated rents for the license holder. The more this type of situation occurs, the greater the danger that Malaysian costs of doing business will rise to uncompetitive levels. The 1997 increase in electric power rates to a level that makes Malaysia the second most costly producer of electric power in the region is worrisome.

The crucial question in the Malaysian context is whether the new bumiputra billionaires being created have acquired the right kind of experience to be able to match the earlier performances of the more successful Korean chaebol. Few of these individuals, for example, came to their tasks with much experience with either manufacturing or exporting. If these new holders of great wealth can make the necessary transition to industrial and international entrepreneurship, Malaysia has little in its future to be truly worried about. If they cannot make this transition, then Malaysia has two not mutually exclusive choices. The economy can continue to depend on foreign direct investors to play this role or it can attempt to look elsewhere locally for entrepreneurial talent. For the most part, the incentive structure needed to stimulate foreign direct investors can arguably be said to be place despite the recent temporary capital controls. The same, however, cannot be said with respect to new sources of local entrepreneurial talent.

Finally, we want to point out that there exist fast-acting solutions to the present economic malaise and to the long-run problems of maintaining high growth and increasing international competitiveness. But it requires considerable statesmanship and political skill to overcome the obstacles to the adoption of these quick-relief solutions.

The first politically sensitive reform is to relax the ownership restrictions of ICA to enable the needed recapitalisation of the banks and large firms. UMNO must make a credible commitment to the lifting of capital controls as well as to the permanence of the ICA reforms if the troubled firms are to succeed in issuing new shares. The ICA reforms will also have the salubrious effect of encouraging the small and moderate (import-substituting) firms owned by non-bumiputras to expand their capacities, and eventually become big exporters.

The second politically sensitive reform is to revise the state industrial policies to include expiration dates for state subsidies and import protection. The government must institute a weeding out process within its infant industry program to prevent high-cost inputs from undermining international competitiveness. This "tough love" approach will help to focus the thoughts of the protected firms on improving productivity.

Our suggestion for the reform of ICA is actually neither radical nor politically infeasible. The National Economic Recovery Plan unveiled by Daim Zainuddin in July 1998 had made just such a proposal. In its essence, the suggested ICA reforms are similar to the "graduation requirement" we recommended for incorporation into the national industrial policy. The fact is that the government has succeeded in creating a professional and entrepreneurial bumiputra community that equals the non-bumiputra community in competence and competitiveness. By most indications, Malaysia now has a large, well-educated bumiputra middle-class that is actively engaged in nearly all industrial and modern service activities. Furthermore, there is no reason to think that explicit industrial policies, backed by state subsidies and import protection, are needed to guide the investments of well-informed bumiputra entrepreneurs.

These are extraordinary times in Malaysia, and extraordinary political leadership is important. Part of extraordinary leadership is the political courage to assess objectively whether the continuation of the race-based programs and the industrial policies has more to do with political patronage than with providing "infant industry protection" to backward (?) bumiputra professionals and businesses. If the answer is the former, then the economic costs from a rigid ICA are not serving the cause of social justice, the defensible motivation behind the race-based policies. It is then time to throw away the crutches that are getting in the way of the economy moving forward faster. A fast growing and fiercely competitive economy will do more to enrich the bumiputra community than state-generated rents can ever hope to do.