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Still Not a Tiger: The Decline of Malaysia's Electronics Sector
By Michael Manetta
Malaysian policy makers in 2010 proposed numerous initiatives to propel the economy out of its middle-income trap over the next 10 years. Facing higher structural labor costs, the economy is unable to maintain the growth model based on low-value-added manufacturing that was largely successful for the 30 years prior to the 1997 Asian financial crisis. One of the most noticeable manifestations of the middle-income trap has been the secular decline of Malaysia’s once-dominant electronics and electrical products (E&E) sector, which at its height in 2000 accounted for more than one-third of the country’s total value added in manufacturing, over 70% of revenue from manufacturing exports and almost 4% of world E&E exports.
Since then, Malaysia’s E&E sector has witnessed dramatic deceleration in productivity, stagnation in exports and deterioration of its global market share. The sector remains dominated by downstream industries that increasingly face competition from low-cost producers in the Philippines and China. Confronting similar challenges, the Asian Tigers (South Korea, Taiwan, Hong Kong and Singapore) were largely successful in making the transition to higher-value-added E&E production, which Malaysia so far has been unable to emulate.
Examining the causes of the secular decline in the country’s E&E sector reveals that structural factors have created hurdles to productivity growth. In particular, for nearly four decades, the New Economic Policy (NEP) and its ethnicity-based affirmative action policies have been stifling a key evolutionary process in the E&E sector that other export-driven economies in the region were able to ride to higher-value-added production on their way to high-income status. While this missed opportunity does not condemn the Malaysian economy to stagnation, it does constrain the entrepreneurial forces that will be critical during the next phase of development.
Evidence of Decline
E&E exports already had begun a secular decline by the time the financial crisis hit in late 2008. As early as the mid-1990s, the finished electronic goods industry (including consumer, commercial and industrial final goods) began stagnating, with real export revenues peaking in 2000. Semiconductor growth peaked in 2003, at the beginning of a global economic boom. Parts and components surged in 2003-06, only to drop precipitously in 2007-08. Figure 1 shows the real export value of Malaysia’s three major E&E subsectors, as well as that of a commodity-related manufacturing subsector.
Data on the total value added in E&E manufacturing (Figure 2) likewise show a dramatic slowdown in growth after the Asian financial crisis, averaging just 1.9% y/y in 1999-2008, after registering an average growth rate of nearly 30% y/y in 1988-97. As a result of this competitive decline, Malaysian E&E exports fell to 3% of the world total in 2009 from 4% in 2000, as production shifted to lower-cost manufacturers elsewhere. This contrasts with the experiences of South Korea, Hong Kong, Taiwan and Singapore, all of which saw their shares of world E&E exports swell over the same period.
Figure 1: Real Exports by Selected Manufacturing Sector (constant MYR, millions)
Source: Bank Negara Malaysia, IMF, RGE estimates
Figure 2: Value-Added Growth in the E&E Sector (y/y)
Source: Bank Negara Malaysia
One proximate cause of the sector’s decline was a precipitous drop in investment following the Asian financial crisis. Along with human capital development, investment is a major driver of labor productivity growth, which in turn drives real wage growth. In other words, firms can tolerate higher labor costs as long as they are productivity-driven. Of course, many economies in the region faced declining investment-to-GDP ratios after 1997 (see Figure 3), but Malaysia suffered one of the steepest drops. To ascertain whether Malaysian competitiveness also dropped, we need to compare the adjustments in labor costs and productivity in Malaysia to those in other countries in the region.
Figure 3: Investment-to-GDP Ratios for Asian Countries (% of GDP)
Source: World Bank
Figure 4 shows ratios of value added per manufacturing worker, a proxy for labor productivity, in Malaysia compared to other regional economies in 1996-2006 (the last year of available data). A data point above the black line indicates that Malaysian labor productivity is higher than that of the comparative economy, with the ratio representing the factor by which productivity differs. So a ratio of 2 suggests Malaysian workers are twice as productive as their regional counterparts.
In some cases—notably vis-à-vis China and Indonesia—Malaysian labor productivity fell substantially after 1997. The Malaysian-Philippine productivity ratio remained relatively unchanged until 2003, while Malaysia’s workers actually saw productivity rise relative to Thailand’s after 1998. This discrepancy in outcomes could be the result of varying degrees of exposure to the Asian financial crisis: Thailand was hit harder than China, and Indonesia suffered tremendously from the crisis (hence the spike) but was less affected than Malaysia by the U.S. dot-com bubble of 2001. At no point in the sample period did Malaysia’s productivity change substantially relative to higher-income countries like Singapore and South Korea, suggesting Malaysia remained largely in line with those countries in productivity growth.
Figure 4: Value Added per Manufacturing Worker (Ratio of Malaysia to Neighbor)
Source: Economist Intelligence Unit, RGE estimates
Note: Data points below the black line indicate lower productivity in Malaysia relative to the comparative economy, while points above the black line indicate higher Malaysian productivity.
The next step in uncovering Malaysia’s competitiveness dynamics is to compare relative labor productivity with relative unit labor costs (ULC), presented in Figure 5. According to economic theory, Malaysia’s labor costs should fall or rise in line with productivity losses or gains. In this case, we can compare bilateral labor productivity ratios with corresponding labor cost ratios. The ratios should be approximately equal; otherwise, one economy is arguably more (or less) competitive than the other.
As Figure 4 illustrates, Malaysia’s largest relative productivity losses after 1998 were to China and Indonesia (and later, the Philippines). Figure 5 displays the evolution of relative labor costs over the same period. As expected, Malaysia’s relative ULC fell dramatically vis-à-vis China in 1998 before declining more slowly thereafter. The decline in labor costs vis-à-vis Indonesia likewise tapered off after a steep initial drop.
Figure 5: Ratios of Malaysia’s Manufacturing Sector ULC to Those of Neighbors
Source: Economist Intelligence Unit, RGE estimates
Note: Data points below the black line indicate lower ULC in Malaysia relative to the comparative economy, while points above the black line indicate higher ULC in Malaysia.
The balanced relationship between labor costs and productivity seems to hold with regard to Thailand, as both the labor cost ratio and productivity ratio settled around 1.5 after 1998. Likewise, Malaysia’s labor cost and productivity ratios relative to higher-end producers like South Korea, Singapore and Japan remained between 0 and 0.5 for the decade, with limited fluctuation.
Yet in other cases the differential did not hold, to Malaysia’s detriment. Malaysia’s productivity ratio with the Philippines fell below 2 after 2003, while Malaysian labor costs remained more than twice as high as those of the Philippines (the ratio remained above 2). The disparity is even more pronounced when comparing Malaysia to China: The productivity ratio fell below 1 in 2002, while labor costs stayed above 2 until 2008. Likewise, the Malaysia-Indonesia labor cost ratio remained above 7 for most of the decade, while the productivity ratio dropped to 1 by 2003. Figure 6 summarizes the ratios presented in Figures 4 and 5 for easier comparison.
Figure 6: Asian ULC & Value-Added (VA) Ratios Relative to Malaysia
Source: Economist Intelligence Unit, RGE estimates
In other words, in response to the investment downturn, Malaysian labor costs were unable to correct sufficiently relative to many regional economies to match changes in relative productivity levels. From the other angle, productivity growth was insufficient to keep up with changing labor cost differentials. This is a textbook case of the middle-income trap. With Malaysia’s relative labor costs above relative productivity levels, the country’s manufacturers could not compete with their lower-cost counterparts.
At the same time, the productivity-labor cost differential between Malaysia and the Asian Tigers was roughly in line with economic fundamentals. Malaysian productivity remained lower, as did relative labor costs. So why did Malaysia’s E&E sector fail to make headway against those of the Asian Tigers? Again, the proximate cause is investment: Malaysia’s investment-to-GDP ratio remained below that of Singapore and South Korea for much of the decade. But investment is only the symptom of a broader structural issue hindering Malaysia’s economic development.
Malaysia Diverges From the Tiger Path
Malaysia largely followed the same industrialization path as the Asian Tigers—particularly Singapore—through the 1990s by encouraging foreign investors to take advantage of the country’s relatively cheap labor force. In both Malaysia and Singapore (and, to a lesser extent, Taiwan and South Korea), multinational corporations (MNCs) set up shop and established downstream E&E production facilities that relied heavily on cheap labor and access to intermediate and raw materials (as well as tax incentives in most cases).
In Singapore, the presence of MNCs spurred local entrepreneurs to begin “clustering” around the downstream enterprise, acting as suppliers and logistics managers. Over time, this led to the development of a robust, indigenous E&E sector that increasingly produced further upstream, which typically included the stages in the supply chain in which labor adds more value—i.e., the stages with higher levels of labor productivity. By being in close proximity to the downstream manufacturers, these upstream firms also had advantages over foreign suppliers in terms of delivery time and cost, as well as relational factors. Thus, by the time labor cost increases forced downstream production facilities to lower-cost markets, local firms were experienced and competitive enough to continue operating in the E&E supply chain at higher levels of value added. In this way, Singapore and the other Asian Tigers have managed to increase global market share of E&E since 2000. The country’s comparative advantage shifted, and the E&E sector evolved with it.
Malaysia’s New Economic Model (NEM)—presented in 2010 as a 10-year vision for Malaysia's ascension to high-income status—notes that Malaysia’s large electronics manufacturing sector, even after more than 35 years of existence, remains dominated by large MNCs. Despite the presence of these large firms, relatively few domestic companies have sprung up to provide high-value-added upstream components and services, a critical missed opportunity. Entrepreneurs in the Tigers took advantage of the supply chain linkage opportunities provided by large downstream producers to develop indigenous industries that eventually produced at higher positions in the value chain. Thus, as labor costs rose, productivity was rising in tandem, a dynamic that has been largely absent from Malaysia’s E&E growth story.
A 2009 World Bank paper acknowledges that explaining this absence is difficult but suggests that insufficient human capital development and poor linkages with research institutions were partly to blame. A lack of high-quality academic institutions may have posed challenges, but the Asian Tigers faced similar constraints during their development processes. Though Malaysian students, like many Taiwanese and Singaporeans, studied abroad to gain skills they could not get at home, many have never come back to apply those skills in the domestic economy. As a testament to this problem, in 2010, the government courted some 700,000 skilled expatriates to move back to Malaysia.
This Malaysian “brain drain” is largely the result of the country’s outdated affirmative action policies. Established under the NEP of 1971, affirmative action in Malaysia seeks to rectify socioeconomic disparities within the local population by expanding opportunities for ethnic Malays (bumiputra or bumiputera), often at the expense of other ethnic groups (namely ethnic Chinese). In particular, the NEP favors bumiputra ahead of other ethnic groups in areas like education (via access to scholarships and academic placements) and housing (via access to discounted home financing). Non-bumiputra who leave the country for education or work often opt not to return due to the institutional bias against them in many aspects of life.
One of the most interesting and distorting of these biases pervades the business world. In order to redistribute wealth to the historically poorer bumiputra community, all domestic companies incorporated in Malaysia must reserve at least 30% of new shares for bumiputra to purchase at discounted prices. This “forced divestment,” as critics call it, essentially taxes local start-ups that wish to go public and makes expansion more difficult, which helps explain why initial public offering (IPO) growth was relatively flat through the 2000s (Figure 7) and why equity remains a minor source of manufacturing investment financing (Figure 8).
Figure 7: Value of IPOs on Bursa Malaysia (MYR, millions)
Source: Bank Negara Malaysia
Figure 8: Sources of Manufacturing Investment (MYR, millions)
Source: Bank Negara Malaysia
Meanwhile, the continued presence of the government in the economy—via procurement policies and access to joint ventures with the nearly 500 government-linked corporations (GLCs)—has provided ample opportunity for rent-seeking by well-connected bumiputra (which is, to be fair, a small proportion of the overall bumiputra population). A 2004 UN paper notes that ethnic discrimination in Malaysia “primarily involves the business community and the middle class, where interethnic tension is most acute. Interethnic business coalitions have become increasingly important over time, often with an ethnic Malay partner securing rents for gaining access to government-determined business opportunities, and the ethnic Chinese partner with access to capital and business acumen getting the job done. Such joint ventures have generated considerable resentment, especially among those denied access to such business opportunities.”
Limiting resources—both human and financial capital—and perpetuating an unlevel playing field for entrepreneurs creates a strategic disadvantage for local firms. Small local start-ups cannot readily tap global talent pools and capital markets the way MNCs can, which explains why the latter continue to dominate Malaysia’s E&E sector. Thus, the NEP has been a major structural barrier to the development of a competitive, local, upstream E&E sector, a process that helped the Asian Tigers evolve into high-value-added producers in the global electronics supply chain.
The Outlook for Reform
Many observers have noted that the NEP’s original policy goals—poverty eradication and the restructuring of society to “eliminate the identification of race with economic function”—have been achieved by most measures, though this conclusion is by no means unanimous. Still, Malaysia has made much socioeconomic improvement from the severe income inequality and poverty that characterized the country four decades ago.
In this context, the New Economic Model (NEM)—one of a dizzying array of initiatives and plans outlined by the government and its various commissions in 2010—proposes “revamping” affirmative action “to remove the rent seeking and market distorting features which have blemished the effectiveness of the program. Affirmative action will consider all ethnic groups fairly and equally as long as they are in the low income 40% of households. Affirmative action programs would be based on market-friendly and market-based criteria together taking into consideration the needs and merits of the applicants.” (emphasis added)
In other words, the members of the government-appointed National Economic Advisory Council (NEAC) who drafted the NEM have proposed changing affirmative action from an ethnically based policy to one based on socioeconomic status. By breaking patronage links, eliminating corporate ownership requirements and engendering a more meritocratic environment, the NEM seeks to remove one of the more pervasive structural barriers to investment and entrepreneurship in the country while retaining the social support it originally sought to provide. Indeed, Prime Minister Najib Razak echoed these sentiments in a landmark 2009 speech in which he criticized implementation of the NEP and called for the elimination of the 30% bumiputra corporate ownership requirement. He went so far as to announce an elimination of the bumiputra equity requirement for new foreign firms listing in Malaysia and proposed watering down the equity requirement for domestic companies planning to go public.
Yet upon the June 2010 release of the 10th Malaysian Plan (10 MP)—a five-year plan that details government development priorities—Najib effectively U-turned, affirming that the 30% ownership requirement would remain in place for the time being. The prime minister’s party, the United Malays National Organization (UMNO), relies heavily on bumiputra support, and this likely pressured Najib into abandoning such a controversial change to Malaysia’s political economy in favor of the more agreeable NEM proposals. Other measures that will enhance economic competitiveness—such as a more liberal labor law, internationalization of the ringgit, privatization of GLC assets and investment in education—certainly will improve the country’s economic potential. In addition, the country’s current growth outlook makes reaching high-income status (defined as per-capita income over US$15,000) by 2020 a very achievable goal. A well-developed domestic market and global commodity demand should help the economy achieve a 5%-plus real annual GDP growth rate over the medium term. Such a pace, if sustained, should be enough to boost per-capita GDP to high-income territory over the next 10 years.
Nonetheless, it is likely that growth increasingly will be driven by industries based on commodities, especially natural gas and palm oil; capital-intensive manufacturing (such as petrochemicals); and services such as Islamic finance and tourism. In fact, the 10th MP places these four sectors, as well as three others (wholesale/retail trade, information technology/communication and education), ahead of E&E in its presentation of the National Key Economic Areas, which outlines the sectors the government sees as critical to growth over the next five years.
Proposals for upgrading E&E do say all the right things, noting that while a “strong cluster ecosystem with leading global companies has been established, opportunities exist to further develop domestic capabilities, particularly in R&D, and increase Malaysia’s share of higher value added activities.” Initiatives to exploit these opportunities include developing “centers of engineering excellence by collaborating with industry and academia,” “promoting state skills training centers and co-funding masters and PhD programs in critical fields” and “focusing on strategic segments of the value chain such as design, testing and precision machining.” Yet the minister of higher education confirmed in June that no new state universities were planned under the 10 MP, and the plan lacks details about which “strategic segments” will be selected, how they will be selected and what types of support the government will provide.
For its part, the NEAC in its NEM follow-up proposal released in early December 2010 continued to sound the alarm about the risks of neglecting E&E, saying that “if growth in E&E does not become top priority, our supply chains will be marginalized or worse, by-passed.” The authors note that a major obstacle to growth in the sector is “the absence of fairer competition to raise competitiveness within the nation. The existing restrictions on equity holdings and operations as well as slow liberalization and deregulation policies make it difficult for domestic and global entrepreneurs to invest in Malaysia, undermining the efforts of local players to improve themselves through competition.” Yet changes to address this are unlikely until new elections are held (which could be in 2011) and the government has the political confidence (and willingness) to confront popular resistance to affirmative action reform. Even then, the outlook is doubtful, given the political cooperation that would be required for such a controversial change.
The Path Ahead
Industrial production (IP) and export data through Q3 2010 confirm that the E&E sector is returning to the precrisis trend of decline, though certain sectors have shown promise. Production of electrical machinery and equipment appears to be driving a resurgence in “electrical” IP, which consists of finished household appliances, consumer goods and office equipment. Electrical IP was a solid 12.6% higher in Q3 2010 than its precrisis peak in Q3 2008. Still, the E&E sector overall continues to produce below 2007 levels, and even nominal export revenues remain below 2006 peaks.
Figure 9: Nominal Export Revenues of the E&E Sector Through Q3 2010 (MYR, millions)
Source: Bank Negara Malaysia
The decline of one sector, however important, does not banish an economy to stagnation. But at present, Malaysia appears to be diverging from the path of the Asian Tigers, having missed the opportunity to develop a comparative advantage in an increasingly knowledge-intensive, high-value-added industry. More troubling is that this failure stems in part from a structural barrier that may also constrain other sectors of the economy. Indeed, despite the numerous initiatives aimed at enhancing the country’s appeal to investors, net FDI has been decidedly negative since 2007, including a MYR16.5 billion net outflow YTD through Q3 2010. Thus, the underperformance of the electronics sector over the past 10 years should serve as a warning to the country’s policy makers that the continuation of distortionary policies may limit Malaysia’s future growth prospects, especially relative to other Asian economies.