Report No. 7208-MA

Malaysia:Matching Risks and Rewardsin a Mixed Economy(In Three Volumes) Volume 1: Main ReportOctober7,1988

Country Operations DivisionCountry Department 11Asia ReionFOR OFFICIAL USE ONLY

Document of the World Bank

This report has a restricted distribution and may be used by recipientsonly in the performance of their official duties. Its contents may not otherwisebe disclosed without World Bank authorization.

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CURRENCY EQUIVALENTS

Currency Unit = Ringgit (M$)M$1.0 US$0.39US$1.0 = M$2.59

(as of May 1988)

FISCAL YEAR

January 1 - December 31

ACRONYMS AND ABBREVIATIONS

CIC - Capital Issues CommitteeCICU = Central Information Collection UnitDOS = Department of StatisticsEPF = Employee Provident FundEPU = Economic Planning UnitFELDA = Federal Land Development Authority5MP = Fifth Malaysia PlanFIMA = Food Industries of MalaysiaFTZ = Free Trade ZonecDP = Gross Domestic ProductGNP = Gross National ProductHICOM = Heavy Industrial Corporation of MalaysiaICU = Implementation Coordination UnitIMP = Industrial Master PlanKLSE = Kuala Lumpur Stock ExchangeKTM = Malayan RailwayLPN = National Paddy and Rice AuthorityMARA = Majlis Amanah RakyatMDB = Manpower Development BoardMIDA = Malaysian Industrial Development AuthorityMIPS = Malaysian Industrial Policy StudiesMOF Ministry of FinanceMPE = Ministry of PublicNEP New Economic PoliciesNFPE Non-Financial Public EnterprisesPERNAS = Perbadanan Nasional BerhadPETRONAS = Petroliam Nasional BerhadPNB = Permodalan Nasional BerhadRISDA = Rubber Industry Smallholders Development AuthoritySADC = State Agriculture Development CorporationSEDC = State Economic Development CorporationSLCHP = Spacial Low Cost Housing ProgramVAT = Value Added Tax

FOR OMCIL USE ONLY

MALAYSIA

Volume I: Main Report

Table of Contents

Page No.EXECUTIVE SUMR ....... ..................... i

Io INTRODUCTION*ooo.ooo*eoo*oo* *.*. *.*a* 1

II. RECENT ECONOMIC DEVELOPMENTS, 1981-87 ........................ 3

A. The Expansion of 1981-843.............. ................. .. 3Fiscal Expansion ........ 6The Construction Boom........................ .......... 9Loss of ............................ 10

B. The 1985-86 Adjustment Period............................ 15External Shocks ......... 16Internal Shocks ............... *9e 19Fiscal Turnaround ......................... 21

C. The Beginning of Recovery--1987..........................o 23Factor Market Adjustmentsj u s t m e n tso.................... 26

D. The Emergence of Structural Weaknessesk.................. 26Long-run Constraints on Public Deficits. cits.....**. 27Rising Wages and Falling Profitso...... 000000004-00*0 32The Mismatch between Risks and Rewardswards......**. 35Struccural Unemployment.9..... .. . ... ............. 42

E. Overall Assessment... 46

III. MEDIUM-TERM GROWTH PROSPECTSO............. 50

A. Growth Potential--The Supply Side..... 51Efficiency and Productivity Growth. o w th............. 52Policies to Improve Productivitytuctivi...ty....... ... 60Public Enterprises.t.e.., rs....s... 60Tariff Reformf.o.*** .................. 66Industrial Licensing and Restructuring.............. 67Corporate Income Tax Reoo r m 71

Investment Tee n ds 74Oil vs. Non-oil Private Investment.................. 76Investment by Ind u s tr.y...o ... ...... ........ 76

Policies to Encourage Private Investment.. * * 80Structural Polces.. i c ie...s.....o 81Foreign Direct Investment...vse......... t...... ..... 89

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contants may not otherwise be disclosed without World Bank authorization.

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Page No.

B. Growth Outlook--the Demand Site.......................... 91Private Consumption.................................... 92Government Spending ............................. * 94Off-budget Government Programs...... .................. 101Overall Impact............................. 102

IV. ECON)MIC OUTLOOK AND INTEGRATED POLICY RECOMHENDATIONS ....... 103

A. Economic Outlook... **** ** **........ ......**.. 103The External Environment...... ......... ............... 103Prospects for Exports and the Balance of Payments ...... IllThe Domestic Environment........e...... ............ 113Major Uncertainties. ................... ................. 116

B. Integrated Policy Recommendations ....................... 116Consistency in Policy Programs. ........................ 118Business Confidence.*.*.. ... .......... . 119Amendments to the EPF.................................. 119Public Financesu.................................... 121

Conclusion ........ > ~~~~~122

Appendix 1 - Assessing the Viability of Non-oil Primary CommodityExports ...... 124

Appendix 2 - Construction of the Flow of Funds Table................ 126Appendix 3 - EPF: Life-Time Accumulatio- by the Individual ........ 129

The Base Case........................................ 129Appendix 4 - Methodology for Calculating Total Factor

Productivity Growth ................................ 136Notes on Data Used ................................... 137

Reslt ............................................... 137Appendix 5 - Methodology Underlying the Calculation of the

Marginal Effective Tax Rate (METR) ................... 140Note on Assumed Project ............................. . 142

Appendix 6 - The Determinants of Private Fixed Capital Formation.... 143Construction of the Data ............................. 143

Appendix 7 - Private Consumption in Malaysia***...................... 145

TABLES

2.1 Key Macroeconomic Developments, '981-872.2 Composition of Change in Demand2.3 Consolidated Government Accounts2.4 The Composition of Public Investment, 1978-872.5 Selected Statistics in Property Markets, 1981-872.6 Manufacturing Unit Labor Costs in East Asia2.7 Major Commodity Export Prices, 1981-872.8 The Structure of Exports, 1981-872.9 Adjustment to Shocks, 1984-872.10 Sustainable Long-Run Public Sector Deficits2.11 Flow of Funds: Overview, 1980

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2.12 Flow of Funds: Overview, 19852.13 Flow of Funds: Overview, 19862.14 Nominal Rate of Return by Institution, 1981-873.1 Labor Productivity Growth3.2 Size Structure of Manufacturing Firms3.3 Intercountry Comparison on the Role of SHEs3.4 Comparative Profitability Ratios in Public and Private Firms3.5 Average Tariff Levels3.6 Marginal Effective Tax Rates in Selected East Asian Countries3.7 Local and International Prices of Steel Bars3.8 Price Trends of Industrial Properties and Land in Selangor

State3.9 Difficulties in Borrowing from Banks3.10 The CIC-Guided P/E Ratio3.11 Capital Gains for New Issues, 19813.12 Estimation of Actual Equity Generated in Industrial Activities3.13 Inflow of Foreign Direct Investment3.14 Japan's Direct Investment to Asian Countries4.1 External balances of East Asian Countries4.2 Non-Tariff Barriers Against Imports from Selected Asean

Countries4.3 Non-Tariff Barriers Protectionism in Selected Commodities4.4 Malaysia - Balance of Payments4.5 National Accounts in Constant 1978 Prices4.6 National Accounts Growth Rates at Constant Prices

FIGURES

2.1 Real Wage and Labor Productivity2.2a Korea: International Competitiveness2.2b Malaysia: Real Exchange Rate Movements2.3 Net Fiscal Impulse, 1972-872.4 Holdings of Federal Government Debt 19872.5 International Comparison of Public Debt2.6 Decomposition of GNP by Income Sources, 1972-873.1 Efficiency in Resource Use in Malaysian Manufacturing

Industries3.2 Composition of Capital Formation3.3 Personal Income and Consumption3.4 Total Expenditure, Subsidies and Transfers

HAPIBRD Map No. i- , R

OOREWORD

The preparation of this report benefitted greatly from the assist-ance and cooperation provided by the Government of Malaysia. In particular,the author would like to thank officials in EPU, the Ministry of Finance, theMinistry of Trade and Industry, MIDA, EPF, CICU, Ministry of Public Enter-prises, Bank Negara, the Ministry of Labor, and the Department of Statisticsfor their generous help in providing data and explanations to the mission.

The report was prepared by a World Bank mission which visitedMalaysia from November 23-December 14, 1987. The mission members were: HomiKharas (team leader); Ken Ohashi (finance); Vic Paqueo (employment); GerardoSicat (public finance); Yoon Je Cho (private investment), all from the WorldBank, and Hafiz Shaikh (consultant, nonfinancial public enterprises). Thereport was discussed with Malaysian government officials in August 1988, andsubsequently updated. The views expressed, however, are those of the authorsand are not representative of the positions of the Malaysian government.

EXECUTIVE SUMMARY

A recovery in 1987 has led Malaysia out of its worst growth periodsince independence. Along with growth, a record surplus in the currentaccount of the balance of payments and negligible inflation are concretedemonstrations of the successful macroeconomic adjustment undertaken since1982. At that time, the country was beset with serious macroeconomic imbalan-ces, notably a public sector deficit of 191 of GNP and a deficit on the cur-rent account of the balance of payments of 141. External borrowing and debtwere accelerating, and the global environment of high interest rates,depressed commodity prices and slow trade growth was unpromising. Governmentmoved forcefully to address its macroeconomic problems and, although the over-all public sector deficit and total public debt remain high today, the degreeof adjustment achieved in the face of unfavorable external conditions is astriking tribute to pragmatic policy making, and has ensured that Malaysiaremains in the ranks of the most creditworthy developing countries.

Strong growth in 1988, estimated at about 6-7Z, serves to reinforcethe impression of successful macroeconomic performance and policy-making.Although encouraging, recent performance should not be interpreted as groundsfor complacency nor as a signal that the need for adjustment is over. A cleardistinction must be drawn between cyclical and structural issues; much of therecent gains can be attributed to cyclical, external developments--mostimportantly, improved demand and prices for commodities and a boom in theglobal electronics industry. Yet the external environment can easily sour,and the experience of the setbacks to the New Economic Policy (NEP) targets ofpoverty eradication and restructuring during the 1985-86 recession shows thatreliance on aggregate demand management alone cannot ensure the achievement ofa high, sustainable growth rate. Structural adjustment must therefore becontinued. The challenge for policy makers is to manage interventions in theeconomy to achieve restructuring objectives in the context of a turbulentworld environment, while taking advantage of the efficiency gains to beobtained from liberalization of markets.

In addition to the challenge of meeting NEP targets, there are twoeconomic challenges that merit urgent attention. First, despite the signifi-cant progress made in reducing the public sector deficit since 1983, the levelof the deficit as a percent of GNP remains cause for concern. The recentincrease in the deficit can be traced to lost revenues following the recessionand the general decline in tax buoyancy from falling commodity prices andprofits. The collapse in oil prices has been especially significant in thisregard. The policy challenge in this area is to reestablish a growth-orientation to fiscal policy without increasing the size of the overalldeficit: increasing revenues in a non-distortionary manner, improvement ofthe efficiency of nonfinancial public enterprises (NFPEs) and the gradualelimination of other implicit and explicit subsidies and transfers that addlittle to growth, are examples of how this can be achieved.

Second, factor market distortions and other administrative andinstitutional constraints have led to a slump in private investment growth andthe emergence of sizeable unemployment. During 1988, both these indicators

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have improved, but the levels of investment and unemployment are still farfrom those prevailing in the healthy growth period of the 1970s. The recoveryhas also underscored the lessons of the recession--that growth depends impor-tantly on maintaining the competitiveness of manufactured exports and onsupport of business confidence through relaxation of industrial licensingpractices and other rules of compliance. The liberalization measures and newincentives introduced since 1986 have met with considerable success inattracting foreign investment and boosting export-oriented business. However,more can be done to broaden the base of investment funds, encourage newentrepreneurs and spur private sector initiatives to boost aggregate domesticdemand further over the medium term. The policy challenge in this area is tofully unlock the gains of past reform measures through a further rationaliza-tion of measures that remove constraints and enhance competitiveness andbusiness confidence.

Recent Macroeconomic Developments

Since 1980, Malaysia's macroeconomic performance has been irregular,with growth, the current account, investment, unemployment and the public sec-tor deficit all exhibiting sharp fluctuations. Following the oil price risein 1979/80, government embarked on an ambitious expansion of development proj-ects, driving total eapital formation to a peak of 38Z of GNP. Although thisprotected the economy against the global recession in 1981-82, it led tounbalanced growth and the emergence of high fiscal and current account defi-cits. Since then, the Government's policy dilemma has been how to cure exter-nal and internal financial imbalances without derailing growth.

Expansionary fiscal policy, coupled with a property boom, sustainedgrowth through 1984. Rising private savings, in part due to the increasedcoverage of the Employee Provident Fund and in part to high real interestrates, helped bring the current account deficit down to more manageable pro-portions. But other pressures were accumulating: real wages rose faster thanproductivity as a result of the tightness in the labor market generated byfiscal expansion and the construction boom; the real exchange rate appreciatedin line with the US dollar, eroding the competitiveness of manufacturingrelative to other East Asian exporters by as much as 50Z; property prices hadsoared out of line with household incomes; and total public debt was approach-ing the same level as GNP.

The recession in 1985 and 1986 resulted from a combination ofexternal and internal factors. Terms of trade losses threatened both the cur-rent account and public finances. When government responded by first increas-ing public savings and then cutting investment, it withdrew the demand stimu-lus that had buoyed the economy in the early 1980s. At the same time, theproperty boom collapsed and exports slowed. In response, monetary policy waseased and the ringgit depreciated. Nevertheless, private investment declinedas a result of worsening profitability, sustained momentum in wage growth,high levels of government investment in directly competitive areas, and a dropin foreign investment; and unemployment started to accelerate as labor absorp-tion in the public sector and in construction slowed. The result was a highlysuccessful adjustment in public finances and in the balance of payments, butat the inevitable cost of growth.

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The recovery in 1987 has reversed the deterioration in economicperformance. Growth was led by manufacturing (13%) and agriculture, forestryand fisheries (7.5X); within manufacturing, the largest contribution to growthwas in the export-oriented sector of electronics, textiles and apparel, andwood-based products, and within the primary sector, sawn timber and logproduction and cocoa were largely responsible for the good growth perfor-mance. Amongst other key commodities, rubber output was up, but palm oilproduction declined. The service sector also grew, with trade, transport andstorage responding favorably to commodity price improvements. Only construc-tion continued to slide, by 6%. Aggregate domestic demand, particularlyprivate sector demand, has been sluggish and remains, in real terms, below thelevel prevailing at the start of the Fourth Malaysia Plan (1981-85). Lowdemand, rather than robust growth, is also primarily responsible for thecurrent account surplus. Private non-oil and gas investme.nt, for example, hasfallen below 10 of CNP.

Initial indications are that growth in 1988 will accelerate to6-7%. The leading sector is manufacturing which continues to enjoy strongexport demand growth. But the base of manufacturing expansion is expected tobroaden into resource-based industries, such as food, oils, beverages andtobacco, domestic consumer-oriented products, notably cars, and constructionmaterials, such as cement. On the demand side, public and private investmentare expected to lead the recovery and, although exports will grow rapdily,imports will grow even more quickly, negating any net demand stimulus frominternational trade. Overall, the large trade surplus achieved in 1987 shouldbe maintained, permitting a continuation of the policy of prepaying externaldebt. The main cause for concern in the short-run, then, is the state ofpublic finances, which will once again suffer from falling oil prices--ifbudgeted investments are actually made, the deficit could again exceed 8% ofCNP.

To meet the challenge of converting recent short-term growth sutcessinto sustainable growth, policymakers must address further structural impedi-ments to growth which have been deferred, and on occasion accentuated, duringthe macroeconomic adjustment program of the last few years. For example, thecapital-intensity of manufacturing has grown and the demand for labor hasshrunk since 1980, partly as a result of programs to reduce the burden ofcorporate income taxes, designed to encourage investment, and to increaseEmployee Provident Fund contributions, designed to boost savings. Forexample, there has been a bias in factor pricing, resulting from capital-cheapening corporate income tax provisions and high payroll taxes on labordesigned to boost private investment and savings. As a result, employmentgrowth in the 1980s in manufacturing has only been 1.3% per year while valueadded has grown at 6%. Similarly, problems have emerged in human and physicalcapital accumulation due to rigidities and rationing in education and trainingsystems and the expansion of non-financial public enterprises (NFPEs). Last,legitimate efforts to protect the economy against external shocks have contri-buted to an inequitable distribution of the burden: formal sector wage earnershave been protected while corporations, new entrants and informal workers andthe unemployed have been hurt; and savers in low risk schemes, including ASNand EPF, have enjoyed protected returns, while investors have suffered. Inaddition, use of public credit, employment generation schemes, electricity

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pricing discounts, tax incentives and other implicit subsidies have been usedto protect selected groups but at the cost of larger fiscal deficits, whichwill impose a burden on the whole economy in the future.

To rectify these problems and allow government to build on itssuccessful adjustment program, reform in four major areas is proposed: (a)support for private investment; (b) reform of NFPEs; (c) stabilization ofpublic deficits, debt and spending levels; and (d) employment and humanresource development. For the most part, the recommendations made below withrespect to these areas are justified on microeconomic efficiency grounds.Taken together, however, they would also help resolve important macroeconomicdislocations expressed in the falling share of profits in national income, inthe sluggishness of private demand and in the rise in unemployment. As such,the recommendations should be viewed as a comprehensive package, consistentwith desired macroeconomic trends and designed to remove impediments tosustained growth. Such an approach would complement the policy reforms whichGovernment has recently initiated but which have yet to show significantresults in broad-based growth, investment and employment generation because ofunintended spill-over effects into other areas.

Structural Issues and Prospects for Growth

The best hope for medium-term growth lies in the manufacturingsector. A symbolic milestone in Malaysia's transition towards an industrial-izing nation w4s passed in 1987, when this sector overtook agriculture as thelargest in the economy. The structure of the industrial base is potentiallyvulnerable however. The most rapidly growing segment, oriented towardsexports, is narrowly concentrated in electronics and garments. With limitedlinkages to the rest of the economy, this sector is heavily dependent oncompetitive wages. In US dollar terms, however, wages have been volatile as aresult of domestic labor market adjustments and exchange rate fluctuations.Furthermore, technological changes and competition from other developingcountry exporters of manufactures pose an increasing threat to Malaysia inthese products.

Another segment of manufacturing, oriented inwardly, has grownwithin a policy environment that features variable effective rates of protec-tion, easy access to inexpensive credit, handsome fiscal incentives andrestrictions on new entrants caused by industrial licensing. In addition,Government has itself become a large direct investor in major industrial proj-ects. Although domestic industrial growth was also rapid in the early 1980sit was inefficient and costly. Capital and intermediate good inputs grewfaster than output, and total factor productivity growth turned negative inthe 1980s. Employment growth was also disproportionately low compared tooutput growth as the capital intensity of production increased, andunemployment has become a major social concern.

Problems in the manufacturing sector were initially disguised byhigh levels of demand, temporarily created by a government spending andproperty boom in the early 1980s, but were exposed during the ensuing reces-sion. A sustained decline since 1979 in profitability caused by wage growthin excess of productivity and by high real interest rates contributed to a

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steady drop in private non-oil investment. Government cutbacks in infrastruc-ture investment and expansion of directly productive investment have furtherdeterred private investment. Finally, sharp increases in the costs of capitalgoods relative to other countries were caused by the property boom and by highregulated prices for steel and cement.

The drop in private investment, which bottomed out in 1987, hasoccurred despite a steady rise in private savings and a resultant increase inliquidity and low interest rates in the banking sector. Thus, althoughprivate savings reached 30X of GNP in 1987, these were not transformed intoproductive, private investment largely because of a structural shift in thecomposition of savings.

Since 1980, private savings have been increasingly generated by thehousehold sector rather than by corporations, and are channelled into highreturn/low risk assets which finance government deficits. The redistributionof savings from corporations to households has also constrained privateinvestment by introducing a mismatch between the risk profiles of savers andinvestors. This has occurred because a sizeable portion of household savingsis intermediated by nonbank institutions, such as provident and mutual funds,insurance companies and cooperatives. These intermediaries are unwilling tobear the risk associated with lending for productive activities. They there-fore purchase government securities and other high quality assets and reducethe availability of equity and other risk-finance to the corporate sector.The development of a broader range of financial intermediaries and instru-ments, including well-capitalized venture capital funds, is required tochannel private savings back towards domestic investors.

More recently, the conditions for investment have improved markedly,as wages have fallen, profits grown and the real effective exchange ratedepreciated. Government has also liberalized industrial licensing and regula-tions governing foreign direct investment, and reduced administrative delaysin the issuance of licenses. The early estimates for 1988 show that thesehave reversed the downward trend in private investment. This momentum couldbe sustained over the medium tenm, if remaining constraints are removed andconfidence in the economy strengthens. Such constraints include heavy corpo-rate contributions to the Employee Provident Fund (EPF), crowding out bypublic enterprise investment, the risk mismatch in the flow-of-funds, and therestrictive legal basis on which corporations must base overtime, bonus andother benefit payments to labor.

A dominant feature of industrial growth over the last decade hasbeen the emergence of the NFPE sector to center stage. In contrast to earlygrowth in the sector based on acquisition of existing assets, recent growthhas been driven by investment in new projects at a rate that has givenMalaysia one of the largest NFPE sectors amongst non-socialist economies. Thesector is dominated by a few large firms, of which some are extremely profita-ble (PETRONAS) and others big money losers (HICOM). Although these dominatethe financial aggregates, beyond them is a complex of over 700 smaller compa-nies, who to all practical intents and purposes operate outside the purview ofthe Federal Government. These smaller companies are particularly inefficientand together represent a sizeable drain on overall public sector finances,

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amounting to over M$800 million per year out of a total of M$2 billion nega-tive net profits of all loss-making NFPEs in 1986.

Although Government has acted swiftly to reduce the deficit broughtabout by the collapse in petroleum revenues and, earlier, by the sharp expan-sion in public investment, it has done so largely through cutbacks in realexpenditure. Although this was a desirable course to take due to the short-term inelasticity of revenues, an overreliance on cuts in capital projectsrather than in subsidies and transfers has proved problematic. In fact,development spending has been a blunt instrument for achieving short termfiscal policy goals, because of the lags involved in planning and implementinginvestment projects, and the lorng gestation of projects once initiated.During the 1980s, the effect of public investment policies was to lock inlarge public deficits, as spending (particularly by NFPEs) could not be halteduntil 1985 without leaving projects unfinished with wasted earlier expendi-ture, and to cause an overheating of the labor market in conjunction with anin-phase construction cycle. Similarly, although government initiated aSpecial Low Cost Housing Program in 1986 to combat the recession, the fulleffects of this are likely to be felt only now in 1988, when the recovery isalready firmly in hand. Further initiatives by government to accelerate therecovery through additional spending should be avoided as these tend toamplify the natural business cycle on both the up-swing and the down-swing, tocrowd-out private investment and to use capital resources sub-optimally.

One consequence of high public investment and large overall deficitshas been an exponential rise in total public internal and external debt.While the government has successfully managed external debt by limiting newborrowings, refinancing old, high interest rate debt, and prepaying otherloans, thereby maintaining the debt service ratio at very comfortable levels,it has steadily built up internal debt to finance expenditures. When debt isexpressed as a ratio to GNP, Malaysia has one of the highest levels ofindebtedness of any country, developed or developing. The burden of servicingthis debt is substantial (interest alone will likely amount to 10% of GNP bynext year) and subject to sharp fluctuations in response to global changes ininterest and exchange rates. Although this is not as yet a problem due toaccass to new domestic resources from the EPF, over time a growing interestburden will steadily limit policymakers' room to maneuver. Moreover, as aresult of these contractual obligations, Government is increasingly usingrevenues derived from petroleum to finance current expenditures rather thanreplacement assets. In addition to debt service, Government is faced withrising financial claims to support statutory bodies, other governmentagencies, explicit and implicit subsidies, pensions and the like. Overall,over 40 cents out of each dollar of public expenditure go towards financialtransactions (including a build-up of assets in some statutory agencies)rather than towards current or development expenditures on real goods andservices. In fact, the burden of Adjustment in public finances has beendisproportionately great on real as opposed to financial transactions.

The slowdown in the rate of expansion of the public sector hasforced new entrants into the labor force, particularly college graduates, tolook elsewhere for jobs. Other sectors, however, have not been creating jobsand, since 1984, wages for new entrants have fallen by perhaps one-half.

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Because wages for existing employees have been sticky downwards in nominalterms, and inflation has been minimal, a sizeable wedge has emerged betweenthe wage rates for workers with similar experience and education. This wedgehas persisted over time because of the high costs of firing and because of theunwillingness of some firms to move to a ts.-tier labor market with its atten-dant problems of low morale and productivity. Given the dispersion in wagerates, there are significant benefits to searching for a high paying job,especially for the young and relatively well-educated who do not need to workimmediately. The unwillingness of this group to work for low wages and theirpreference to look for appropriate employment has contributed to a steady risein unemployment, even in years of rapid output growth.

Falling wages for new entrants have not been immediately reflectedin declining average wages. Because of the nature of negotiated wageagreements and the slow pace at which low-paid workers have entered the laborforce, the average wage has continued to rise in conjunction withunemployment. More recently, the dynamics of wage adjustment have shifted andaverage wages have started to decline. Along with expected output growth,this should lead to a fall in the unemployment rate.

The lengthy process of labor market adjustment reflects a signifi-cant degree of short-term rigidity in existing labor contracts and the absenceof direct linkage to productivity, price or profitability developments, exceptin the case of plantation workers. It also reflects rigidities in the abilityof higher education, vocational and on-the-job training systems to respond tochanges in the structure of demand for labor, due in part to heavy subsidiesin these systems and the consequent wedge between social and private rates ofreturn. Given this, Government efforts to reduce unemployment throughKeynesian-type public spending programs are unlikely to succeed in creating anefficient deployment of human resources.

These factors suggest that the challenges facing Government in termsof generating growth and employment over the medium-term are considerable.There are, however, two important advantages favoring the country. First, asboth product and factor markets seem to operate quite well in Malaysia, albeitslowly, price adjustments may provide an effective mechanism for equilibrationif left to operate in a stable macroeconomic environment. Already, wageadjustments and interest and exchange rate developments are helping restoreprofitability and slow the increase in unemployment. Second, Government hasrecently undertaken significant reforms in the system of industrial licensingdesigned to reduce the cost to firms of doing business. With these in place,the rewards to overcoming the remaining structural weaknesses should beconsiderable.

Policy Objectives and Recommendations

A coordinated strategy will be required to sustain growth over themedium-term. Government's broad objectives should be to increase efficiencyin production, support private investment, remove the bias against labor andimprove human resource development. In so doing, it must reduce the size ofthe government deficit to a sustainable level, and avoid the large fluctua-tions in spending that have characterized the recent past. Achievement of

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these objectives, combined with a continuation of prudent policies to avoidlarge macroeconomic imbalances, would create an environment in which a dynamicprivate sector can be expected to thrive.

Policies to Improve Efficiency. Efficiency improvements can beexpected from policy reforms which increase the competitiveness of the indus-trial sector and promote greater neutrality and transparency in the incentivesystem. Government is already moving towards these ends, with positiveresults reported by monitoring agencies. To strengthen this process, thisreport recommends consideration be given to the following measures:

(a) early attention to privatization and/or cl ure of small and loss-making public enterprises;

(b) a performance evaluation system to restructure the incentives facingNFPEs. Such a system would require enhanced monitoring and datacollection, and should be implemented in a hierarchical fashion,with the federal Government monitoring major holding companies whichwould in turn monitor their subsidiaries;

(c) an intensified public/private dialogue un industrial restructuringto focus on mechanisms for sharing risk, including promotion oflong-term credit, venture capital funds and linkages with foreigninvestors;

(d) avoidance of new tariff protection, except on a transitional basis,and, in the medium term, a reduction in the 210 protective tariffswith rates greater than 30Z to reduce the wide dispersion in protec-tion across sectors;

(e) introduction of an exemption from the development tax for companiescomplying with NEP; while such a deduction already exists, itsimpact is muted by the existence of a broad array of other taxcredits and deductions. These should be accredited only againstincome tax payments and not against the development tax.

(f) reductions in corporate contributions to the EPF to minimize thebias towards capital intensity in production; and

(g) the reform of the corporate income tax to reduce capital-cheapeningtax holdings, depreciation and investment allowances but withcompensation in the form of lower nominal statutory tax rates.

Policies to Support Private Investment. Several of the measures toimprove efficiency will also boost private investment by improving the confi-dence of the business community in government's commitment to private sector-led development. For example, lower corporate contributions to EPF willprovide an important stimulus by increasing the share of profits in nationalincome and restoring international competitiveness. In addition, Governmentshould consider:

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(a) reorienting public expenditure towards maintenance and necessaryinfrastructure projects, while restraining directly productiveinvestments;

(b) reducing regulated prices of cement and steel closer to borderprices, and liberalizing other administrative procedures that leadto inflated investment costs;

(c) supporting the generation of equity finance by reform of the KualaLumpur Stock Exchange with a focus on regulations governing thedetermination of stock prices for new issues, take-overs and mergersand, in the medium-term, developing venture capital funds thatcould, in part, tap the long-run capital available in providentfunds and insurance companies; and

(d) encouraging the development of a more flexible wage compensationpackage by linking overtime and bonus payments to productivity orprofitability.

Policies to Support Employment and Human Resource Development.Reforms in this area should focus on removal of the bias present in the cur-rent system against labor intensive production, against the young, and againstefficient human capital formation. Individual enterprises should beencouraged to provide greater on-the-job training, so that changes in thestructure of output are accommodated by retraining of workers not retrench-ment. A closer partnership between the public and private sectors in shapingtraining courses should also be supported through a sharper delineation oftheir roles, with the private sector taking the lead in the delivery oftraining and the public sector taking the lead in establishing direct andindirect access to finance. In addition to reducing the corporate contribu-tion to the EPF and in legislating more flexible wage contracting, Governmentshould consider:

(a) a voluntary exemption from the EPF for these under 25 years ofage;

(b) improvements in the delivery of vocational and on-the-job trainingprograms through establishment of appropriate incentives and compe-tition;

(c) deductions from corporate EPF contributions for 50% of firms' costsof approved training; and

(d) reorganization of the Government's financial assistance program forhigher education through implementation of higher user-chargescoupled with an enhanced student loan program.

As the primary institution responsible for financial capital accumulation, theEPF could also become a central element in improving accumulation of humancapital. It should mandate withdrawals and make loans for approved trainingprograms with tangible connections to future jobs, while leaving the deliveryof such programs to the private sector and corporations. It should also

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implement a student loan program to cover higher educational fees. By bring-ing to bear detailed knowledge as to the market rates of return to education,available from its data base, EPF can assist in the process of making curric-ula and course development more in tune with market signals.

Government should also develop a performance-based contractualsystem to implement its training objectives, whereby Ministry of Labor and EPFwould become providers of training finance, while public and private courseswould compete for students and charge user-fees to cover costs. The institu-tional responsibilities of these agencies would be to ensure that fundingwould only be released once a cycle of training, hiring and retention on thejob was completed. Such programs have worked successfully elsewhere to allowfirms and workers to adjust to demand and technological changes without uanec-essary retrenchment and to raise wages and employment prospects for theunemployed and those in danger of losing their jobs.

Policies to Stabilize Public Debt, Deficits and Spending. As grossdebt levels have reached high proportions by international standards, Malaysiashould act to stabilize the debt by reducing overall public sector deficits.It should also avoid as far as possible sharp cycles in development spendingoccasioned by external shocks. Reductions in the deficit should be aimed atdecreasing overall spending by reducing subsidies and transfers and bystricter control over development expenditures to weed out unproductiveprojects. This may involve a change in the composition of spending as, insome instances, reducing distortions may even involve higher expenditures.This is likely to be true in the deregulation of cement and steel prices andin the removal of overly restrictive budgetary constraints on maintenance. Itwould be useful, therefore, to undertake these reforms in tandem with a pro-gram of raising revenue, through broadening the sales tax base or introductionof a VAT, and cutting expenditures in other areas. In addition, where possi-ble Government should move off-budget the operations of departments and statu-tory bodies directly providing public services, by increasing user-charges andinitiating greater self-reliance in funding. One example noted above is inselected educational programs. To achieve these objectives, public financemust be placed on a more solid and less volatile footing by:

(a) cutting explicit and implicit subsidies to statutory bodies, govern-ment agencies and others, such as those in transport, housing, riceproduction, distribution and milling, and education;

(b) restricting new lending, lending guarantees, equity contributions,tax exemptions and other forms of financial support for loss-makingpublic enterprises by full or partial divestiture, liquidation andNFPE incentive reform;

(c) reducing debt service costs and exposure through more aggressiveinternal and external liability management, including use of swapoperations and, potentially, commodity bonds;

(d) unifying the sales, excise and service taxes to reduce administra-tive costs, perhaps in the context of a VAT implemented at theretail stage; and

- xi -

(e) shifting the basis for grants to statutory authorities from a pro-gram to a consolidated budget basis to avoid the current situationwhere recipients of Federal grants for specific programs also build-up financial assets based on surpluses in other activities.

Conclusion

Implementation of these reforms would give the economy a solid foun-dation for long-term economic growth. From a macroeconomic perspective theywould put more purchasing power in the hands of the private consumer and moreprofits in corporate treasuries, expanding private domestic demand which isthe sector that must lead growth over the medium-term. The recommendedreforms would also induce greater employment, particularly amongst the youngand more highly educated, and more labor-intensive growth. The measuresproposed to reduce the public deficit would also help sustain private demandand would reduce pressures on domestic capital markets to mobilize funds topurchase government debt, releasing funds for private investment. From amicroeconomic perspective, the reforms would introduce greater neutrality intofactor and output prices, more efficient risk-sharing in the economy, moreeffective physical and human capital formation and a better matching betweenindividuals' expected earnings and expenditures in retirement. Consistencybetween desired macroeconomic and microeconomic outcomes would be achieved ifthe reforms were implemented as a package rather than as individual items.

I. INTRODJCTION

1.1 From an economic perspective, the Malaysian economy, as it standstoday, is a seeming paradox. There is excess supply in all the major factorsof production: unemployment has risen to worrying levels in rural and urbanareas and in all skill categories; liquidity in the banking system is ampleand short-term interest rates on Treasury bills and interbank loans havedeclined to very low levels; finally, an increased supply of land is beingidled. In some countries, these trends could be ascribed to major distortionsin the economy or deficient aggregate demand. This is not the case inMalaysia, however. The trade regime is one of the most open of all developingcountries, international capital flows in and out freely, the exchange ratefloats according to supply and demand, inflation is low, domestic capitalmarkets have been liberalized and labor unions are moderate; furthermore,public expenditure and deficits are high. Yet, seemingly embarrassed by therichness of potential, real GDP and consumption per capita have stagnated forthe past three years, and are only showing signs of a vigorous expansion in1988.

1.2 Any judgment of economic performance on the basis of short-termgrowth rates is unquestionably narrow. Malaysia has made great strides inreducing poverty, in restructuring society and in adjusting to some of themost severe external shocks to afflict any developing country. Between 1980and 1982 for example, the terms of trade deteriorated by 17%, wiping out about5% of national income per year and leading to sizeable deficits in the currentaccount of the balance of payments. The adjustment from a deficit of 14% ofjIGP in 1982 to a surplus of about 8% of CGP in 1987 is a remarkable feat. Butthe successes in adjustment will quickly pall if growth does not resume andwith it the Government's ability to achieve employment and other objectives ofthe New Economic Policies (NEP).

1.3 A short-term hiatus in growth need not be of great concern, espe-cially when viewed against the background of Malaysia's strong past growth.In present circumstances, however, a more detailed look at the causes ofstagnation is warranted because of its coincidence with the Government's shiftin growth strategy towards a concentration on industrialization. As part ofits policy program, Government has expanded public investment and employment,mobilized new domestic savings, rapidly built up public indebtedness andsupported manufacturing growth through directed credit, tax holidays andexemptions, and labor training programs. Despite these measures, there areindicators of worrisome trends that go beyond the aggregate growth statis-tics. Private investment has declined and with it efficiency growth andtechnological upgrading. Public enterprises have outgrown their institutionalcontrol structures and are an increasing financial burden on the Treasury.Public expenditures have had to be sharply curtailed to contain rising publicdebt. Finally, unemployment has steadily risen and the most dynamic economicsector, manufacturing, has generated far fewer new jobs in the 1980s than itsoutput growth rate would warrant. A fundamental issue, therefore, is whetherthese trends imply that the institutional and policy framework needsadjustment or whether they are transitory phenomena occasioned by politicaluncertaincies and unfavorable international economic developments.

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1.4 The first stage in implementing Government's growth and industrial-ization strategy was to secure the requisite resources for investment. Thefundamental theme of resource mobilization has been addressed in two previousWorld Bank reports, "Development Strategies and their Financing" (1985) and"Industrializing a Primary Producer" (1986). Malaysia's high savings ratesand secure external creditworthiness are testaments to the Government'ssuccesses in managing this stage. As the immediacy of resource mobilizationissues has receded (with the important exception of managing continued highpublic deficits), attention in this report is turned to the issues associatedwith the allocation of resources and the transformation of accumulatedfinancial capital into an efficient and dynamic industrial base. To a signi-ficant degree, these issues are concerned with mechanisms for balancingrewards to investors and savers commensurately with the degree of risk under-taken. The report, therefore, analyzes investment, financial intermediation,and wage-setting processes which all involve risk-sharing at the firm andsectoral levels. It also addresses the macroeconomic response to externalshocks, stemming largely from terms of trade changes and involving fiscal,monetary and exchange rate policies that apportion the burden of adjustmentamong the public and private sectors, wages and profits, and households andcorporations.

1.5 As recent events have diverged significantly from what wasanticipated in the Fifth Malaysia Plan (5MP) for 1986-90, major Governmentinitiatives to address the problems of low private investment and highunemployment are taking place without benefit of an overall macroeconomicframework. Accordingly, an update of macroeconomic performance and medium-term prospects is provided in Volume I of this report. The analysis firstretraces developments in the Fourth Malaysia Plan (1981-85) as this heraldedthe start of the industrial growth strategy, and ther. identifies severalsignificant structural weaknesses, rooted in the period of the FMP, which werebrought into full view during the recession of 1985-86. Next, the prospectsfor medium-term growth are discussed, from both supply and demandperspectives. The last chapter contains a set of integrated policy recom-mendations to sustain growth. Volume II of the report contains chapters onpublic enterprises, public finance and employment. These chapters containmore detailed analysis on which the policy recommendations and medium-termscenario in Volume I is based.

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II. RECENT ECONOMIC DEVELOPMENTS, 1981-87

2.1 The period 1981-87 covers the Fourth Malaysia Plan (1981-85) and thestart of the Fifth Plan (1986-90). During this period, the economy underwentsharp reversals in growth performance and macroeconomic policies, brought onby external shocks and by the country's accelerating structural transformationfrom primary conodity production to industrialisation. The vicissitudes ofthe period are illustrated by a series of landmark events: the most severerecession since the country's independence arose in 1985-86, during which realper capita national income fell by 18X; the value of manufactured exportssurpassed the major primary commodity exports for the first time in 1987;federal government savings turned negative for the first time in 1986; themerchandise trade account recorded the first negative balances for decades in1981 and 1982 but achieved the largest surplus on record in 1987; and thecountry started to reduce its external debt through a program of prepaymentsstarting in 1987.

2.2 A review of the turbulent events of the 19809 provides valuablelessons for assessing Malaysia's current growth prospects, new strategicdirections and the efficacy of government policy instruments. These lessonsshould prove helpful to the Government in its handling of economic planningand management, particularly now that events have overtaken the assumptionsand projections of the Fifth Plan. Under these circumstances, the policyagenda outlining how best to achieve the objectives of job creation, struc-tural transformation, poverty eradication and restructuring of society must berethought. It is hoped that this review will assist in this process. Thischapter, therefore, outlines the major economic trends of this period--the"forced" expansion of 1981-84, the major adjustment and subsequent recessionof 1985-86, and the recovery of 1987--and concludes by identifying currentmacroeconomic problems rooted in this earlier period and the structuralfeatures underlying these problems.

A. The Expansion of 1981-84

2.3 At the turn of the decade, the Malaysian economy entered a new phaseof growth marked by a sharp deterioration in the terms of trade and theemergence of sizeable deficits in the current account. The average impact ofexternal price developments during 1981-83 was to reduce national income by4.52. Moreover, the slowdown in international economic activity dampeneddemand for exports. On the supply side, real growth was negatively affectedby the plateau reached in important agricultural commodities, especiallyrubber and timber, but this was offset by a boom in the exploitation ofpetroleum and natural gas.

2.4 Given these concerns, the Fourth Plan targets were correctly setbelow the actual performance of the 1970s. Real GDP growth of 7.6% wasprojected, largely based on manufacturing expansion (11), but also includingsizeable contributions from construction (9%) and government (9%). Two keycomponents of this forecast were: (i) continued rapid expansion of manufac-tured exports, especially textiles and electronics and (ii) moderately stronggrowth in domestic demand (5.9%) led by non-oil private investment (11%).

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2.5 The Plan envisaged an almost total reliance on domestic resources tofinance growth. The foreign financing component was to average less than 0.2Zof total investment. Fiscal and monetary policy would be oriented towardsresource mobilization and would channel the funds towards private investors.The private sector would spearhead growth in productive capacity while publicsector investment would be geared to poverty alleviation, restructuring ofsociety and improving the quality of life.

2.6 As indicated in Table 2.1, actual events quickly diverged from thePlan forecasts. The declining terms of trade experienced in 1981-82 limitedprivate sector investment. Government, however, compensated for the short-fall by launching an accelerated public investment and expenditure program tosustain real growth at an artificially high level. Although this protectedthe economy against the global recession of 1981-82, the cost of this policywas a soaring current account deficit. The sectoral balance envisioned in thePlan could not be maintained; government services and construction expandedrapidly, while the rest of the economy became weaker. Excess supply emergedin both sectors, reflected in ballooning public deficits and an overhang ofunsold properties.

Table 2.1: KEY MACROECONOMIC DEVELOPMENTS, 1981-87

FMPtarget Actual1981-85 1981-85 1981-84 1985 1986 1987

Terms of trade index 1980=100 /a 99.5 80.2 80.4 79.2 76.0 79.3Current account surplus (Z GNPT -0.1 -8.5 -10.2 -2.4 -0.3 8.3Overall public sectordeficit (X GNP) -6.7 -15.4 -17.6 -5.7 -10.6 -8.4

Real growth:GDP 7.6 4.7 6.7 -1.0 1.2 5.2Agriculture 3.0 2.8 2.9 2.5 4.0 7.5Manufacturing 11.0 5.3 8.6 -3.8 7.5 12.7Construction 9.0 3.7 8.1 -8.4 -14.0 -6.0Government services 9.0 5.3 6.5 2.1 4.3 4.0

/a 1970 weights.

Source: Fourth Malaysia Plan, 1981-85; Economic Report of the Treasury,Ministry of Finance; Bank Negara Malaysia, Annual Report, 1987.

2.7 The large current account deficits in 1982 and 1983 were primarily areflection of high gross fixed capital formation by the public sector.National savings remained high, at over 25Z of GNP. Investment has sincedeclined, starting with reductions in Federal government development expendi-ture, then extending to the NFPEs as projects initiated in the early 1980s

were completed, and culminating with the collapse in private investment in1985 and 1986 as recession took hold, competitiveness deterioriated andcommodity prices plunged. Between 1983 and 1987, gross fixed capital forma-tion has fallen from 38Z to 24Z of GNP. Although public sector savings havealso declined, private savings growth has more than offset this, reaching arate of 291 of CNP in 1987. Thus, of the twenty percentage point turnaroundin the current account between a deficit of 121 in 1983 to a surplus of 81 in1987, fourteen percentage points are accounted for by lower investment and theremainder by higher private savings.

2.8 The Plan had allowed for a rapid growth in both exports and imports,but overall the net external sector was expected to contribute little to totaldemand growth. The engine of growth was to have been domestic private demand,particularly private investment. While domestic demand did indeed lead growththrough 1984 (Table 2.2), the composition was not as expected. The role ofpublic sector consumption and investment was proportionately almost doublethat originally envisaged, while private demand grew more slowly. When therecession year of 1985 is included, the fall-off in private demand shows upeven more starkly; private demand growth over 1981-85 was only one quarter oftotal demand growth, rather than the three quarters of growth anticipated.The public sector and the net trade account provided the impetus for growth.More recently, domestic demand has actually fallen, and growth has only beenrealized because of export performance and a reduction in imports.

Table 2.2: COMPOSITION OF CHANGE IN DEMAND(X of change in CDP)

FMPtarget Actual1981-85 1981-85 1981-84 1984-87

Domestic 97.8 75.1 102.4 -276.3Private 74.1 28.1 57.7 -161.9Public 23.7 47.0 44.7 -114.4

External 2.2 24.9 -2.4 376.3Exports 57.1 73.2 68.4 305.3Imports /a -54.9 -48.4 -71.3 71.0

/a Negative sign indicates growth in imports.

Source: Fourth Malaysia Plan, 1981-85; Economic Report of the Treasury,Ministry of Finance.

2.9 While the shrinking private sector role in economic growth wasinitiated by the terms of trade decline in 1981 and 1982, thereafter severalinterlocking factors combined to generate a situation where incrementalprivate activity was jeopardized by excess capacity, falling profits, rising

-6-

costs of new expansion, public encroachment into private spheres, and loss ofcompetitiveness in trade caused by rising unit labor costs in manufacturing.To some extent, these problem. were accencuated by the reflationary expendi-ture policy of the general Government and public enterprises, coupled withaccomodating monetary and exchange rate policies.

Fiscal Exp!nsion

2.10 The scale of fiscal expansion in 1981 and 1982 was unprecedented.Based on actual and expected future increases in revenues from petroleum,government launched an ambitious series of development projects. Publicdevelopment expenditure almost doubled as a share in GNP, from 14.3Z in 1976-80, to over 271 in both 1981 and 1982 (Table 2.3). Although expenditures werepartially financed by a surplus in NFPS operations, attributable to profitsgenerated by PETRONAS and its subsidiaries which reached 5.7Z of CNP in 1982,the consolidated public sector deficit swelled from 81 of CNP in 1979 to 221and 19S in 1981 and 1982 respectively.

Table 2.3: CONSOLIDATED COVERNMENT ACCOUNTS(1 of GCP)

1976-80 1981 1982 1983 1984 1985 1986 1987(average)

Federal and State GovernmentsRevenue 29.2 32.8 33.1 33.2 32.5 36.3 37.0 31.0Current expenditure 26.1 30.9 30.5 30.6 29.5 30.9 35.6 32.4Operating Surplus 3.1 1.8 2.6 2.6 2.9 5.4 1.4 -1.4

Operating surplus of nonfinancialpublic enterprises (NFPEs) 1.0 4.0 5.7 6.6 6.8 7.8 4.5 4.5

Consolidated public operating surplus 4.1 5.8 8.3 9.2 9.7 13.4 5.8 3.1

Development expenditure 14.3 27.6 27.2 26.2 22.9 19.1 16.4 11.5Federal Government TEX DU 230.5 16.8 12.4 110.5 TO. 7.4NIPES 2.3 4.2 6.7 9.4 10.5 8.6 5.8 4.1

Overall deficit -10.2 -21.7 -18.9 -17.0 -13.2 -5.7 -10.6 -8.4

Source: Ministry of Finance, Economic Report of the Treasury; Sank Negara, Annual Report, 1987.

2.11 Public investment was mainly oriented towards infrastructure(Table 2.4) with transport, education and irrigation expenditures doublingbetween 1980 and 1982. In many instances, these projects were justified asmuch by their contribution to domestic demand as by their future expectedreturns. Irrigation for padi production for example, has very low or negativereturns when evaluated at border prices, but has strong linkages to ruralactivity in the construction phase. Similarly, many transport projects,including the Sandakan airport, were overdesigned, lowering their rate ofreturn but increasing their short-term contribution to aggregate demand. Inaddition, expenditures on defense were raised, from M$713 million in 1979 toM$2.1 billion in 1082.

2.12 The current expenditures of the Federal Government also rose rapidlyin the early 1980s, accounting for 26X of GNP in 1981 compared to 23X in1979. The most rapidly growing items were for operating expenditures in theprovision of economic services in agriculture and rural development, commerceand industry (see statistical Appendix, Table 3.2). General administrationexpenditures also soared, from M$752 million in 1979 to M$2.1 billion in 1982,as a result of higher wages and an expansion in the number of civilservants. Health and education programs were also expanded. Last, debtservicing, largely comprised of interest payments, accelerated as total publicdebt and interest rates rose; at M$2.7 billion in 1982, debt servicing chargesrepresented 16.3Z of federal operating expenditure, compared to M$1.3 billionand 12.72 in 1979.

2.13 In 1982, a process of structural adjustment was initiated to redressthe twin deficits in the public sector and the external accounts. As shown inTable 2.3, the fiscal adjustment was primarily based on two factors. First,the operating surplus of the NFPEs rose with the coming on stream of liquifiednatural gas exports and the expansion in petroleum production and exports(Table 2.7 below). The NFPE surplus rose steadily in nominal terms and as apercent of GNP until the collapse of petroleum prices in 1986. The secondelement of fiscal adjustment was in development expenditures. The share ofGCP accounted for by Federal Government expenditure in 1984 and 1985 hadreturned to the level of the late 1970s, around 12Z of GNP. This was accom-plished by a one-third cut in nominal development expenditures, concentratedin defense and commerce and industry, and, in 1987, in infrastructure (roadsand irrigation). Social services, including education, health and housingwere largely spared.

2.14 Although Federal government development expenditure was reducedafter 1982, overall public sector investment remained high through 1984because NFPE investment continued to grow until then. The expansion of theNFPEs was partly a function of the fact that these expenditures were notdirectly controlled by the Treasury, and partly because of the long gestationof the projects, which implied that, once initiated, investments could not beeasily halted without considerable wastage. During 1982-84, investment byNFPEs grew by 392 annually, and by 1984 the NFPEs accounted for half of allpublic investment--much higher than their 102 share in 1979.

Table 2.4: THE COMPOSITION OF PUBLIC INVESTMENT, 1978-87

1978-80 1981 1982 1983 _ 1984 1985 1986 1987M$ bln 1 H$ bln 2 MS bln M$ bln 2 MS bln X MS bln 2 MS bln Z MS bln Z

Infrastructure 3.8 83.1 7.5 81.1 9.6 84.7 10.6 84.4 10.0 83.1 10.1 82.8 10.3 91.6 6.1 70.8Land development /a 0.5 11.2 0.7 7.2 0.9 7.7 0.6 5.2 0.6 5.3 1.2 9.8 0.4 3.5 0.2 2.5Social sectors 0.4 7.8 0.8 9.1 1.1 10.1 1.1 8.7 1.1 8.9 1.0 7.8 1.1 10.2 1.1 13.4Transport and utilities 2.1 46.4 3.9 41.4 5.7 50.4 6.4 51.0 7.3 60.5 6.7 55.0 5.8 51.9 3.8 43.6 1Others 0.8 17.7 2.2 23.4 1.9 16.5 2.4 19.5 1.0 8.4 1.2 10.2 2.9 26.0 1.0 11.3 0

Directly Productive 0.8 16.9 1.8 18.9 1.7 15.3 2.0 15.6 2.0 16.9 2.1 17.2 0.9 8.4 2.5 29.2Commerce and industry 0.3 6.3 0.7 7.1 0.9 7.7 1.1 9.0 1.5 12.3 1.4 11.7 0.2 1.5 1.5 18.0Housing 0.2 4.2 0.6 6.4 0.4 3.3 0.5 4.2 0.3 2.1 0.3 2.4 0.3 2.4 0.3 3.7Agriculture 0.3 6.4 0.5 5.4 0.5 4.3 0.3 2.4 0.3 2.5 0.4 3.1 0.5 4.5 0.7 7.5

Total 4.6 100.0 9.3 100.0 11.4 100.0 12.5 100.0 12.0 100.0 12.2 100.0 11.2 100.0 8.6 100.0

/a Including drainage and irrigation.

Source:

II__

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The Construction Boom

2.15 The counterpart to heavy government investment was a continuation ofthe boom in construction, which had started in 1977. Driven by civil worksprojects financed by windfall receipts from oil, the construction sectorexpanded by 9.71 during 1981-84. The sector was, however, unable to expand asfast as demand, so prices rose. By 1982, price increases had added 35X toconstruction costs relative to 1978. By comparison, the producer price indexfor local production had risen by only 21.6X.

2.16 Adding to the cost of investment in the early 1980s, and contribut-ing to the boom in construction, was the steady rise in the price of land andproperty, especially in urban areas. Office rental rates in Kuala Lumpur, forexample, as reported by the Valuation Department of the Ministry of Finance,more than doubled between 1980 and 1982 (Table 2.5). This indicates theconsiderable tightness in the property market that triggered the boom. On thesupply side, obtaining land alienation licenses and constructing office orresidential property became an easy route to instant wealth. Investorsrealized both value added from construction and capital gains on the land andproperty, wAich together yielded handsome returns. With tangible collateral,commercial bank lending for property also soared, facilitating both theexpansion of const,u.tion and accommodating price increases. On the demandside, however, growth was more modest as real income gains and private con-sumption spending slowed. The ratio of housing prices to household income, aninverse measure of the affordability of housing and hence of likely demand,grew from 3 to 5 between 1979 and 1982.

2.17 The result of these forces was a speculative cycle of considerableamplitude, both for prices and for construction output. Price changes havenot served to equilibrate the property market. At the end of 1984 there was auizeable stock of unsold residential and commercial properties which, despitelow prices, has yet to be worked off. The current vacancy rate for officespace in Kuala Lumpur is an estimated 201.

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Table 2.5: SELECTED STATISTICS IN PROPERTY MARKETS, 1981-87

1981 1982 1983 1984 1985 1986 19871e

Office rentals in Kuala Lumpur /a 30 46 38 28 23 17 13(Z change) 36.4 53.3 -17.4 -26.3 -17.9 -26.1 -23.5

Housing values /b ('000 ringgit) 73.6 80.3 80.8 83.8 79.7 70.1 n.a.(X change) 23.3 9.1 0.6 3.7 -4.9 -12.0

Household income /c ('000 ringgit) 16.2 16.0 16.6 18.9 16.1 15.2 n.a.Housing credits /d (bn. ringgit) 7.0 9.4 11.3 13.7 16.5 n.a. n.a.Housing v^lue/household income 4.54 5.02 4.87 4.43 4.95 4.61Memo: CPi (O change) 9.7 5.8 3.7 3.9 0.3 0.7 1.5

/a Ring5it per month per square meter.7r Average value of single-story terrace houses in a sample of cities.71 Private disposable income per household.7T Total loans for housing including credit institutions, commercial banks,

finance companies, government housing loans, cooperatives and others./e Preliminary.

Source: Property Market Report, various issues, Ministry of Finance; Bank NegaraMalaysia, Annual Reports; World Bank, "Malaysia: Housing Sector Study,"1988.

Loss of Competitiveness

2.18 The simultaneous expansion in construction and in governmentservices brought about a tightening of the urban labor market. At the sametime, the productivity growth in agriculture associated with a switch fromrubber to oil palm began to slow, and the downward trend in agriculturalemployment which had been observed during the Third Malaysia Plan (1976-80)reversed itself. Overall unemployment rates fell from 5.7Z in 1980 to 5.11 in1982.

2.19 These changes in the labor market brought about a rise in real wagesrelative to productivity. The traditional measure of the real wage, the nomi-nal wage deflated by the rise in the consumer price index, did not grow fasterthan in the 1970s. Thus, it was not the case that workers were enjoying acce-lerating increases in their living standards. What did happen, however, is

- 11 -

that the real wage grew far faster than productivity (Figure 2.1).]/ From theperspective of a c3mpany, it is the relationship between the real wage andlabor productivity that is one important factor in determining competitive-ness, not the real wage per se. The reason for the divergence between the twoindices can be traced to labor market developments and the negative trend inproductivity during this period.

2.20 Other countries in East Asia also suffered from the phenomenon ofdomestic wages rising faster than productivity (Table 2.68. But whereas theywere able to hold down unit labor costs in US dollar terms by aggressive de-valuations, the rise in unit labor costs in Malaysia was aggravated by theGovernment's exchange rate policy, resulting in a loss in international compe-titiveness. In Korea, Thailand and Taiwan, unit labor costs in manufacturingdenominated in US dollars were roughly level with their 1980 values in 1984and 1985. In Hong Kong, they were over 202 lower. Only in Singapore andMalaysia is the trend sharply upwards, with a rise of 40-50Z in just fouryears.

1/ The index of labor productivity used in Figure 1 is an index of the ratioof value added to employment in the whole economy and in the manufactur-ing sector in the two panels, respectively. When the ratio between valueadded and output is constant, such an index also represents output perworker. The comparison between productivity and wage rates is a usefulindicator of the wage cost involved in production. Real wage grwoth atthe same rate as productivity growth implies a constant proportion oftotal wages to output in constant ULC. When wage growth exceeds produc-tivity growth, the wage bill per unit of output is increased and, ceterisparibus, there is upward pressureon costs and a decline in competitive-ness.

- 12 - Figure 2.1

Real Wage and Labor ProducUvity

130 -aIYalF t990-100

120 - fa Labor ProductM* Rea Wage

110 -

100

90 -8

80

70

60-71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87

Year

Real Wage and Labor ProductvityMwmniurtuling hIdusry, 1980=100

170 - 004%

B Labor ProductMly160 - * Rea Wage /

150- /140 -

130 /

120 -

110

100

90

80' _

70 - \u ,so

71 72 73 74 ;S 76 77 78 79 80 81 82 83 84 85 86 87Year

- 13 -

Table 2.6: MANUFACTURING UNIT LABOR COSTS IN EAST ASIA(1980 = 100)

1981 1982 1984 1985 1986 1987

A. Unit Labor Cost in Domestic CurrencyKorea 108.1 126.2 131.2 145.4 147.8 163.0Taiwan, China 113.9 121.9 132.7 128.5 126.4 124.8Singapore 111.9 131.9 140.0 151.0 134.1 nea.Hong Kong 108.8 130.7 116.0 132.0 127.4 n.a.Malaysia 109.7 125.3 154.8 178.3 169.9 153.9Thailand 110.8 109.9 114.9 121.4 n.a. n.a.

B. Exchange Rate (LC/US$)Korea 112.1 120.4 132.7 143.2 145.1 135.4Taiwan, China 102.3 108.6 109.9 110.6 105.0 88.4Singapore 98.7 99.9 99.6 102.8 101.7 n.a.Hong Kong 112.5 122.0 157.1 156.6 156.8 n.a.Malaysia 105.8 107.3 107.7 114.1 118.6 115.8Thailand 106.6 112.3 115.4 132.6 n.a. n.a.

C. Unit Labor Cost in US$ (A/B)Korea 96.4 104.8 98.9 101.5 101.9 120.4Taiwan, China 111.3 112.2 120.7 116.2 120.4 141.2Singapore 113.4 132.0 140.6 146.9 131.9 n.a.Hong Kong 96.8 107.1 73.8 84.3 81.3 n.a.Malaysia 103.6 116.8 143.8 156.3 143.3 132.9Thailand 104.0 97.9 99.6 91.6 n.a. n.a.

2.21 The contrast in exchange rate developments between Korea andMalaysia is indicative of totally different approaches to exchange ratemanagement. In Korea, particularly since 1980, the nominal exchange rate hasbeen adjusted so as to offset any increases in unit labor costs made in domes-tic currency terms (Figure 2.2a). Thus, purely domestic factors influencedthe exchange rate. By contrast, Malaysia pursued a more accommodating ex-change rate policy which closely reflected international events and whichdisplayed the typical characteristics of an oil exporter. As the dollarsoared in 1980-84, the real exchange rate in Malaysia appreciated(Figure 2.2b). More recently, it has depreciated in line with the UScurrency. The real appreciation in the value of the ringgit, however,combined with the rise in real wages, was a blow to Malaysian competitiveness,particularly in manufacturing, from which it is only slowly recovering.

2.22 The different exchange rate experiences between Korea and Malaysiareflect inherently different systems for dealing with international capitalflows. Korea has a closed capital account and effective central bank controlover the nominal parity of the won. Malaysia has an open capital account and

- 14 - Figure 2.2a

KOREA: INTERNATIONAL COMPETITIVENESS

17- _(1008100)o ULC In Korean Wan

160- + WanAU.S.$ o

o ULCInU.S6

140

140130

120

110

1 " " / '''''''' P * a..*,,, ;""100 a.4.00

90

o0- f 1979 1980 1911 1982 1983 1994 1S85 1996 1997

Yeaw

Figure 2.2b

MALAYSIA: REAL EXCHANGE RATE MOVEMENTS(1998=100)lo~~~~~~to

.50-.

140 - REER

130

got -

t20-

70

1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1901 1982 1993 1984 1995 196 1997

YEAR a-

- 15 -

a floating exchange rate regime. The competitive problems in Malaysia arosenot because of exchange rate mismanagement pE se--exchange rates were left tofloat during this period-but because, given exchange rate movements, thenominal wage rose too rapidly. The Taiwan example illustrates how exchangerate movements similar to those experienced in Malaysia need not have resultedin a loss of competitiveness had wage increases been kept down.

2.23 One policy that sustained the ringgit in the early 1980s was theGovernment's decision to utilize foreign borrowing to finance its investmentprogram. In 1981 and 1982 net public foreign borrowing amounted to 7.5Z and9.61 of GNP, respectively. Over the period of forced expansion, 1981-84,foreign savings on average financed 28Z of total investment compared to theplan forecast of 0.22. A substantial proportion of the foreign borrowing (571in 1983-84) was undertaken by public enterprises. This recourse to externalfunds helped these agencies escape the surveillance and discipline that couldhave been imposed by the Federal Government had there been a greater relianceon the Treasury as a source of funds. Overall, net foreign inflows more thancompensated for the current account deficits being registered. Central Bankforeign exchange reserves built up steadily, and pressure to depreciate theexchange rate was temporarily diverted.

2.24 Rising real wages and an appreciating currency imposed a profitsqueeze on manufacturing which was reinforced by a large shortfall of privateconsumption and investment below expected levels: the former as a result ofreal income losses due to the prolonged terms of trade deterioration, and thelatter because of declining economywide profits and rising global interestrates. Furthermore, one source of rapidly growing domestic demand, theinvestment binge of the NFPEs, failed to benefit local industrialists sincemuch of the public enterprise investment was highly import-intensive, withforeign machinery and equipment purchases closely linked to financial andtechnical assistance being sought from abroad. Against this background, it isnot surprising that manufacturing growth during 1981-84, at 7.6Z, fell farshort of its target of 11Z.

B. The 1985-86 Adjustment Period

2.25 In 1985, government efforts to adjust the structure of publicfinances started to bear fruit. The Federal Government deficit narrowed and,for the first time in the 19809, the overall expenditure of the NFPEs wasbrought below their revenue. Government efforts were oriented towards improv-ing efficiency and productivity in government services. At the same time,monetary policy was loosened to facilitate growth and provide liquidity forprivate investment. Interest rates were brought down and a New InvestmentFund of M$l billion was set up to channel funds into the directly productivesectors. The policy mix therefore shifted towards a tight fiscal/loosemonetary stance in sharp constrast to the strategy in previous years which hadtargeted loose fiscal policy at growth maximization and tight monetary policyat managing the balance of payments and inflation.

2.26 The actual performance of the economy in 1985-86 was mixed. On theexternal side, the terms of trade declined sharply with the result that real

- 16 -

national income per capita fell by 6.5% and 11.2Z successively.11 Exportreceipts also fell with weakness in commodities coinciding with a downturn inmanufactured exports. Despite this fall, however, imports were reduced byeven more (-101 in 1985, concentrated in investment and intermediate goods(Statistical Appendix Table 4.7)) and considerable progress was achieved inreducing the current account deficit. This improvement, coupled with easinginternational liquidity, assured access for Malaysia in foreign capitalmarkets. A program of external debt refinancing was instituted and Malaysiabecame the first developing country to obtain a syndicated credit at a ratebelow LIBOR, and one of the first developing countries to obtain a creditrating from the major US agencies.

2.27 Internal developments were considerably less favorable. Real GDPstagnated for two years, the worst performance since independence. The conso-lidated public sector deficit rose again in 1986, reaching 10.6Z of GNP, asrevenues from all sources declined: income taxes fell in response to thelower income in 1985; indirect tax receipts fell as imports and salesdeclined; and petroleum-based taxes and royalties collapsed with the fall inoil prices. Unemployment also started to rise significantly, as labor-intensive sectors in commerce, government and construction were badly hit, andreached 8.5Z by 1986.

External Shocks

2.28 The immediate cause of Malaysia's recession was a collapse in theprices for its major exports (Table 2.7). While the diverse mix of commodi-ties exported had in the past provided a solid hedge against price fluctua-tions, the problems of 1985 and 1986 were caused by a simultaneous reductionin prices for petroleum, palm oil, rubber, sawlogs, tin and cocoa. Based onan analysis of historical post-war commodity prices, however, it appears thatthe probability of a shock of such magnitude or larger occurring is quitehigh--one year out of every three is liable to see a deviation from trend ofM$2 billion in primary (non-oil) commodity exports due to price fluctuationsalone (see Appendix 1). This analysis suggests that Malaysia will in allprobability be faced with similar situations in future. In light of theeconomy's vulnerability to external events, a smoother pattern of real govern-ment spending is desirable in order to minimize sharp oscillations in theeconomy.

2/ The official terms of trade index uses 1970 weights and consequentlyaccords petroleum a very low weight. The income figures above arecalculated using data on current and constant 1978 price exports andimports.

- 17 -

Table 2.7: MAJOR COMMODITY EXPORT PRICES, 1981-87

1981 1982 1983 1984 1985 1986 1987/a------ (M$/ton) - …

A. Prices

Petroleum(US$/barrel) 39.0 36.3 30.7 29.3 27.6 14.8 18.2

Palm Oil 1,153 829 984 1,583 1,046 579 720Rubber 2,503 1,927 2,344 2,308 1,919 2,100 2,420Tin 32,150 30,535 30,088 29,343 28,711 16,089 16,915Sawlog. ($/cu meter) 156 175 149 166 141 151 186Sawn timber($/cu meter) 360 352 371 368 409 435 451

Cocoa n.a. 3,440 4,000 5,110 5,000 4,700 4,357

S. Export volume growth rates

-------- (percent) - …-- …

Petroleum -9.9 18.0 18.8 16.0 1.2 12.5 -4.0Palm oil 9.9 14.9 7.9 1.6 8.6 33.9 -6.1Rubber -2.7 -7.2 13.4 1.8 -5.9 1.3 6.9Tin -14.7 -26.9 17.5 -30.7 44.9 -29.7 22.9Sawlogs 4.4 21.1 -3.0 -9.5 15.8 -2.9 20.7Sawn timber -10.1 9.1 11.8 -17.9 -3.2 7.9 30.8Cocoa n.a. 36.5 -0.7 15.6 23.2 30.1 48.5

la Estimates.

Sources Economic Report of the Treasury, various issues, Ministry of Finance.

2.29 To some extent, the impact of the terms of trade decline was offsetby rising commodity export volumes, particularly in petroleum, palm oil andcocoa. Other commodities had a more mixed performance, with rubber and timberexports declining in 1985 and then rebounding in 1986, while tin and sawlogsposted strong real gains in 1985 before volumes retreated back in 1986.Nevertheless, the total value of major commodity exports fell by almost one-quarter in nominal terms by 1986 relative to 1984.

2.30 One result of weak commodity exports was to increase the importanceof manufacturing exports. These had doubled between 1981 and 1984 (Table2.8), largely on the basis of rapid growth in electronics exports, particu-larly semiconductors, and have roughly reached parity with commodityexports. In fact, Malaysia's manufactured export performance had been ratedamong the best of all developing countries in the 1970s. The World Bank'sWorld Development Report 1987 shows Malaysia to be the sixth best developingcountry exporter of manufactured goods in the 1970s after better known leaders

- 18 -

Table 2.8: THE STRUCTURE OF EXPORTS, 1981-87

1981 1984 1986 1987M$ mln % MS mln % M$ mln % M$ mln Z

Commodities 20,807 76.8 26,471 68.5 20,460 57.3 24,914 55.1

Petroleum 6,918 25.5 8,733 22.6 5,400 15.1 6,290 13.9Palm oil 2,710 10.0 5,194 13.5 3,346 9.4 3,250 7.2Rubber 3,712 13.7 3,495 9.1 3,182 8.9 3,915 8.7Tin 2,138 7.9 1,163 3.0 651 1.8 839 1.9Saw logs 2,473 9.1 2,774 7.2 2,872 8.0 4,286 9.5Sawn timber 971 3.6 1,169 3.0 1,305 3.7 1,770 3.9Other 1,885 7.0 3,943 10.2 3,704 10.4 4,563 10.2

Manufactures 6,302 23.2 12,156 31.5 15,264 42.7 20,267 44.9

Electrical machinery,appliances and parts 3,017 11.1 6,749 17.5 8,491 23.8 10,976 24.3

Transport 308 1.1 569 1.5 518 1.5 722 1.6Food and beverages 600 2.2 777 2.0 960 2.7 1,223 2.7Textiles, etc. 785 2.9 1,141 3.0 1,643 4.6 2,286 5.1Wood and wood products 473 1.7 416 1.1 537 1.5 851 1.9Rubber products 83 0.3 107 0.3 155 0.4 243 0.5Chemicals 417 1.5 452 1.2 760 2.1 917 2.0Minerals and metals 221 0.8 433 1.1 714 2.0 1,074 2.4Other 398 1.5 1,512 3.9 1,486 4.2 1,975 4.4

Total 27,109 100.0 38,627 100.0 35,716 100.0 l5,ot 100.0

Source: Bank Negara Malaysia, Annual Report; Economic Report of the Treasury; EPU.

- 19 -

such as Korea, Hong Kong and Taiwan (China). But whereas other countries,particularly the newly industrializing countries (NICs), diversified theirmanufactured export base while registering rapid growth, Malaysia's manufac-tured export structure has become highly concentrated, with the volatileelectronics and electrical machinery subsector accounting for over half of allmanufactured exports.

2.31 The rate of growth of manufactured exports slowed in 1985 and 1986as a result of two factors. First, there was a dramatic shake-out in theglobal semiconductor industry which had been a consistently strong growthperformer until then. Second, compounding this effect, was the loss ofcompetitiveness in manufactured exports that further slowed growth across thespectrum of exports, particularly in transport, minerals and metal., wood andwood products, food and beverages and other products.

2.32 The decline in commodity export prices in 1985 and 1986 affectedreal GDP growth in two ways. First, output responded directly to pricechanges. This effect, however, does not seem to have been very important asthe volume of commodity production and exports remained strong in 1985-86,except for tin, logs and rubber. Second, decreased prices indirectly affectedoutput by reducing purchasing power and hence domestic demand. In Malaysia,however, the impact of terms of trade changes on consumption also seems tohave been limited. In 1985-86, the decline in private consumption associatedwith price shocks was about 6X, or about one fifth of the fall in domesticdemand. Consumption did not respond immediately to the negative terms oftrade because private income was protected through growth in the publicdeficit and because private coumption in general only reacts partially tosingle year changes in income.- Overall, the Malaysian trade sector was amajor source of strength during 1985-86, contributing 17.2 percentage pointsto rell GDP growth, shared evenly between export expansion and import compres-sion., Part of the source of the recession must, therefore, be sought for indevelopments other than external shocks.

Internal Shocks

2.33 Economic performance in any year is a function of a complex mix ofcyclical and structural trends, set in motion by past developments, bybehavioral adjustments reflecting fresh expectations about the future, and bypolicy changes mirroring the current situation. Each of these elementsimparted a negative impulse to the economy in 1985-86 which cumulativelyresulted in the recession.

3/ See Appendix 6 for a discussion of the consumption function.

4/ The import compression, largely of intermediate and capital goods, servedto protect domestic output from the full force of declining consumptionand investment; part of the decline in demand fell onto a decline indemand for foreign goods. There was, however, little visible importsubstitution during this period.

- 20 -

2.34 Two intartwining ba*es- the kursting of the property market bubbleand thie dowatura- in the overall bu':z -.,_cls-coincided to turn Malaysia'sadjustment program iuto a fult-fi'cli.A and ultimately very painful reces-sion. Signs of overheating in tht p:operty market had clearly emerged by1984; property prices had risen a record rates, over twice as fast as theconsumer price index over the preceding decade. Housing investment which hadhoverel,around 5Z of GNP in the mid-1970s, rose to about 9% in the early1980s.-' The price and output developments pushed the supply of housing wellbeyond underlying demand. New construction was facilitated by easy credit forproperty development based on its proven track record of good collateral andcapital gains, which were optimistically extrapolated into the future. Thus,in common with other speculative bubbles, the property boom thrived on opti-mistic expectations for the future. These expectations were dashed whenglobal commodity prices fell, New housing construction w:as promptly halted.Coupled with the decline in government civil works projects and the collapsein demand for commercial property as corporate profits were squeezed, theconstruction sector went into a tailspin which has still to bottom out, losingone fifth of its real value added by 1986.

2.35 At the same time as the property bubble burst, the business cycleturned down. Along with other countries, Malaysia's economy has fluctuatedaround a consistent upward trend. One characteristic of this cycle is thatthe upswing is associated with wage rates rising faster than productivity. Asthis occurs, corporate profits are hurt, investment declines, and growthsuffers. An adjustment peried of slower growth, during which wage gains areminimized and productivity improved, is required to restore balance to theeconomy. As illustrated in Fig. 2.1 above, the wage-productivity relationshiphad shifted out of balance by 1984. While a *number of factors, including theshift towards capital-intensive output, inefficient investments and fallingcapacity utilization, were responsible for the fall in productivity growth,the result was a growing share of wages in total value added and a decline inprofits. Caught in a cash-flow squeeze, corporations trimmed their invento-ries--stock adjustments in 1985 alone reduced real output growth by almostthree percentage points.

2.36 Structural factors were also at play in reducing growth in1985-86. The tremendous growth impetus that had been provided by petroleumand gas exports flattened out. Tin production was also severely disruptedwith the suspension of the Kuala Lumpur Tin Market. Weaknesses also emergedin the financial services sector, necessitating Central Bank interventionthrough direct control in some instances and tighter regulation, monitoringand supervision in other cases.

5/ These data on housing investment are drawn from "Malaysia: The HousingSector" World Bank Report No. 7292-MA. They are based on survey data ofthe stock of housing and are substantially above official figures basedon the flow of new residential construction. The latter, however, alsoshow the same pattern of a two-thirds rise in the ratio of housinginvestment/GNP between the late 1970s and the peak in 1982.

- 21 -

2.37 Growth performance also reflected changes in domestic policy. Astrategy of facilitating a real effective exchange rate depreciation throughchanges in nominal parities was adopted in 1986. The Malaysian ringgit fellby 72 against the US dollar and, as the dollar continued its decline inrelation to other major currencies, the real effective exchange rate depre-ciated rapidly. The depreciation was an appropriate response both to theterms of trade decline and to the overvalued level to which the currency hadrisen, along with the US dollar, up to 1984. The legacy of the 1980-84currency shifts had been large external deficits, which threatened to widenagain in an environment of low commodity prices and a weakening of mostmanufacturing subsectors. Adjustment was required for long-run growth but itinvolved short run costs. In the short run, the exchange rate depreciationdepressed consumption by an estimated 8Z. It is likely that this effectoucurred through a shift in the composition of income from the high-consuming,self-employed group involved in nontraded sectors such as trade and commerce,towards a higher-saving formal sector group engaged in manufacturing andagriculture. One indicator supporting this hypothesis is the increasedcontribution per member to the Employee Provident Fund (+5%) in a year whichsaw average incomes fall by 6Z.

Fiscal Turnaround

2.38 Perhaps the most important policy shift, however, was in the fiscalaccounts. The overall consolidated public sector deficit fell to 7.8% of GNPin 1985 despite the cyclical factors that would typically have led to awidening of the deficit during a year of depressed growth. The NFPEs as agroup accounted for about 4.5 percentage points of the reduction in theoverall public deficit/GNP ratio. Their revenues exceeded their total expen-ditures for the first time since 1981, largely as a result of a cutback incapital expenditure, and increased profits from faster oil extracti and thecoming on stream of liquified natural gas. The net fiscal impulse,- theportion of the deficit attributable to policy changes rather than cyclicalfactors, was highly negative in 1985 (Figure 2.3). In fact, expenditure andtax changes together imparted an 11% reduction in domestic demand. Themagnitude of this change, particularly in comparison to earlier years,reflects the Government's success in bringing the expenditures of NFPEs undercontrol. As discussed above (Table 2.4), the cutbacks in investment werelargely in defense and transport. By 1986, investments in irrigation,commerce and industry were also pared back.

2.39 The negative fiscal policy impulse did not last long. The fall intax revenues from petroleum and other sources, coupled with a levelling off ofgovernment expenditures, led to a resurgence of the deficit. At the sametime, the NFPE accounts also returned into the red as PETRONAS' surplusdeclined. Exacerbating the NFPE difficulties was the rise in the value of theyen and the consequent surge in debt service obligations. In addition tothese structural elements, which account almost entirely for the increase in

6/ See Volume II, Chapter 2, for a detailed discussion of the methodologyinvolved in the computation of the net fiscal impulse.

Figure 2.3

- 22 -

Net FiscaL Impulse, 1972-87

Net Fiscal ImpulseSe-mtN'tiity Anq"si

0.1 -

0.08 C Net Fiscal Impulse

0.06 -0.04

0.02

0 0 '-0.02

-.0.04-

. .-0.06 /0

W-0.08

-0. 1

-0.12

-0.14

--0.16 C onsolidated-0.18 ~~~~~~~~~~~deficit/GNP

-0.218

-0.22

1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1966 1987

a Al + A2 0 A3 V CD/GNP

Note: The legends in the chart represent assumptions about the potentialfor which the corresponding net fiscal impulse is calculated. Aland A2 are variations on the 10 potential GNP growth assumption;and A3 assumes 81 growth but is otherwise based on the sameassumptions as Al.

- 23 -

the deficit, the Government undertook several discrete policy changes. AnAnti-Recession Committee was formed to create employment and growth andimprove the government accounts. As a result of the recommendations of thisCommittee, the Special Low Cost Houaing Program was launched, to build 240,000units over three years. In addition, a total of M$2 billion was restored tothe initial cutbacks in the Fifth Plan development budget. Overall, fiscalpolicy became neutral in 1986.

2.40 Monetary policy was accommodative throughout this period, andnominal interest rates began to fall in line with global developments (seeStatistical Appendix Tables 8 and 5.8). Real interest rates, however, rose asinflation was squeezed out of the system by the recession. Both the depositrate and the prime lending rate increased in real terms, aggravating the dropin domestic demand. To assist in recovery, the authorities implemented newcredit programs including the New Investment Fund (NIF) and a small industriesdevelopment fund. They also reduced administrative requirements in theoperation of the Export Credit Refinancing scheme and increased the scope ofits operations by moving from a positive to a negative list approach indetermining eligibility. These measures helped boost credit supply, whichrose at an annual rate of 10Z, but were not effective in restoring momentum tothe all-important private investment sector. In fact, econometric analysisindicates that credit is not a significant determinant of private investmentin Malaysia. The loosening of credit policy, theref 9 e, did not prove to bean effective instrument for stimulating the economy.,

C. The Beginning of Recovery--1987 and 1988

2.41 The economy bottomed out in the second half of 1986 and strengthenedthroughout 1987. As in the downturn, the upswing coincided with a change inthe terms of trade. The provisional estimate for real GDP growth in 1987 is5.4%, based on a strong performance in the manufacturing and agriculturalsectors, particularly in the fourth quarter of the year. The balance ofpayments also improved, with the current account registering a surplus of 8.1Sof GNP, based on substantial gains in export revenues. This permitted theauthorities to prepay some M$2 billion in external debt and to build upexternal reserves by almost M$3 billion. The only negative items in theeconomic performance were the budget deficit and unemployment growthnumbers. The overall consolidated public sector deficit improved to 8.4% ofCNP but only because of a temporary shortfall in spending on developmentprojects. Unemployment rose to 9.1%. In addition, evidence that the share ofworkers earning less than M$200/month--the minimum compiled figure--has surgedfrom 42% to 55% suggests that the number of underemployed or part-time workers

7/ This conclusion is based on regressions reported in Appendix 6. Otheranalysts have found the interest rate to be a significant determinant ofinvestments but the effect is typically weak and sensitive to modelspecifications. Although funds such as the New Investment Fund have beenin high demand, this can be attributed to the below-market interest ratecharged. It is likely that these funds substitute for other commercialbank credits.

- 24 -

has risen sharply, indicating an even worse aggregate employment situationthan shown by the unemployment rate.

2.42 Recovery in output growth and the current account surplus indicatethat the process of macroeconomic adjustment was largely completed in 1987.This adjustment can be viewed from both an external and internal perspec-tive. As shown in Table 2.9, the current account surplus reflects a rapidreal growth in exports of 11.3%, coupled with price improvements that togetherboosted the share of exports in GNP to a record 70X. At the same time, italso reflects private sector savings far in excess of private investment.

2.43 On the trade side, both commodity and manufactured exports rosesharply; the value of total merchandise trade increased by 26.5% over 1986.Commodity export growth was led by double-digit volume growth in tin, logs,timber and cocoa, and by strong price increases in petroleum, palm oil,rubber, tin, logs and timber (Table 2.7). The higher palm oil price followeda sharp increase in demand with the entry of India into the market as a resultof drought damage to that country's oil seed production. Log and timberexports, particularly from Sarawak, were mostly destined for Japan, stimulatedby the construction and housiug boom that has followed the appreciation of theJapanese yen. Manufactured export growth was also strong, partly as a resultof improving competitiveness following the ringgit's depreciation. In ringgitterms, the biggest increases in manufactured exports were posted in theelectronics, electrical machinery, apparel and textile sectors, but the gainswere broad-based (Table 2.8). Smaller industries, such as rubber and wood-based products, also showed strong export gains, and some domestically-oriented sectors, such as steel and food and beverages, were also able toexport in limited quantities.

2.44 On the internal side, adjustment was evenly divided between thepublic and private sectors. The overall public sector savings/investment gap,which had rebounded to 11.3Z of GNP in 1986 as a result of the fallingrevenues from petroleum, was reduced by about 3 percentage points of CUP by areduction in public fixed investment. This redug ion was concentrated inenergy, transport and miscellaneous investments_ Meanwhile, the privatesector saved an estimated 16.6% of CNP more than it spent, helping finance thepublic deficit and the current account surplus. The private surplus rose as aresult of sharply higher savings. These stemmed from the fact that incomegains from higher commodity prices were saved, and because the fall in wagesand increase in unemployment helped Aepress private consumption. As a result,

8/ The current revenues and expenditures of the general government bothdeclined as a ptlportion of CNP in 1987. Income tax revenue was nega-tively affected by the low profits registered in 1986, particularly byoil companies. Falling oil prices also account for lower export dutieson petroleum and for the reduction :n the operating surplus of nonfinan-cial public enterprises. Despite this, public savings did not decline asmuch as might have been expected because current expenditures were heldconstant in nominal terms and also declined in relation to CNP as aresult of growth in the economy.

- 25 -

aggregate domestic demand continued to fall by 1.11 in 1987. Even this modestdecline, however, represents an improvement over the 10.8Z decline in domesticdemand registered in 1986.

Table 2.9: ADJUSTMENT TO SHOCKS, 1984-87(X of CNP)

1984 1985 1986 1987/a

Change in terms of trade (Z) 6.9 -4.5 -15.6 7.4

Exports (goods and nonfactor services) 58.2 59.2 61.8 69.5Growth rate (Z) 13.8 0.4 17.6 11.3

Imports (Goods and nonfactor services) 56.2 51.9 54.9 54.7Growth rate (Z) 6.5 -10.0 -2.7 6.2

Current account -5.3 -2.4 -0.2 8.1Net external financing 5.3 2.4 0.2 -8.1

Public sector -6.5 -6.0 -11.3 -8.5Savings /b 9.7 11.1 5.8 3.0Investment 16.2 17.1 17.1 12.5

Private sector 1.2 3.6 1;.5 16.6Savings 21.0 16.2 21.5 28.1Investment /c 19.8 12.6 10.1 11.5

/a Estimates.7T Total public sector current surplus.7T Includes change in stocks.

Source: Economic Report of the Treasury; 1987 Staff Estimates.

2.45 Domestic-oriented manufacturing, while still sluggish at 5.3Z growthcompared to 19% for the export-oriented sector, was the swing performer in therecovery. That is, it was changes in the domestic-oriented manufacturinggrowth, relative to its 1986 performance, which allowed overall manufacturedgrowth to improve in 1987. Much of this improvement, however, may be cyclicalin nature as domestic demand in 1987 was sluggish, and declined somewhat.Thus, production gains may have gone towards replenishing inventories whichhad been depleted during 1985 and 1986. This does not, however, imply thatgrowth is likely to slow in 1988. On the contrary, preliminary indicationssuggest an acceleration of manufacturing growth and a more broad-based parti-cipation by subsectors such as transport, cement, oils and tobacco productswhich had missed the 1987 recovery. In the longer-term, improvement indomestic demand, particularly in private consumption and investment, isnecessary to sustain a diversified, rapidly expanding manufacturing sector.

- 26 -

Factor Market Adjustments

2.46 The provisional estimate of macroeconomic performance in 1987suggests a strong momentum to growth that should carry over to 1988. At amicroeconomic level as well, the signs are encouraging. The high degree offlexibility exhibited in Malaysia's credit and labor markets in 1987 is espe-cially noteworthy. As a recession is typically a period of adjustment forfirms, and of a shift of resources from less efficient to more efficientsubsectors, its depth and length will be partly affected by the speed withwhich factors of production are reallocated. Evidence of well-functioningfactor markets, therefore, augurs well for a solid-based recovery.

2.47 Following a reduction in statutory reserves and liquidity require-ments, the availability of domestic credit eased substantially in 1987. Thecontinued drop in investment led to a slight fall in commercial bank loansoutstanding through the middle of the year. Coupled with a growth in depositsassociated with higher real disposable income, domestic interest rates fellsharply in real and nominal terms. The three-month fixed deposit rate fell toits lowest level in over a decade (2.5Z). This responsiveness of interestrates to liquidity seems to have assisted in boosting both consumption andforeign investment inflows, alleviating the economic downturn.

2.48 Labor markets too have demonstrated a degree of flexibility. Highunemployment has contributed to a levelling-off of wage demands; in newnegotiated contracts covering a three-year period, only nominal increases inwages have been recorded. The wage for new entrants has been falling since1985. However, average payments to all employees continued to rise through1986 (by 7.2% in that year), reflecting built-in escalators in old contractsand payments made for retrenchment. The average wage finally stabilized ordeclined in 1987, and should now begin to fall rapidly, restoring profita-bility and encouraging output increases in all sectors.

D. The Emergence of Structural Weaknesses

2.49 Although the short-term prospects for growth of the Malaysianeconomy are excellent, they are heavily conditioned on the current buoyantexternal trade and commodity price outlook. To translate this into a longer-term sustained growth, there must be a recovery of private investment and adecline in unemployment. These have shown encouraging signs of improvement in1988, but, viewed in a historical context, the levels of private investmentand the rate of unemployment still reflect inherent structural weaknesses inthe recovery. The most important of these are: (a) an inability to alter thestructure of public finances to achieve a sustainable deficit in the face oflarge external shocks; (b) growing subsidies to alleviate private incomeshortfalls and, hence, a fall in overall profitability and in private invest-ment; (c) a mismatch between a pool of savings seeking low-risk returns andthe economy's need for risk-taking entrepreneurial investments in new produc-tive activities; and (d) rigidities in the labor market that have created atwo-tier wage system and sizeable structural unemployment.

- 27 -

Long-run Constraints on Public Deficits

2.50 High public sector deficits must be financed by new borrowing fromdomestic or external sources, money creation, or a run-down of previouslyexisting assets. Analysis of the prospects for these financing sources is auseful method for evaluating the size of the public sector deficit that can besustained over time. In Malaysia, recourse to money creation (or borrowingfrom the Central Bank) has been minimal in the past few years; governmentpolicy has expressly been to avoid such financing as it can lead to inflation-ary pressures in the economy. Furthermore, after an initial surge in 1981 and1982, borrowing from international capital markets has also been reduced. Infact, with the cost of external money above that of domestic funds (particu-larly on debts incurred in the pre-1982 high interest environment), a programof prepaying external debt has been initiated. Asset draw-downs have onlyrecently become important, and are clearly not a long-run source of funding.Thus, the bulk of deficit financing has taken the form of domestic borrowing,largely from non-bank institutions such as the Employee Provident Fund, otherpension funds, and Petronas (Fig. 2.4).

2.51 To date, debt management in Malaysia has focused on external liabi-lities. Through a program of refinancings and the initiation of prepayments,total public external debt service has been kept at a manageable and commen-dably low level: after rising to 17.61 in 1986 as a result of falling commo-dity exports, the debt service ratio has been brought down again and shoulddip below 15% in 1988. In comparison with other developing countries,Malaysia has remained amongst the most prudent and creditworthy of foreignborrowers.

2.52 Through its debt management policies, Malaysia has been able toavoid the short-term debt crises afflicting other developing countries. Itretains superior access to foreign credit markets and, because of the govern-ment's minimal resource to the banking system and the effective mobilizationof incremental private savings in non-bank financial entities, public borrow-ing has not resulted in high interest rates, as observed in other developingcountries like Turkey and Brazil. Over the long-run, however, the accumula-tion of high public deficits into high overall debt will pose increasinglydifficult debt mangement problems for policy makers. Indeed, Malaysia todayhas one of the highest public debt/GNP ratios in the world (Fig. 2.5), whenboth domestic and foreign indebtedness are combined. As a result, theinterest on public debt now absorbs a huge 10 of GNP per year.

2.53 The build-up of public debt would be less important if the economywere growing at a rate faster than the interest rate. In that case, thegrowth in GNP is typically a lower bound for the growth in financial assets ofan average middle-income developing country. Thus, the amount of new borrow-ing that the public sector could do by just maintaining its share of totalfinancing would more than offset the amount of interest that would have to bepaid. In fact, the noninterest public sector accounts (i.e. the primarybalance, discussed in Volume II, Chapter 2) could show a sizeable deficitwithout any tendency for debt/GNP to rise. When the growth of GNP slows belowthe interest rate, however, interest payments cannot be covered by new borrow-ing without a dangerous climb in the debt/GNP ratio. Instead, the primary

HOLDINGS OF FEDERAL GOVERNMENT DEBT1987

Bitewal (5.7%)Multilater (3.4%)

Social SecurityEXTERNAL DEBT (38.5%)

Foreign Market

INTERNAL DEBT

s~~~~~~~~~~~~~~~~~~ni

Other Domesficlnstitons (2.5%)

Corporations (5.7%)Ofer Financial Insfftiuions

Central Bank (2.0%) (19.0%)

ca*.41974a

11%

INTERNATIONAL COMPARISON OF PUBLIC DEBT150 -

140 - 137.1

130 - ;3

120 - DomesUc Debt

110 106 105.6 ZI Foreign Debt

100-

90 87

CL80

70 ~~~~~~67.1 '

60 9. 58 55.8 55.4 55.352

50 447 44.4 4

40 - 00

30 6- 25

20 -

104359

0 r~~~~~~~~~ .

'T00~~~~~~~~~~4C4

- 30 -

balance must be brought into surplus to generate the resources to payinterest. Malaysia is in this latter situation.

2.54 Given the sizeable spread between the interest rate and GNP growth,the debt/CNP ratio in Milaysia will continue to rise unless the primarydeficit is brought into surplus. The urgency for undertaking adjustmentquickly rather than permitting further rises in the debt ratio stems from twofactors. First, the already high public debt/GNP ratio suggests that the roomfor further increases is limited without eventually being faced with theunpleasant choices now confronting many highly-indebted developing countriesand developed countries--namely, the need to reduce deficits in an environmentwhere entitlement programs and contractual spending obligations are so greatthat major cuts in discretionary programs must be made to have any impact onthe budget. Second, the fact is that as the debt ratio is allowed to rise,the primary surplus required to eventually stabilize further growth becomeslarger. That is, the cost of postponing adjustment is to mandate morecontractionary fiscal policies in the future, prejudicing long-term growth.

2.55 A quantitative evaluation of the trade-offs involved is presented inTable 2.10 which shows the results of some simulation exercises in whichsustainable deficits, measured inclusive and exclusive of interest payments,are calculated. The results depend on alternative long-run debt/GNP ratios(shown in each row), and on t47 differential between interest rates and growthrates (shown in each column).- For example, if the initial debt/GNP ratio is140X, and the interest rate exceeds the growth rate by 2 percentage points, aprimary surplus of 2.91 of GNP would be required to maintain the debt ratiounchanged. Lower surpluses could cause an increase in the debt ratio, whilehigher surpluses would lead to a decrease. These results make allowance forthe fact that not all deficit financing leads to debt creation. A certainportion may be monetized in a growing economy with low but positive infla-tion. Another adjustment is made for valuation changes in external debt whichcan affect the debt/GNP ratio even in the absence of new flows of externalborrowing.

2.56 The figures in the table illustrate the trade-off between short-runexpansion and long-run contraction in fiscal policy. For any positiveinterest/growth differential, the higher the debt ratio is allowed to growthrough expansionary short-run fiscal policy, the more contractionary thelong-run primary surplus must be to eventually stabilize the debt ratio. Thefigures also demonstrate that when growth slows and interest rates rise, amajor contraction in fiscal policy is required to prevent a surge in thedebt/GNP ratio. This is what has happened, internationally as well as domes-tically, in the 1980s. There has been a shift from an environment wheregrowth exceeded the interest rate by about two percentage points in the late

9/ These exercises are, of course, only indicative as they treat importantvariables, such as the interest rate and the growth rate, as given,whereas in reality both will interact with the level of the publicdeficit. See Vol. II, Chapter II for additional details on themethodology.

- 31 -

1970s to one where the interest rate now exceeds growth by about the samemargin. For debt/CNP ratios in the range 130-140X, the impact of this changein the economic environment is to mandate a six percentage point reduction inthe public deficit/CNP ratio in order to avoid further debt build-ups.

Table 2.10: SUSTAINABLE LONC-RUN PUBLIC SECTOR DEFICITS(percent of CNP)

Interest-growth differential -2 -1 0 1 2Debt/CNP ratio (2) (percentage points)

120 Primary deficit 2.9 1.5 0.2 -1.2 -2.5Overall deficit 12.5 11.1 9.8 8.4 7.1

130 Primary deficit 3.1 1.6 0.2 -1.3 -2.7Overall deficit 13.5 12.0 10.6 9.1 7.7

140 Primary deficit 3.3 1.7 0.2 -1.4 -2.9Overall deficit 14.5 12.9 11.4 9.9 8.3

145 Primary deficit 3.4 1.8 0.2 -1.4 -3.0Overall deficit 15.0 13.4 11.8 10.2 8.6

150 Primary deficit 3.5 1.8 0.2 -1.5 -3.1Overall deficit 15.5 13.8 12.2 10.5 8.9

160 Primary deficit 3.7 1.9 0.2 -1.6 -3.3Overall deficit 16.5 14.7 13.0 11.2 9.5

Note: Interest rate assumed fixed at 8%; inflation at 21; US dollardepreciation at 3Z. Allowance is made for some non-debt monetaryfinancing consistent with inflation (seignorage) and for the valua-tion adjustments associated with currency realignments on externaldebt. Negative sign indicates a surplus.

Source: Bank staff calculations.

2.57 The interest rate in Malaysia is now expected to exceed the growthrate by about 2 percentage points. To stabilize the debt ratio at currentlevels of 137Z of GNP, the 1988 deficit would have to be reduced to 8%. Thisseems to be an unrealistic target. A more reasonable phased deficit reductionshould aim to stabilize the debt ratio by 1991 at a level of 145% of GNP.This would imply that the primary deficit should shift from its current levelof -2.7X to a surplus of 3.0% by 1991--a substantial, but not unrealisticfiscal adjustment.

2.58 The simulation exercise demonstrates that the problems faced by theMalaysian Government in achieving fiscal adjustment, i.e., in reducing thedeficit to a level that is sustainable without an exponentially increasing

- 32 -

debt ratio, have become more acute because of the slowdown in growth. At thesame time, the slowdown in growth is related to the way in which the adjust-ment has been made. Adjustment can be achieved through tax increases, reduc-tions in subsidies or expenditure cuts in different areas, but each approachhas a different impact on growth. In Malaysia, the bulk of adjustment wascarried out by cutting expenditure, particularly development expenditure, witha disproportionate reduction in infrastructure spending. This was, however,the most costly form of adjustment in terms of foregone growth since infra-structure investment is an important determinant of private investment (seepara. 3.87 below). As a result, the aggregate reduction in domestic demandwas a multiple of the reduction in public investment.

2.59 From a growth perspective, the least costly way of reducing adeficit is by increasing government revenues and reducing subsidies, as longas these can be done in a nondistortionary fashion. Measures such as broaden-ing the tax base, eliminating exemptions, and increasing lump-sum or landtaxes in line with property revaluation, are examples of such nondistortionarytaxes. Unfortunately, the tax effort in Malaysia over the period 1982-87 hasnot been successful in these areas. For example, it is estimated that 75Z ofdomestic manufacturing production and imports are exempt from the sales tax,ane that the average effective rate is less than 2Z of the value of sales.More and more distortions have arisen through capital-cheapening investmentallowances, discretionary granting of exemptions, and a narrowing of the salestax base. These coexist with high statutory corporate income tax rates anddevelopment taxes. Some progress, however, has been made in the 1988 budgettowards improving the contribution of the tax effort towards fiscal adjust-ment.

2.60 Maintaining expenditures and using higher revenues to cut thedeficit helps growth because the private sei8yr is thought to have a lowerpropensity to spend than the public sector. - The same arguments suggestthat cutting income transfers and subsidies to the private sector would be aseffective as raising taxes, and potentially even better because such measureswill often be associated with the removal of distortions that have beenartificially created by public programs. As in the case of taxes, however,there has been little success in this regard until recently. For most of the1980s, government outlays for items not directly related to real consumptionor investment rose sharply despite declining interest rates. By 1987, only60% of all government financial expenditure added directly to domestic demandfor real goods and services. The remainder was dissip4ted in transfers,subsidies, loans, debt service and other financial obl-gations. Cutting backon these areas would be less damaging for growth then cutting direct expendi-ture.

Rising Wages and Falling Profits

2.61 In the 1970s, Malaysia was most vulnerable to external pricedevelopments in its major agricultural primary commodity exports. However,

10/ The classic "balanced-budget multiplier" in Keynesian economic analysis.

- 33 -

mechanisms have evolved in the modern plantation sector to distribute thegains and losses from commodity price swings in an equitable fashion betweenprofits and wages through explicitly incorporating productivity clauses andprice bonuses in wage contracts. This has serv d to protect profits during adownswing and to reward workers during the upswing of commodity price cycles.

2.62 More recently, the price of petroleum has become a major componentof the overall terms of trade. However, the built-in stabilizers present inagricultural commodity contracts are not prrsent in petroleum or gas produc-tion. The recent collapse in energy prices led to a sharp reduction innational income, concentrated in a decline in profits and indirect taxes. Ineffect, the Government absorbed the terms of trade losses, and has not yetdistributed the burden over the rest of the economy.

2.63 While profits have been declining, wages have been increasing. Thechanging distribution of national income in favor of wages is shown inFigure 2.6. It is apparent that the wage share was roughly stable in the1970s, at about 50Z of national income, but has since risen sharply, espe-cially in the last three years of declining or stagnant income. The data inFigure 2.6 is obtained as follows. Average compensation to wcrkers isobtained from the Ministry of Labor. This is multiplied by total employmenttaken from the Treasury's Annual Sconomic Report to give the wage bill.Indirect taxes are broken out from Federal Government revenue. Profits arederived as a residual, using the national accounts identity between GNP andthe sum of wages, profits and indirect taxes. Such a measure imputes anaverage wage to all workers, including the self-employed. In this sense, themeasures are not comparable to national accounts where no imputation ofreturns to labor for the self-employed is made. It is interesting to note,however, that national accounts figures also show a rise in the share of wagesin value added from 38% in 1978 to 401 in 1983. Furthermore, profitabilitydata from the Financial Survey of Companies reinforce the finding of acollapse in profitability after 1984.

2.64 In 1985 and 1986, both wage rates and the total wage bill continuedto rise, despite growing imbalances in the labor market reflected in risingunemployment. Several factors influenced this rise. First, labor contracts,which are typically negotiated over a three-year cycle, still reflected thegenerous awards that were typical of the tight labor markets of the 1982-84boom. Thus, although the marginal wage for new entrants turned down in 1985compared to 1984, average real wages in all sectors (with the possible excep-tion of private services) continued to increase. Second, the high cost ofretrenchment built into labor contracts implied a temporary surge in wagepayments during the recession years when lay-offs were taking place. Third,other elements of inflexibility, such as fixed overtime and bonus allowances,EPF contributions and seniority provisions, also imparted an upward bias towages. Finally, although new nominal wage increase have been held to minimallevels, the absence of significant inflatiorc has meant that workers have notsuffered substantial eros;on in their real wages. The downward stickiness ofnominal wages for existin, workers has precluded a rapid real wage adjustmentexcept for new entrants.

DECOMPOSMON OF GNP BY INCOME SOURCESMalaysi, 1972-87

80 -

74.2Profit 71.8

70 - 69.8Es Indirect Tax 65.2 65.9

wjage 59.760-

55.6

51.450-

40-C ~~~~~~~~~~~~~~36.2

31.1

30 - ~~~~~~~27.0

21.9 21.6 ooo,

20 -18.1

13.8

1 0

72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 X

rasc os~~~~1:

- 35 -

2.65 The cyclical factors associated with the terms of trade decline in1985-86 accentuated a structural trend of a rising wage share that had itsroots in the early 19809. During this time, government jobs accounted for 20Xof all new jobs created in the economy. As the average government real wagewas consistently at least 25% above the economywide average, there was a shifttowards a growing fraction of high-paid labor as the government sectorexpanded. Furthermore, the Government's countercyclical expenditure policyduring 1980-84 reinforced the absorption of workers in labor-intensive sectorssuch as construction. As a consequence, the overall elasticity of employmentwith respect to value added in this period was greater than one. Wage gainsalso outstripped productivity gains. This combination of a greater growth inemployment than growth in production and higher real wages has generated therise in the wage share.

2.66 The wage share has also been affected by changes in governmentpolicy responses to external shocks. External shocks were formerly absorbedthrough flexible agricultural contracts, but with the underlying structuralmovement in the economy towards the volatile oil and gas sector and thegreater emphasis on countercyclical spending, external price shocks haverecently been absorbed by the Govcrnment. At an aggregate level, this isobserved from the correlation between the wage share and the terms of tradeindex. For the period 1974-80, this correlation coefficient is 0.06-that is,the terms of trade had almost no effect on income distribution in the economy,a sound testament to the effectiveness of contracting techniques in theplantation sector. For the period 1980-87, however, the correlation betweenthe terms of trade and the wage share is -0.61--that is, a fall in the termsof trade was strongly associated with a rise in the wage share, an indicationof the protection afforded wage earners against external shocks. Such protec-tion, however, can only be temporary. As Government debt and debt servicebuild up, the fiscal stance must contract and the terms of trade losses bepassed through into the economy.

2.67 The corollary of a rising wage share is a falling share ofprofits. Around 1980, profits represented about one third of national pro-duction; by 1985-87 they had fallen to one fifth. The fall in profits is themajor explanatory factor behind the recent fall in investment; changes inprofits explain about 80X of changes in private investment (see paras. 3.83ff. below). With the recovery of profitability in the second half of 1987 and1988, following the terms of trade improvements, wage declines and the ringgitdepreciation, there is good reason to expect a recovery of investment. Tosustain this in the medium-term, however, will require more flexibility inwages if and when the external environment deteriorates again.

The Mismatch between Risks and Rewards

2.68 For the economy as a whole, total investment must equal domesticsavings plus foreign savings. The close relationship observed between profitsand investment, however. does not imply an equally close relationship betweendomestic savings and investment. One major weakness apparent in the Malaysianeconomy is the seeming inability to transform high levels of private domesticsavings into equally high levels of private domestic investment. Instead,private savings in the 1980s have been used to fund substantial public sector

- 36 -

deficits and, more recently, to permit a build up in external reserves ayltofinance privatge sector capital outflows and foreign asset accumulation.-

2.69 A useful tool to analyze the final disposition of private savings isa flow-of-funds account. Although this is unavailable in sufficiently dis-aggregated form in official statistics, a flow-of-funds matrix can be compiledfrom data in a variety of sources. The disadvantage, of course, is that thedata may not be mutually consistent and, for some items, may not exist fromprimary sources. In the latter situation, estimates can sometimes be derivedby the residual method, utilizing the property of the matrix that totalsources of funds must equal total uses. This, of course, is not a fullysatisfactory solution, as it tends to accumulate all data errors and inconsis-tencies into a single entry. The numbers shown in the flow-of-funds tablesincluded here should therefore be treated as illustrative of general trendsrather than as definitive in their own right. Detailed data sources and adescription of the methodology used in compiling the tables are presented inAppendix 2.

2.70 The overall flows-of funds for 1980, 1985 and 1986, respectively arepresented in Tables 2.11-2.13. The year 1980 was taken as the most recentperiod before serious internal and external imbalances developed and serves asa proxy for a "normal" year. More recent years, 1985 and 1986, represent aperiod of distress, especially for the private corporate sector. The differ-ence between the flows in the early and recent periods shows the impact ofadjustment policies and external shocks oa domestic financial intermediation.

2.71 In the flow-of-funds tables, the economy is divided into threesectors: public, private non-financial, and financial intermediaries. Wherepossible, these are further subdivided: general government and public enter-prises; corporations and households; the banking system, provident funds andother nonbank financial intermediaries. This last category includes insurancecompanies, farmers' organizations, the Permodalan Nasional Berhad (PNB), TabunHaji (Pilgrim's Fund), building societies and cooperative, development andsavings banks. An external sector is also added to complete the circulationlinks.

2.72 For each sector of the economy, estimates are made for savings andfixed capital formation. The difference bettween these items represents a netaccumulation of financial assets which can be further broken down into changesin loans or deposits with different financial intermediaries, and holdings ofcash, securities, equity and other financial instruments.

2.73 The major trends between 1980 and 1985-86 are striking. The firstrow in the tables shows that gross national savings inc-eased perceptibly over

11/ The foreign asset accumulation by the Malaysian private sector is anormal response in an economy with open capital markets, to the desirefor diversification. The ratio between domestic and foreign assets willchange according to interest rate and exchange rate expectations, leadingto capital outflows or inflows according to underlying conditions.

Table 2.11: FLOW OF FUNDS4 OVERVIEW, l980(M$ btllion)

PrivatePublic sector nonfinancial sector FNnancial Intermedlaries

Cor- Banking Provident External GrossGovernment NFPEs /a porations Households system fund Other sector Change nationalUse Source Use Source Use Source Use Source Use Source Use Source Use Source Use Source in stock Total savings

NonfinancialSavings - -2.6 - - - 10.5 - 7.5 - 0.0 - 0.0 - 0.0 - 0.8 - 16.2 15.4Capital outlays 6.2 - - - 8.9 - 1.5 - 0.0 - 0.0 - 0.0 - - - -0.4 16.2 -

FinancialSavings-capital inv. -8.8 - - - 1.6 - 6.0 - 0.0 - 0.0 - 0.0 - 0.8 - - -0.6Net financial Inv. -8.8 - - - 1.6 - 6.0 - 0.0 - 0.0 - 0.0 - 0.8 - - -0.6

Total FinancialUses and Sources 1.2 10.0 - - 9.2 7.6 8.3 2.3 10.0 10.0 2.0 2.0 2.2 2.2 3.1 2.3 - -

Depgults8anking system 1.0 - - - 2.1 - 2.2 - - 6.0 0.3 - 0.4 - - - -Provident funds - - - - - - 2.0 - - - - 2.0 - - - - -Other - - - - - - 1.3 - - - - - - 0.8 - 0.5 -Currency - - - - - - 0.6 - - 0.6 - - - - - - -

LoansBanking system - 0.1 - - - 5.3 - 1.4 7.0 - - - - 0.2 - -Provident fund - - - - - 0.1 - - - - 0.4 - - 0.3 - -Other financial - - - - - - - 0.2 - - - - 0.2 - - -Direct - 1.2 - - 1.3 - - - - - - - - 0.1 - -Government - - - - - - - - - - - - - - - -Foreign - 1.6 - - - - - - - 1.0 - - - - 2.6 -

SecuritiesBanking system - 1.0 - - - - - - 1.0 - - - - - - -Provident fund - 1.1 - - - 0.1 - - - - 1.2 - - - - -Other financial - 0.2 - - - 1.3 - - - - - - 1.5 - - -Direct - - - - 0.5 - - - - 0.5 - - - - -

Equi tyBanking system - - - - - - - - - - - - - - - _Provident fund - - - - - 0.1 - - - - 0.1 - - - - -Other fLnancial - - - - - - - - - - - - - - -Government 0.2 - - - - - - - - 0.2 - - - - - -Direct - - - - - 0.3 0.7 - - 0.5 - - 0.l - - _

OtherDomestic - 4.8 - - 4.8 - 1.5 0.7 0.7 0.7 - - - 0.8 - -Foreign - - - - 0.5 - - - 1.3 0.5 - - - - 0.5 1.8Stock change - - - - - 0.4 - - - - - - - - -_

/a A breakdown by NFPEs is not available for 1980. These are Included in the corporate sector.

Table 2.12: FLOW OF FUNUS: OVERVIEW, 1985(M$ billion)

PrivatePublic sector nonflnancial sector Firancial intermediaries

Cor- Banking Provident External GrossGovernment NFPEs porations Households system fund Other sector Change nationalUse SourcUs ese SourcSource ource Use Source UTs- Source Use Source Usou rcurce Use Source in stock Total savings

NonfinancialSavings - 1.4 - 5.5 - -3.0 - 15.7 - - - - - - - 1.7 - 21.3 19.6Capital outlays 7.2 - 5.0 - 7.4 - 2.4 - 0.4 - 0.2 - 0.5 - - - -1.8 21.3 -

FinancialSavings-fixed inv. -5.8 - 0.5 - -10.4 - 13.3 - -0.4 - -0.2 - -0.5 - 1.7 - - -1.8Net financial inv. -5.8 - 0.5 - -10.4 - 13.3 - -0.4 - -0.2 - -0.5 - 1.7 - - -1.8

Total FinancialUses and Sources 1.3 7.1 4.0 3.5 - 10.4 15.7 2.4 10.2 10.6 3.9 4.1 2.9 3.4 7.1 5.4 - -

DepositsBanking system 0.5 - 1.2 - - - 3.7 - - 5.8 -0.2 - 0.6 - - - -Provident funds - - - - - - 4.1 - - - - 4.1 - - - - -Other - -- - 3.9 - 0.1 - - - - 1.0 3.0 - -Currency - - - - - - 0.2 - - 0.2 - - - - - - -

LoansBanking system - 0.1 - -0.7 - 5.7 - 2.4 7.5 - - - - - - -Provident fund - - - 0.1 - - - - - - 0.6 - - 0.5 - -Other financial - - - - - - - - - 0.2 - - 0.2 - - -Direct - - - - - - 0.4 - - - - - - 0.4 - -Government - - - 0.9 - - - - 0.9 - - - - - - -Foreign - 1.0 - 1.0 - 0.2 - - - - - - - - 2.2 -

SecuritiesBanking system - -1.9 - 0.1 - - - - -1.8 - - - - - - -Provident fund - 3.4 - 0.1 - - - - - - 3.5 - - - - -Other financial - 0.4 - 0.5 - 1.2 - - - - - - 2.1 - - -Direct - 1.8 1.8 - - - - - - - - - - - - -

EquityBanking system - - - - - - - - - - - - - - - -Provident fund - - - - - - - - - - - - - _ _ _Other financial - - - - - - - - - - - - - - - -Government 0.8 - - 0.6 - - - - - 0.2 - - - - - -Direct - - - 0.3 - 0.3 1.9 - - 0.8 - - - 0.5 - -

OtherDomestic - 2.1 2.1 - - 0.0 1.5 - - 0.5 - - - 1.0 - -Foreign - 0.2 -1.1 - - 1.8 - - 3.5 2.9 - - - - 4.9 2.4Stock change - - - 0.6 - 1.2 - - - - - - - - - -

Table 2.13: FLOW OF IFUNDS: OVERVIEW, 1986(M$ billion)

PrivatePublic sector nonfinancial sector Financial intermediaries

Cor- Banking Provident External GrossGovernment NFPEs porations Rouseholds system fund Other sector Change nationalUse Source Use Source Use source Use Source Use Source Use Source Use Source Use Source in stock Total savings

NonfinancialSavings - -0.2 - 2.2 - 0.1 - 14.9 - - - - - - - 0.8 - 17.8 17.0Capital outlays 7.4 - 3.8 - 5.6 - 1.6 - 0.2 - 0.2 - - - - - -1.0 17.8 -

FinancialSavings-capital inv. -7.6 - -1.6 - -5.5 - 13.3 - -0.2 - -0.2 - - - 0.8 - - -1.0 -

Net financial inv. -7.6 - -1.6 - -5.5 - 13.3 - -0.2 - -0.2 - - - 0.8 - - -1.0 -

Total FinancialUses and Sources 0.4 8.0 1.0 2.6 -1.0 4.5 16.1 2.8 9.0 9.2 4.0 4.2 3.5 3.5 6.5 5.7 - - -

DepositsBanking system -0.1 - 0.8 - -1.0 - 3.3 - - 3.3 0.1 - 0.2 - - - - - -

Provident funds - - - - - - 3.9 - - - - 3.9 - - _ _ - _ _Other - - - - - - 3.3 - - - - - - 1.2 - 2.1 - - -

Currency - - - - - - 0.4 - - 0.4 - - - - - - - - -

LoansBanking system - 1.3 - - - 0.3 - 1.9 3.3 - - - - -0.2 - - - - -

Provident fund - - - - - - - - - - 0.2 - - 0.2 - - - - - 0Other financial - - - 0.4 - 0.6 - 0.9 - -0.1 - - 1.8 - - - - - -

Direct - - - - - - 0.4 - - - - - - 0.4 - - - - -

Government - - - 0.8 - - - - 0.8 - - - - - - - - - -

Foreign - 1.2 - 0.2 - 0.2 - - - - - - - - 1.6 - - - -

SecuritiesBanking system - -0.1 - - - 0.1 - - - - - - - - - _ _ _ _Provident fund - 3.4 - 0.1 - 0.1 - - - - 3.6 - - - - - - - -

Other financial - 0.4 - 0.3 - 0.5 - - - - - - 1.2 - - - - - -

Direct - 1.3 1.3 - - - - - - - - - - - - - - - -

EquityBanking system - - - - - - - - - - - - -Provident fund - - - - - 0.1 - - - - 0.1 - - _ _ _ _ _ _Other financial - - - - - - - - - - - - - - - - - - -

Government 0.5 - - 0.3 - - - - - 0.2 - - - - - - - - -

Direct - - - - - 0.2 -0.6 - - 0.5 - 0.3 - -1.6 - - - - -

OtherDomestic - - - 0.2 - 0.3 5.4 - 0.2 1.9 - - 0.3 3.5 - - - - -

Foreign - 0.5 -1.1 - - 1.4 - - 4.7 3.0 - - - - 4.9 3.6 - - -

Stock change - - - 0.3 - 0.7 - - - - - - - - - - - - -

- 40 -

the period, as expected in a time of rising national income. The generalgovernment marginally increased its "savings", from minus M$2.6 billion toplus M$1.4 billion in 1985 and minus M$0.2 billion in 1986. These figuresinclude adjustments made for the portion of development expenditure that doesnot represent capital formation, and for other balancing items such as profitsof Bank Negara. They therefore differ from the standard figures for publicsavings that reproduce the overall public sector's operating surplus ordeficit. The corporate sector, however, showed a sharp decline in savings.In 1980 the NFPE surplus was only about M$0.3 billion, but the private corpo-rate sector had savings of about M$8.7 billion. In 1985 and 1986, however,private firms appear to have been dissaving--that is, running down financialassets by more than they increased capital formation. In contrast, householdson average doubled their savings in 1985/86 relative to 1980.

2.74 The substitution of household savings for corporate savings is adistinctive feature of the 1980s. It is consistent with the trend noted abovetowards a rise in the share of wages in national income. It is also sympto-matic of a period when the returns generated by financial intermediaries, suchas EPF, PNB and LUTH, have been consistently high and positive in realterms. These returns accrue to the households owning unit trust shares; theirincrease over the period has added substantially to household income andsaving.

2.75 Associated with the fall in corporate savings is a fall in corporateinvestment. In 1980, the private corporate sector was able to fully fund itsown investments. While making significant use of the banking system, thecorporate sector deposited and withdrew roughly balanced amounts. By the mid-1980s, they were heavy net recipients of funds. Furthermore, throughout the1980s, formal equity markets played a very small role in raising capital. Theimplication is that corporate balance sheets must have deteriorated signifi-cantly over this period, making it increasingly difficult for lenders to findcommercially viable companies without a heavy overhang of existing debt.

2.76 As the source of savings shifted, the structure oc financial inter-mediation has also adjusted. Despite a 40% rise in nominal incomes, thebanking system intermediated the same nominal amount of new flows in 1985/86as in 1980--around M$10 billion. In 1980, this represented 70% of total newfinancial intermediation; by 1986 it had fallen to 55%. The big gainers werethe EPF, which doubled the size of its annual flows in the five-year interval,and other intermediaries, which grew by 50%. The latter trend illustrates thegrowing importance of deposit-taking cooperatives. Recent scandals andfinancial failures among these institutions attest to the danger of rapidrealignment in financial structures prior to the establishment of provensystems for monitoring and regulation by the Central Bank.

2.77 The rationale behind the growth of EPF and other nonbank financialcompanies and the stagnation of the banking system is explained by comparingthe returns to individual investors in these entities. Table 2.14 comparesthe annual dividend for PNB/ASN and EPF with the savings deposit rate ofcommercial banks, the total return on the Kuala Lumpur Stock Exchange (KLSE)and GNP growth, which serves as a proxy for some other diversified investmentportfolio. In terms of the size of the return and the stability of the yield,

- 41 -

the trust funds clearly offer preferred investment instruments. Investors,particularly those in PNB/ASN, have been well protected against the downturnin the economy, but at the same time benefited handsomely in the boom years of1981-84. In addition, the trust funds have strong backing from the FederalGovernment, further reducing their risk, and legislated privileges whichpermit them access to profitable transactions at minimal risk (for example,PNB's take-over prerogatives).

Table 2.14: NOMINAL RATE OF RETURN BY INSTITUTION, 1981-87(X)

1981 1982 1983 1984 1985 1986 1987

PNB/ASN 20.0 18.0 18.0 17.2 17.2 10.0 10.0EPF 8.0 8.0 8.5 8.5 8.5 8.5 8.5

Commercial bankSavings deposits 7.0 6.5 6.0 7.5 6.0 6.0 4.020 + year governmentsecurities - - - 8.6 8.6 8.6 7.6

KLSE 13.9 -18.9 40.8 -19.3 -17.6 12.8 0.5(ONw dividend) (4.6) (4.6) (3.0) (5.1) (5.5) (4.7) (4.1)

Memo: GNP growth 8.2 7.4 9.2 13.9 -3.2 -8.3 5.9

Source: Economic Report of the Treasury; PNB and EPF Annual Reports; KualaLumpur Stock Exchange.

2.78 Government's involvement in the trust funds, particularly PNB, isclosely tied to the broader objectives of the NEP, under which funds aremobilized from the Bumiputera community to purchase assets in trust for thecommunity. However, the policy of implicitly guaranteeing high returns at lowrisk, which was thought necessary for such mobilization, has built up thetrust funds at the cost of introducing distortions in the structure of finan-cial intermediation. It also seems likely judging from the flow-of-fundstables, that this policy has diverted funds that would otherwise have goneinto the banking system rather than creating a pool of new savings. Thecommon practice of banks' extending loans to individuals for the purpose ofpurchasing ASN units illustrates the same tendency.

2.79 The major implication of the shifting structure of funds is that thesupply of risk-capital to corporations is being squeezed. Nonbank financialinstitutions such as pension funds and insurance companies have a strong

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proclivity to invest in low-risk assets such as government bonds. The EPFhas also established a small housing finance subsidiary (MBSB) to enter thelucrative mortgage market. The commercial banking system has also stronglyincreased its mortgage activity, reflected in a rise in lending to householdsin the flow-of-funds tables. In 1986, however, the banks expanded their loansto the corporate sector by only M$300 million. Liquidity is available--thedifficulty is in finding creditworthy borrowers prepared to pay a sufficientpremium over bench-mark long-term Treasury bonds to cover the additional risk.

2.80 Interest rates in competitive capital markets, such as those inMalaysia, are primarily determined by two factors: the risk-free interestrate and a premium that must be added to compensate for the riskiness of anyparticular loan. In Malaysia, the risk-free interest rates on medium- andlong-term bonds have been maintained at attractive positive levels which,despite the surge in funds seeking low-risk investments, have not come downbecause of the administrative process for determining rates in the absence ofa well-functioning secondary market in government securities. This in turnraises the cost of funds for all other medium-term loans. Meanwhile, theshift of funds to institutions less willing to take risk has increased thepremium charged on risky assets. As a result, funds are available for low-risk activities--witness the dramatic fall in short-term lending rates andinterbank loans in 1987--but not for higher risk activities such as capitalformation in manufacturing.

2.81 In the future, as the EPF continues to expand, the mismatch in theflow of funds will likely worsen unless corrective measures are instituted.As the Government brings its deficit under control and starts to issue evenfewer securities and at lower rates, the rising cash surpluses of the nonbanksector will be hard pressed to place their funds in prudentially soundareas. Yet institutions such as the Provident Fund cannot be expected tobecome venture capitalists; this is too speculative and, as occurred in thePhilippines, can compromise the financial integrity of the institution and ofindividuals' retirement benefits. Instead, sound institutions such as thedevelopment banks should be encouraged to tap these funds through their ownbond issues and to be more aggressive in taking on commercial risk for anappropriate premium.

Structural Unemployment

2.82 The stubborn increase in the unemployment rate since 1982 suggeststhat market mechanisms on their own may be insufficient to restore fullemployment. Furthermore, the fact that unemployment has continued to rise inyears of rapid growth (1983, 1984 and 1987) as well as years of slower growth,indicates that the problems are of a structural nature combined with cyclicalfactors associated with the recession. In such an environment, classicalKeynesian-type measures to reduce unemployment by stimulating demand are

12/ This is appropriate, given the prudential obligations of these entities.In the case of EPF, governing regulations require at least 70% of totalinvestments be held in government securities.

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unlikely to be successful and may even disrupt and slow-down equilibratingmarket forces. It is unlikely that higher demand will make an immediatesignificant dent in unemployment because (i) high costs of retrenchment havecreated a situation of labor hoarding in the work-place, so increased outputwould be met through greater productivity not increased employment and (ii)search activities would remain high.

2.83 Care must be taken in interpreting unemployment numbers in Malaysia,especially when making international comparisons, because of differences incoverage across countries. In Malaysia, the unemployed include those notactively looking for a job, but who would be prepared to work if the rightopportunity (or wage) should arise. These account for over one-half ofcurrent unemployment. They are mostly recent school-leavers; the incidence ofunemployment is highest for those completing secondary education, and lowerfor those with no formal education and primary school leavers. This lattergroup are largely from poor households and cannot afford to be unemployed.Despite the considerable attention focussed on them, unemployment rates arealso low for college graduates. Overall, the unemployed tend to be young(about 75X aged less than 25), reasonably skilled, and prepared to wait forappropriate work. The incidence of unemployment is almost the same in ruraland urban areas.

2.84 Some indication of the nature of unemployment can be gleaned fromthe Labor Force Surveys. About 80Z of the middle and upper secondary schoolleavers were "waiting for answers" to previous job enquiries, rather thangiving as reasons for their unemployment "unqualified" or "no suitable jobavailable." Given that tne duration oi unemploymenL is lusi than si wnthsin two-thirds of the cases, and that a very small proportion of unemployment(perhaps 1X) is due to retrenchment of existing workers, the data stronglysuggests that the problem is not one of an aggregate shortage of jobs, butrather of extended "search" as adjustment in wage expectations and specificjob opportunities occurs.

2.85 There are three reasons why unemployment has risen in the past fiveyears: (i) a fall in demand for labor, a consequent development of a two-tierlabor market characterized by a large disparity in wages for similar occupa-tions and, hence, a need to explore alternative job opportunities; (ii) ademographic bulge in the increase of young entering the labor force amidbottlenecks in the higher education system preventing the absorption of 18 to19 year-olds into universities; and (iii) a reluctance by the young to acceptwork at wages half of those received by a five-year older cohort.

2.86 A disparity amongst wages for similar jobs primarily reflects thetiming of entry into the labor market. Given the very low inflation ratesthat have prevailed recently, even small or zero increases in the nominal wagehave been insufficient to bring down the average real wage of workers hiredbefore 1984. These workers were able to obtain relatively high wages becauseof a temporary tightness in the labor market following the construction boomand rapid expansion in government. With the onset of a recession and thedecline in the terms of trade in 1985-86, it was necessary for real wages tofall to share the burden of income losses. The burden of adjustment, however,fell almost entirely on new entrants to the labor force as incomes of those in

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existing jobs were protected through contracts. The upshot has been theemergence of a two-tier labor market, wherein workers employed on the basis ofsalary scales prevailing before 1984 have substantially higher wages (aboutdouble, abstracting from the three years experience differential) than currentnew entrants for equivalent work.

2.87 Not all firms are prepared to implement two-tier compensationsystems. Problems in terms of worker morale and low productivity can arise.In Government, abandoning the principle of equal-pay-for equal-work runscounter to a central philosophy of promoting equity. Thus, a differential inwages across jobs has arisen, and the young spend time in searching for thebest paid job. Given the existing rates of retirement, illness/death, andother factors affecting the turnover of "old" workers, the wedge between wagesis likely to persist for some time. The wedge is also sustained by the highcontractual costs of firing (on average six months pay), that prevents firmsfrom substituting low wage new workers for more expensive old workers.

2.88 In normal circumstances, the education system helps keep down theneed to search for appropriate work by matching the skills required by indus-try with those supplied to the student body. The education system, however,has been unable to keep pace with the rapid change in job markets. One recentfeature, for example, has been a sharp compression of wages across skilllevels, eroding the profitability of secondary education and vocationaltraining, but these programs have been slow to adapt curricula. The currenteducational structure is geared to a regime of relative wages that has beensuperseded by recent economic developments. Furthermore, the slowdown in therat- z. go-wth of uniL.ersity space bas exacerbated a bulge in the rate ofentry to the labor force of higher secondary school leavers and a correspond-ing unemployment incidence for this group almost four times higher than thatfor new college graduates.

2.89 Given the definition of unemployment in Malaysia, even those notactively looking for a job are counted as unemployed. In many instances, lowwages are likely to be a natural deterrent (the "discouraged worker"effect). Hence, it is not surprising that unemployment should rise in aperiod of declining wages, particularly when the difference between initialwage expectations and the realities of the job market is as great as it istoday. As wage expectations gradually adjust, however, unemployment numberswill also show a decline.

2.90 Although unemployment is expected to decline gradually as stronggrowth and wage adjustments act together to boost labor demand, government canassist in speeding up adjustment and in creating more resilient and flexiblelabor markets in several ways. The most immediate measure would be to reducethe wedge between old and new workers. One attractive way of achieving thisis to eliminate EPF contributions (on the part of both employees andemployers) for those under twenty-five. The impact of this is likely to be toincrease firm demand for labor, to increase the wage received in hand by theemployee, raising his willingness to work, and to speed up the process ofassimilating young workers into the labor force. The disadvantage, from thepoint of view of public finances, would be a reduced net investable surplus inthe EPF. This would, however, be small--only about 10.9% or M$500 million.

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2.91 This measure should not be viewed simply as a countercyclicaldevice, although its adoption at present will have a timely effect in stimu-lating demand for young workers. It has additional long-term merit. Oneconsequence of the growth/interest rate developments that have taken place isthat the profile of the expected earnings stream of a worker has been shifted;a greater portion of life-time income is being made available after retire-ment, while a correspondingly smaller proportion is available at youngerages. In fact, under current circumstances, a worker who enters the laborforce at age sixteen, and receives normal incremental wage increases as hisexperience grows, is likely to hf37 as much, or more, income in retirement asat any time in his working life.-, As expenditures are typically much lowerduring retirement than in middle-age, particularly as health care is free inMalaysia, the current contribution rates of the Provident Fund are excess-ive. A policy which exempted young workers up to age 25 would create anearnings time-profile more in line with desired life-cycle expenditures.

2.92 A second measure to reduce structural unemployment would be to giveto EPF a mandate to use its funding and institutional capability to promoteworkers' training and education. One approach is to simply allow members toborrow, up to a certain fraction, against their accumulated contributions tofinance training in selected courses, both formal and on-the-job. An alterna-tive is to make funds available to employers with the provisions that:(a) the worker agrees with the training program and (b) if the worker is laidoff following training, he should be reimbursed an amount proportional to thefunding provided and the time elapsed between training completion andretrenchment. A specific proposal in this regard is to allow enterprises todeducL 5Z ox' the cost of tcaining from the annual contributions to individualretirement accounts which must be made under present law. As the workerreceives the benefits of training in the form of higher wages, he stands togain considerably from participation in firm-sponsored training programs.Simulations indicate that this would not be expected to alter the EPF surplusto any significant extent. A 25 year-old worker who withdrew one year's totalEPF contribution (i.e., 20% of earnings) to invest in training with a rate ofreturn of 15%, would have a retirement income less than 1% lower than withoutundertaking the initial EPF withdrawal.

2.93 The use of workers' provident, pension and social security funds tofinance training and education is not new. Singapore, the Philippines and, ina somewhat different institutional context, Mexico all have such provisions.The idea is to create incentive structures that would make it in theemployers' and workers' self interest to rely less on retrenchment to adjustto changes in demand and technology and to depend more on continuous trainingand automatic adjustment of labor compensation with productivity change. Inessence, the EPF scheme would help reduce the risks associated with on-the-jobtraining faced by both workers and their employers.

13/ Retirement income is estimated to be 20-year annuity value of accumulatedlife-time EPF contributions and interest earned thereon, based on retire-ment at age 60 (see Appendix 3).

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2.94 Over the medium term, unemployment will only be held down by a wagecompensation system that is more flexible than the current one. One way ofintroducing flexibility is to amend the Employment Act to allow firms to offerprofit-based or productivity-based overtime and bonus pay in lieu of thelegally imposed fixed rate. In this way, the total compensation package canbe adjusted more quickly as macroeconomic conditions warrant (see Volume II,Chapter 3).

E. Overall Assessment

2.95 In the 1980s, Malaysia was faced with unprecedented commodity pricemovements, a general slowdown in international trade and growth and high realinterest rates. At the time, the Government's strategy was based on anaggressive expansion of public investment, both in infrastructure and indirectly productive activities. This quickly became financially untenable aslarge deficits emerged in the external current account and in fiscalaccounts. High inflation imported from the rest of the world into Malaysia'sopen economy generated further financial instability. Since 1982, the Govern-ment's policy dilemma has been how to cure the external and internal financialimbalances without derailing economic growth. The various combinations offiscal and monetary policy tried have been highly successful in bringing downinflation rates and restoring the current account to surplus. The cost,however, has been a low and uneven growth pattern in the last few years,ballooning public debt, and a worrying consistent decline in real privateinvestment.

2.96 By the standards of other developing countries, Malaysia hasweathered the shocks of the 1980s remarkably well. As a major primary commo-dity exporter, the magnitude of the external shocks with which it has had todeal have been disproportionately large relative to national income. Yet byits own standards set in the 1970s, current economic performance has beenweak. Then, too, the country was hit with substantial external shocks, butthese barely interrupted an impressively stable grcowth path. Why thedifference?

2.97 Our analysis indicates that changes in the source of externalshocks, in government policy responses, and in the external and internalenvironment all played a part. In the 1980s, the Government may have over-reacted to external shocks, underestimated response lags in the economy andmiscalculated the size of short-term/medium-term trade-offs, thereby accen-tuating rather than dampening the cycles. As both product and factor marketsseem to operate well in Malaysia, albeit slowly, price adjustments may haveprovided a more effective mechanism for equilibration if left to operate in astable macroeconomic environment.

2.98 One clear lesson from the 1980s is that countercyclical publicexpenditure cannot be used to raise growth rates permanently, and it can beused to increase current growth only at the expense of future growth. Higherexpenditure in one year must be offset by reduced expenditure (or highertaxes) in future years if public finances are to remain manageable. Giventhis, large changes in public expenditure are undesirable, with efficiencylosses likely both during upswings (when poor project selection, overdesign

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and inadequate supervision cause waste and cost overruns) and downswings (whenimportant expenditures, such as for maintenance are cut back). Malaysia isnow paying for the higher growth it enjoyed in 1981-84 by having to reducepublic expenditure. In the future, the cost will become even more apparent asthe deficit is finally brought under control.

2.99 The high cost of past countercyclical policies is due, in part, torecent changes in the international environment. The cost of such policies isminimized when growth rates are high and interest rates are low. Then, thefuture reduction in government spending is not so burdensome, relative tototal demand in the economy, and does not have to be so large to accommodatedebt service needs. Currently, both these variables-growth and interestrates-are at disadvantageous levels, and therefore a countercyclical policyis less attractive and should be less used.

2.100 Another factor reducing the effectiveness of countercyclical policyis the growing degree of unpredictability in commodity prices. Knowledgeabout whether a price ci.snge is permanent or temporary and about how long acycle is likely to last is a key ingredient in implementing an effectivecountercyclical program. Yet this information is increasingly more difficultto assess. Commodity prices, which in the past have been closely correlatedwith Winess cycles in the OECD, have gradually broken free of this relation-ship._ Petroleum prices have also grown more volatile. Taking a conserva-tive posture with respect to comodity prices would seem to be a more prudentpolicy than fine-tuning a response. In addition, because terms of tradecycles are so unpredictable and have such important financial consequences,the use of the development budget as the major instrument for macroeconomicadjustment to external price shocks is inappropriate. Other policy tools,including new instruments for debt management (see below), could be useful.

2.101 Efforts by the Government to respond to external shocks throughchanges in real expenditures have had undesirable side effects by creatinginflexibilities in the macroeconomy and postponing adjustment. One example ofthis inflexibility is the evolution of wages. A combination of factors,including expansionary public expenditure, the Government's role as a wageleader, downward stickiness in nominal wages and low inflation rates, have ledto a surge in wages in the key manufacturing sector which is far beyond theincrease in productivity levels. This has also occurred in other countries,like Korea and Singapore, but to a lesser degree. In Korea, however, risingdomestic unit labor cost" have been effectively offset through exchange ratepolicy, preventing any erosion in international competitiveness. In Malaysia,by contrast, the real exchange rate has moved along with the US dollar/Japanese yen exchange rate, rather than in response to terms of trade, incomegrowth or international competitiveness. The recession in Malaysia wascompounded by the fact that relative to Korea, Thailand and Hong Kong,Malaysia's competitiveness had eroded by 50% in just four years.

14/ P. Drucker, "The Future of the World Economy," Foreign Affairs, 1986.

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2.102 A corollary of the spurt in wages was a rise in the share of wageincome in total national income and a significant decline in profitability.This was supported by the Government's countercyclical policy and reinforcedby structural policies designed to further NEP objectives. Through expansionin nonfinancial public enterprises, promotion of financial institutions suchas PNB and EPF to mobilize funds from small savers, and other mechanisms, theGovernment has favored wage-earners and savers and penalized corporations andentrepreneurs. Other structural policies such as the increase in EPF contri-bution rates also contributed to the rise in the wage share.

2.103 While temporarily protecting wage incomes in the shortrun in the face ofdeclining national izicome, government policies have led to a fall in invest-ment, an inefficient pattern of resource allocation and a reduction in indivi-dual welfare.

2.104 Private investment has collapsed since 1984 despite a reduction in realinterest rates, ample credit in the economy and a liberalization of governmentlicensing requirements and bureaucratic procedures. The most important deter-minants of private investment are profits and public sector infrastructure,both of which have declined dramatictlay since 1984. Profits have beensqueezed by falling national income - and a rising wage share, while publicinvestment in infrastructure has borne the brunt of efforts to reduce theconsolidated public sector deficit.

2.105 At the same time, scarce investment resources are also being lessefficiently allocated. Private savings have shifted from the retained earn-ings of the corporate sector to savings by individual households. Additionalintermediation is required to transform these savings into productive invest-ment. In practice, and to a very significant extent in 1987, domestic privatesavings have not been channelled into domestic investment but into capitalflight and the accumulation of private foreign assets. This has resulted inpart because financial intermediation is increasingly taking place throughnonbank sources, such as provident and mutual funds, insurance companies andcooperatives, and less through the banking system.

2.106 Some degree of inefficiency is inevitable whenever attempts to restruc-ture society and redistribute income are made. If the redistribution issuccessful, however, the benefits of stability may well outweigh the costsinvolved. Nevertheless, it seems unlikely that the Government's policy ofprotecting wage earners' incomes from external shocks in the 1980s hasincreased substantially the general welfare. A strong indication of this isthat the Malaysian economy has not witnessed a major boom in real privateconsumption, despite the growth in wages. Instead, real per capita consump-tion steadily dropped through the 1980s, and has been just as volatile as GNP.

15/ The fall in national income may be attributed to a decline in externalcommodity prices and to a weakness in domestic demand followingreductions in commodity prices and government expenditure. The latterwill appear as falling sales and slower orders for firms.

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2.107 Overall, the challenge of converting financial successes in mobilizingdomestic resources and restoring health to the balance of payments into abasis for stable medium-term growth and employment generation still remains.Government is, however, to be commended for its macroeconomic and micro-economic adjustment efforts. The latter include liberalization of industriallicensing, easing of administrative procedures, strengthening of bank regula-tion, privatization and tax changes, all designed to reduce the cost to firmsof doing business. Detailed sectoral and subsectoral plans have also beenformulated to coordinate public and private actions. With these measuresalready in place, the rewards to overcoming the remaining structural weak-nesses highlighted above could be considerable.

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III. MEDIUM-TERM GROWTH PROSPECTS

3.1 Although it is now virtually certain that Malaysia will be unable toachieve the targets for income and employment envisaged in the Fifth MalaysiaPlan, there is considerable scope for regaining satisfactory income growthextending well into the 19909. The principal source of growth must be theindustrial sector led by manufacturing. Rapid growth in this sector, however,is conditional on three develypments. First, the trend in total factor pro-ductivity (TFP) growth rates,t which were negative in the early 1980s, mustbe reversed and the rates restored to their positive levels of the 1970s.Second, private investment in manufacturing, both from domestic and externalsources, must be resurrected. Third, demand for a broad range of manufacturedproducts must emerge. This implies broadening the export base beyond elec-tronics and textiles, and revitalizing domestic demand.

3.2 New initiatives should be taken in each of these areas. A restora-tion of efficiency requires further policy initiatives in privatization, inremoval of distortions in effective protection rates, in industrial restruc-turing at the subsector level and in firm-specific training and skills upgrad-ing. To energize private investment, profitability must be restored and theexchange rate/wage/productivity relationship carefully monitored to maintaininternational competitiveness. Lastly, if consumer demand is to play a lead-ing role, a greater share of income needs to be retained as discretionarycash-in-hand rather than as forced savings.

3.3 With suitable policy adjustments, the government is in a good posi-tion to reduce the uncertainties surrounding future growth. The advantageousshort-term prospects for Malaysia, based on rising commodity prices andresidual strength in global economic growth, should provide a valuablebreathing space which would allow for systematic and gradual policy innova-tions. The greatest dangers to fulfilling the country's growth potential liein impatience and complacency. Impatience could steer the authorities into anill-advised expansion in fiscal policy in an effort to reduce unemployment orspur private investment, if these do not improve quickly in spite of moderategrowth; while complacency in the face of an accelerated short-term recoverycould postpone adjustment and leave the economy vulnerable to a future commo-dity price downturn or global recession.

3.4 The discussion of medium-term growth prospects that follows looksfirst at the potential for aggregate output from a sectoral perspective andthen at an aggregate level, from an analysis of productivity growth and newcapital formation. Policies to strengthen performance in these areas areidentified. Next, the demand side is considered, particularly the prospectsfor private consumption and government spending. Finally, supply and demand

1/ The total factor productivity growth rate is a measure of efficiencygains in production. It is measured as the residual between the actualgrowth in output and the contribution to output growth of growth incapital, labor and intermediate inputs.

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are linked together, and placed in the context of international economicdevelopments, in order to arrive at a consistent set of macroeconomic projec-tions.

A. Growth Potential -- The Supply Side

3.5 In the short-run, growth prospects are moderate to good. A conser-vative estimate for 1988 would be in the range 6-7X. Agriculture is unlikelyto repeat its strong performance in 1987, but should grow by 2-3X, largely onthe basis of greater rubber, palm oil and cocoa output that should follow therecovery in commodity prices and run-down in buffer stocks. Padi production,however, is likely to remain depressed. Mining output should also increasesharply as a result of the decision to raise petroleum extraction from 494.2to 540.0 thousand barrels per day. This, in and of itself, will add one per-centage point to the 1988 growth rate. It does not, however, contribute tohigher sustainable growth as petroleum production will plateau out at the newlevel.

3.6 Manufacturing growth holds the key to future performance. It isreasonable to expect potential growth of at least 10% for this sector over themedium-term. During the 1987 recovery from recession, manufacturing growthwas brisk, at about 12Z. Much of this, however, is attributable to the verylow levels to which output had sunk during 1986 and consequently cannot besustained. Sectors such as wood and iron and steel benefited substantiallyfrom this rebound phenomenon and in future would grow much more slowly. Someexport-oriented sectors, including semiconductors and rubber products, alsoenjoyed a sudden suree in demand and output of over 30X that may not bereplicable at such rates over the medium-term.

3.7 On the other hand, domestically-oriented manufacturing has laggedthe general recovery, growing at only 5.31 in 1987, and can be expected topick up steam in 1988 and beyond only if consumer demand recovers. Big-ticketindustries, including beverages, tobacco, cement, petroleum products, cars andtrucks were sluggish in 1987, but show signs of improving strongly in 1988. Acontinuation of this trend is necessary for the overall health of the manufac-turing sector.

3.8 Other sectors in the economy tend to follow overall GDP, rather thanlead the recovery. Transport, trade, utilities, finance and other servicesare closely linked with the main productive sectors. They have the potentialto grow if material product grows.

3.9 The main drag on potential growth in the medium-term will continueto be construction and government services. Construction output has alreadyfallen by a quarter from its 1984 peak, but is unlikely to recover stronglywhile government development expenditure and NFPE investment continue tofall. The brightest light for the short-term prospects of the sector is inhousing, particularly at the low end of the market. The accelerating imple-mentation of the SLCHP should give the construction sector a boost in 1988 andreverse three years of declining output. Cross-country evidence indicatesthat housing investment typically rises as incomes grow for countries atMalaysia's development stage. Once the current overhang of more expensive

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houses is worked off, therefore, growth in housing activity could again be aleading sector in the economy. Government services, however, are unlikely torebound as fast. Pressure on public finances will be apparent over themedium-term and, with interest and maintenance expenditures rising faster thanGNP, the public sector wage bill will be further squeezed.

Efficiency and Productivity Growth

3.10 A sectoral analysis of potential growth runs the risk that theimplicit assumptions about use of resources by each sector are inconsistentwith the economy-wide supply of resources. An alternative methodology forassessing growth potential is based on the growth of inputs into productionand the efficiency with which those inputs are used. Traditionally, econo-mists decompose value added growth into capital and labor growth, with theresidual representing efficiency changes. Few countries can grow rapidly onthe basis of new factor inputs alone. A simple numerical example best illus-trates this point: assume the ratio of the capital stock to GDP is four;assume further an economic depreciation rate of 2Z per year and a labor forcegrowth of 3Z. Then a total investment/GDP ratio of 20X would be required justto maintain the averagg capital per worker constant and, hence, to generategrowth of 3Z per year._/ If investment were to be raised by an additional 10percentage points, to 301 of GDP, growth would still be only 5X (assuming asubstantial return on capital of 201).

3.11 This arithmetic clearly highlights the importance of efficiencyimprovements in generating high levels of growth. In developed countries, thebroadest measure of total factor productivity (TFP) growth has accounted forbetween 40-65Z of GDP growth. In industrializing developing countries, therange has been significantly smaller, at around 10-20Z for successful manufac-turers. These differences are partly a statistical phenomenon, reflecting thedifficulties inherent in measuring labor and capital. An aging, moreexperienced and better educated work-force, characteristic of developedcountries, actually produces more labor than the growth in the number ofemployed would suggest. Once adjustments of this nature are made, the resi-dual TFP growth in developed countries declines.

3.12 Cross-country comparison of TFP growth rates are fraught withproblems caused by differences in methodology, data, sectoral coverage andtime periods. For developing countries, estimates for manufacturing TFPgrowth are 2.31 in Hong Kong (1960-70), 3.81 in Singapore (1957-70), 3.51 inKorea (1960-70), 3.61 in Taiwan (1960-70), 0.6 to -1.2% in the Philippines(1956-70 and 1971-80), 1.7% i Indonesia (1975-82), 0.7% in Thailand (1963-76)and 2.11 in Turkey (1963-76)._

2/ Given the assumptions above, gross investment would need to be 5Z of thetotal capital stock or 201 of GDP.

3/ See A. Krueger and B. Tuncer, "Estimating Total Factor ProductivityGrowth in Developing Country," World Bank Staff Working Paper No. 422;and "Philippines: Issues and Policies in the Industrial Sector," WorldBank, 1987.

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3.13 Malaysia does not collect the data required to do a detailed calcu-lation of the sources of economy-wide growth. One particularly importantmissing variable is the capital stock in each sector or in the economy as awhole. There does exist information on employment in selected sectors,however, and this permits calculation of labor productivity. Although suchestimates are useful, they fail to distinguish increases in output per workerthat arise from greater inputs of other factors from increas.* in outputstemming from efficiency improvements. They must therefore be interpretedwith caution and considered in the light of other information. Estimates oflabor productivity growth are shown in Table 3.1. There is a trend towards agradual decline in labor productivity growth since 1975-80, accentuated duringthe recession, but continuing into 1987. Total labor productivity growth inthe 1980s has been less than one-half of its average growth in the 1970s.Considering that investment rates have been higher in the 1980s, this suggeststhat total factor productivity may also have declined.

Table 3.1: LABOR PRODUCTIVITY GROWTH(z)

1971-75 1975-80 1980-84 1984-86 1986-87 1971-80 1980-87

CDP 3.6 4.7 3.7 -1.5 -0.1 4.2 1.7Agriculture 4.1 5.5 3.1 2.7 -1.8 4.8 2.2Mining -1.3 9.9 13.1 16.1 -2.3 4.7 11.6Manufacturing 2.8 0.4 4.5 3.8 6.6 1.5 4.6Construction -6.3 2.0 1.1 -11.0 -3.1 -1.8 -3.1Governmentservices 5.0 1.7 6.5 1.1 -0.5 3.2 3.9

Source: Staff calculations based on data in Economic Report, 1987, Ministryof Finance.

3.14 A substantial part of the decline in labor productivity growth isdue to agricultural performance. During the 1970s, the rapid shift fromrubber to palm oil helped boost agricultural labor productivity, both by rais-ing output and by reducing labor input requirements. With this transition nowlargely completed, agricultural productivity growth has slowed considerably.

3.15 The other important sector to show a decline in productivity isconstruction. Particularly during the recession years of 1985-86, output inconstruction has fallen far faster than employment. One possible explanationmay be that a significant adjustment has taken place in the number of hoursworked per person. Some evidence suggests that there has been more work-sharing to avoid layoffs; in this case, productivity numbers based on hours ofwork rather than numbers of employees would show a marked improvement over thefigures in Table 3.1. A second possible explanation is that the statistics onconstruction output are severely underestimated by their failure to capturesmall firm activities adequately. Inconsistencies between construction output

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data and housing completion reports point to a potentiai)y severe bias inofficially published data on the construction industry.-

3.16 Two important sectors show a considerable increase in labor produc-tivity in the 1980s--mining and manufacturing. Mining improvements reflectthe coming on stream of petroleum and gas production. The manufacturing storyis less transparent. What is clear is that the considerable growth in manu-facturing value added in the 1980s (6X annually) has been accompanied by agrowth in employment of only 1.31 per year. By contrast, growth in employmentin manufacturing in the 1970s was about 10% per year, roughly comparable to an11X growth in output in this period.

3.17 The growth in labor productivity in manufacturing may be explainedby two phenomena: a growth in capital assets per worker or an increase inefficiency. Separating between these two is critical in evaluating manufac-turing performance as output growth based on large investments may not turnout to be efficient. Indeed, a preliminary analysis based on survey datacollected by the Department of Statistics suggests that the contribution ofcapital to output growLh in the early 1980s was heavy and that overallefficiency declined (see Appendix 3). Although these results should betreated with caution because of the residual-based methodology and inherentdata problems, they do suggest that the strategy of promoting heavy industryand of channeling substantial investment resources into industrial chemicals,refineries, iron and steel and cement has contributed less to output andemployment growth than if those same resources had been reallocated to moredynamic sectors.

3.18 Another indicator of the efficiency of manufacturing can be derivedby comparing the capital and labor inputs used by different subsectors toproduce one unit of value added. The results, averaged for the years 1982-84,are shown in Figure 3.1. The data is based on the Department of Statistics'Survey of Manufacturing Companies. In general, those subsectors that use lessof both capital and labor to produce a unit of value added are c gsidered moreefficient, in technological terms, than those using more inputs." The curvedline in Figure 1 roughly separates efficient sectors (those below and to theleft of the line) from inefficient subsectors (those above and to the right ofthe line). In economic terms, however, two additional criteria are requiredto determine efficiency. First, depending on the structure of wages and

4/ See the World Bank's "Malaysia: Housing Sector Study" (1988) whichconcludes that the flow data on new residential construction and thestock data on completed housing units cannot be reconciled. One or otherof the :es is likely to be systematically biased.

5/ In order to be valid, productivity data should only be considered inyears where there is not excessive underutilization of capacity. Thus,adding more recent years (1985-87) would not be appropriate. It must beborne in mind, however, that several of the capital-intensive subsectorshad not reached full maturity by 1982-84. Measuring their efficiency atinitial stages of production could lead to some bias.

Figure 3.1 : USECapital per UnRt IN MALAYSI STRIESof ValueAdded IE ev 9 1 2- i

3.2 -O IRON& STEEL

3-

2.8 - OGLASS

2.6 -INDUSTRIALCHEMICALS

2.4-

2.2 - \ POTTERY

2-\ NON-FERROUS METALS

PETROLEUM1.8 - ° REFINERIES NON-METALICo MINERALS 0 PAPER

1.6 - 0 FOOD 0 TEXTILES\ O~~~~~~~~~ PLASTIC

PRODUCTS OF1.4 - &PETROLEUM a COAL

1.4 0 WOOD PRODUCTS0

TRANSPORTATiO 0 FABRICATED1.2 0 RUBRMETALS

BEVERAGE LEATHER

I OTHERMACHINERY MANUFACTURING O FURNITURE

OTHER CHEMIC FOOTWEAR0.8 PRODUCTS 0 o o ELECTRICAL SCIENTIFI &

TOBACCO T° PRINTING MACHINERY MEASURINGEQUIPMENT WEARINGAPPAREL

0.6 - I I I I I I I - I I

0 20 40 60 80 100 120 140

Labor per Unit of Value Added

a.t441g74b

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interest rates, some combinations of capital and labor inputs are preferableto others. In Malaysia, it seems plausible that efficient subsectors arethose that are labor-intensive and those that only require small increases incapital as labor is reduced. Subsectors such as rubber, electronics,printing, machinery, scientific and measuring equipment, furniture, footwearand wearing apparel fall within this category. Subsectors such as industrialchemicals, minerals and metals, and refineries are likely to be less efficienteconomically, even though they economize on the use of labor, because of theirheavy use of capital investments.

3.19 The second qualification to be made is that the market prices on thebasis of which value added is calculated for the purposes of the figure maynot correspond to appropriate social prices. Tobacco is one example of asubsector which appears to be very efficient in private terms, but this isbecause of extremely high levels of effective protection. If efficiency wereto be evaluated at border prices, tobacco, automobiles and cement, amongstother sectors, would appear to be considerably less efficient.

3.20 One implication of the substantial apparent differentials in theefficiency of resource use in Malaysia is that considerable gains may beexpected from reallocating resources away from inefficient sectors such aspottery, glass and iron and steel, towards more efficient sectors. In orderto accomplish this, it must be recognized that all subsectors should not beprotected at the same time. Rather, the objective should be to engineer a setof incentives that induce resources to flow into the most efficient sectors.

3.21 The analysis of productivity reveals some disturbing features ofMalaysia's manufacturing system. First, accelerated growth in fixed assets inthe sector has been associated with a decline in the growth of gross output.This is related to the development of highly capital-intensive industries inthe 1980s. Second, these capital-intensive industries have performed poorlyand are characterized by excess capacity, declining productivity, and lowrates of labor absorption (although to some extent the data may also reflectthe long gestation periods inierent in capital-intensive processes). Third,while capital is flowing freely to some subsectors, others, including tex-tiles, footwear and scientific instruments, have failed to even replacedepreciated eqgi,pment. This bodes ill for future productivity gains inmanufacturing.- Fourth, productivity problems are widespread throughoutmanufacturing. They are worse in the capital-intensive sectors, which alsotypically have a high share of publicly controlled firms, but extend to othersectors including the fast-growing exporters of electronics and garments.

3.22 Small-Scale Firms. One consequence of the capital intensive manu-facturing growth strategy adopted has been a decline in the size of the small-scale sector in Malaysia and a rise amongst medium-scale firms. The latter

6/ Note, however, that this is not always an indicator of inefficiency. Insome textile plants, for example, old equipment has been well-maintainedand is the basis of cost competitiveness. Nevertheless, the fact remainsthat productivity is not growing in these subsectors.

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are more capital intensive than either small or large firms, and it is felt,are generally less efficient, capturing neither the flexibility of smallnessnor economies of scale from large operations. The decline amongst firms withless than 100 workers is also thought to be both cause and symptom of anindustrial structure that features limited backward integration from the largeexporting and final good producer to smaller producers of intermediates.

3.23 Table 3.2 shows the size structure of manufacturing firms for 1978and 1985. Firms with less than 100 employees represent about 80% of estab-lishments, but only 30% of employment, 20% of value added and 19X of fixedassets. In all categories, these firms' importance in manufacturing haddeclined since 1978. Growth has instead been more rapid in medium-sizedfirms, employing 100-200 workers, although large firms have also increasedtheir share in value added and fixed assets.

Table 3.2: SIZE STRUCTURE OF MANUFACTURING FIRMS(%)

NumberTotal of estab- Value Value Fixed

Total employ- employment lishments of output added assetsment size group 1978 1984 1978 1985 1978 1985 1978 1985 1978 1985

Below 50 - 16.14 66.3 58.4 12.6 8.8 11.7 9.3 10.3 8.5

50 - 99 - 14.56 16.3 19.3 13.6 12.4 14.2 11.1 12.5 10.6

Below 100 - 30.70 82.6 77.7 26.2 21.2 25.9 20.4 22.8 19.1

100 - 199 - 17.16 8.7 12.6 18.5 25.9 17.8 18.6 16.3 18.4

200 and above - 52.14 8.7 9.7 55.3 52.9 56.2 61.0 60.9 62.5

Source: Survey of Manufacturing Industries, DOS, various issues.

3.24 The decline in small firms has brought Malaysia closer to theindustrial structures of Korea and the Philippines, two countries with acknow-ledged high business concentration, than to that of Japan (Table 3.3).Although the figures in the table are not directly comparable becausedifferent countries compile statistics on size distribution of firms accordingto different criteria, the table does indicate that Japan has been able togenerate much higher value added and employment from its small industries thanMalaysia. Development of small-scale enterprises therefore may offer oneimportant avenue for improving industrial efficiency.

3.25 In every country, financing, marketing and technology upgrading areamongst the major problems faced by small-scale firms. In Malaysia, financing

Table 3.3: INTERCOUNTRY COMPARISON ON THE ROLE OF SMEs

Number of establishments Employment Value addedTotal employ- Malay- Phil- Malay- Phil- Malay- Phil-ment group size sia /a Korea Japan ippines sia Korea Japan ippines sia Korea Japan ippines

4 - 99 81.7/b 90.3 92.7 97.8 30.7 32.6 55.5 35.3 20.1 19.6 38.6 12.8

100 - 199 10.4 (5.0) - 0.9 17.2 (12.2) - 8.0 16.3 (9.9) - 8.3

100 - 299 /c - 7.1 2.5 - - 21.1 16.4 - - 18.1 17.3 -

200 + 7.9 (4.7) - 1.3 52.1 (55.1) - 56.7 63.6 (72.1) - 78.9

300 + /c - 2.6 4.8 - - 44.0 28.1 - - 62.3 44.1 -

/a Figures for Malaysia are for 1984. Figures for other countries are for 1982.

/b Includes less than four employees.

/c Malaysia and the Philippines do not collect data in the 100-299 range.

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seems to be the most acute.71 Furthermore, in contrast to Korea, Japan andTaiwan where large downstream firms provide financing, quality control andtechnical assistance to upstream small and medium firms, these links arelargely absent in Malaysia. In fact, the industrial structure in Malaysia isnot conducive to backward integration for two reasons. First, the preponder-ance of multinationals and foreign companies in Free Trade Zones implies thata major segment of manufacturing probably already has a well-developedupstream linkage with subsidiaries or affiliates abrcad, and there is littleincentive to develop domestically-located upstream firms. Second, the compa-rative advantage of Malaysia still lies in assembly activities, especially inthe electronics and apparel subsectors, where the scope for upstream linkageis small because of limited comparative advantage in intermediate produc-tion. As the manufacturing structure evolves towards other final goods,however, including wood, rubber and other resource based products, and auto-mobiles for example, the scope for integration should increase.

3.26 In parallel to promoting backward linkages, small-scale firm deve-lopment could be encouraged by an orientation towards exports. Although theproportion of firms surveyed by Fong, who exported any portion of theiroutput, increased from 16X in 1980 to 29% in 1985, this is still a smallproportion relative to Taiwan, China or the Philippines. Lack of: informationon foreign markets is a distinct handicap to small-scale firms and the lack ofa marketing infrastructure is keenly felt. Japan and Korea both have publicbodies as well as large private marketing companies that provide necessaryinformation on foreign markets snd technologies. Efforts to develop suchbodies in Malaysia have been tried in the past without great success, but inpart this is seen as due to institutional reasons concerning the compositionof the companies rather than as symptomatic of an inappropriate approach.

3.27 Currently, Government offers a variety of incentives to encouragethe development of small-scale enterprises. These include a sales tax exemp-tion for sales of M$100,000 or less per year; stamp duty exemption for leaseagreements with rents below M$2,400 per month; a 5% abatement of adjustedincome for corporate income tax purposes; credit guarantees and a Special LoanScheme for small business; and direct access to credit through the BankPembangunan Malaysia Bhd. and the Malaysian Industrial Development FinanceCorporation at an interest rate of 7.75%.

3.28 One problem with these schemes, however, is that they are gearedtowards very small enterprises and serve different purposes. For example, taxexemptions also act as a means of reducing administrative costs of collectionfrom small businesses. There is, therefore, a diffused focus to Governmentefforts. There are currently ten ministries and nineteen government agencies

7/ According to a survey of 167 firms by Fong Chan Onn (1987), 50% of firmsreported financial shortages as their most serious difficulty and 27.5%as the second most serious (eF4-er marketing). See "Changes in theIndustrial Structure and the koLe of Small and 1' -m Industries in AsianEconomies: the Case of Malaysia," Institute of eloping Economies,Tokyo, February 1987.

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involved in the promotion of small-scale firms. Each uses differeng,defini-tions of smallness. For example, the Credit Guarantee Corporation -_ regardsfirms with paid-up capital and reserves of less than M$200,000 as small(M$100,000 for non-Bumiputera firms); the corporate income tax abatement isfor companies with shareholders' funds not more than M$200,000 and fixedassets of not more than M$1 million. Exemptions from the licensing require-ment of the Industrial Coordination Act are granted to firms with share-holders' funds equal to or less than M$2.5 million and 75 employees. Tostreamline activities and incentives, a new Coordinating Committee for thedevelopment of small-scale firms has been established within the Ministry ofTrade and Industry. Their definition of a small-scale industry is one withfixed assets below M$250,000. This may be perhaps overly restrictive, as itwould tend to cover only firms employing less than about 10 workers, andleaves an important segment of manufacturing, firms employing 10-200 workers,without any government support.

Policies to Improve Productivity

3.29 Studies of total factor productivity growth in other countriesindicate that the most rapid efficiency gains occur when barriers to competi-tion, such as tariffs, quotas and other protective devices, are absent; whenthere is flexibility in the allocation of factors and neutrality in the wage/interest rate ratio; and when readily available funding and an appropriaterisk-reward structure induces investments in new machinery and equipment. InMalaysia, these criteria are affected by: (i) the role played by NFPEs;(ii) the tariff regime; (iii) the systems of industrial licensing and restruc-turing assistance; and (iv) the corporate tax structure. Policy reform inthese areas can help generate productivity improvements.

(i) Public Enterprises

3.30 The public enterprise sector has grown to perhaps one-quarter of theMalaysian economy, one of the highest ratios in the nonsocialist world.Compared to the private sector, it has lower profitability (Table 3.4), butthese measures, being financial, do not necessarily indicate comparative effi-ciency. Differences between public and private firms in debt/equity ratios,capital-intensity and the pursuit of noncommercial objectives will account forsome of the observed profitability. Nevertheless, it is likely that lowefficiency is one explanatory variable of the public sector's disappointingfinancial performance.

8/ The CGC provides guarantee cover for up to 60% of commercial bank loansto small-scale firms. Loans up to M$50,000 may be made withoutcollateral, and up to M$200,000 can be provided to a Bumiputera company(M$100,000 for a non-Bumiputera Company).

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Table 3.4: COMPARATIVE PROFITABILITY RATIOSIN PUBLIC AND PRIVATE FIRMS /a

(unweighted averages)

1981 1983 1985

ManufacturingPrivate 0.086 0.065 0.049

Public 0.011 0.022 0.024

ConstructionPrivate 0.016 0.057 0.008Public 0.047 0.039 0.022

Mining /bPrivate 0.29 0.28 0.23Public 0.19 0.17 0.17

/a Profitability is measured as net after-tax income as aratio of total assets. "Private" firms are based onDOS surveys of all companies. They therefore are anaverage of public and private firms.

/b Private mining profitability is taken as a weightedaverage of tin mining (0.25) and other mining (0.75)to be comparable to the public sector estimates.

Source: DOS Financial Survey of Companies; CICU data onNFPEs.

3.31 Efficiency differentials between public and private firms arepresent in at least three broadly-defined activities: project evaluation andchoice; implementation and operation; and the decision to close down ineffi-cient firms. There are several instances where, ex post, the public sectorperformed poorly in project evaluation and choice. The selection of large-scale, loss-making enterprises such as Sabah Gas, Sabah Forests, Perwajasteel, Proton Saga and Kedah cement is evidence of optimistic forecasts ofprices and demand and of a failure of the apparatus for investment decision-making. However, with the decision to prohibit large incremental NFPEprojects, additional policy reform of evaluation and choice criteria hasbecome less urgent.

3.32 Data on operating efficiency for public enterprises are notimmediately available. One issue is to differentiate between efficiency andprofitability; the data on net profitability indicate that only about 55% ofNFPE's have had positive profits in each of the years 1982-86. Thisaggregate, however, disguises important sectoral variations. In general,public enterprises in the transport and extractive sectors performed better

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than those in agriculture, manufacturing or services. Public constructionfirms were mostly profitable in the early 1980s but, with the slump inconstruction activity, are now amongst the worst performers. These figuresare unweighted--that is, they are based purely on the number of firmsreporting profits or losses, without regard to whether they are large orsmall. There is, however, a distinct difference in performance according tosize. Small NFPEs--those with less than M$5 million in paid-up capital--account for about two-thirds the total number of NFPEs, and seem to performconsiderably less well than larger NFPEs.

3.33 Negative profits may arise from operational inefficiency or fromlarge payments of taxes or interest which reflect firms' capital structure,depreciation and other accounting factors. For the NFPEs, however, 87% offirms with negative net profits also had negative operating profits. Inaggregate, the debt/assets ratio is low--one-third--and interest payments arenot an undue burden. In selected instances, however, particularly for manu-facturing companies established in the early 1980s, the financial burden isheavy. These companies were set up with debt/equity in the proportion 70:30,with much of the debt obtained from abroad. The appreciation of non-dollarforeign currencies and the dilution of equity as a result of negative operat-ing profits have combined to generate increasingly leveraged financial capitalstructures and heavy debt service burdens on these companies.

3.34 Several factors appear to have contributed to the poor performanceof the NFPEs. First, there has been inadequate evaluation of managementstemming from a diffuse control structure, particularly for smaller NFPEs.This has occurred because of a lack of clarity and priority in objectives,which have ranged beyond profitability to income distribution and restructur-ing of society, pursuit of socioeconomic and employment objectives, develop-ment of backward regions and industrial diversification. While each objectivemay be appropriate for a public enterprise, the inability to quantify andprioritize objectives has made the task of evaluation more complex. In manyinstances, such as in the Ministry of Public Enterprises, the evaluationfunction has been dissolved and left entirely in the hands of the Board ofDirectors.

3.35 Second, poor performance may be ascribed to the incentives faced byNFPE managers. Not only are there few rewards for good performance, but thereis also an incentive to utilize all available funds within the company ratherthan remitting the resources back to the Treasury in the form of taxes ordividends. In fact, besides PETRONAS, very few NFPEs or statutory authoritieshave ever paid a dividend on government equity. An additional disincentive toprofit-making and retention in NFPEs is the threat of takeovers. As part ofthe program to redistribute assets to Bumiputeras, the PNB has acquiredseveral companies at prices that typically reflect the cost of the assetsrather than the market value of the company. Quite appropriately, the PNBsearches out the most profitable companies for takeover, which are preciselythose most coveted by the parent organization. In such an environment, somecross-subsidization, or provision of uneconomic services, then serves tominimize the whreat of transfers.

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3.36 The third source of inefficiency in the NFPE sector stems from theirability to return to Government for additional loans, equity infusions orprotection against closure, mostly to ensure that the social and employment-related functions continue to be undertaken. As long as the economy wasperforming well, resources were provided ungrudgingly. In the presentresource-constrained environment, however, there is more pressure to quantifyand evaluate the cost effectiveness of provision of these noncommercialservices.

3.37 NFPE reforms. This analysis of performance indicates that reform inthe incentive system--broadly defined to include the setting of objectives,financial accountability and the institutional structure of control--and inthe financial structure of corporation balance sheets should be considered.Two mechanisms to achieve such reform can operate in tandem: a performanceevaluation system for NFPEs, and a strengthening of the program of privatiza-tion.

3.38 Privatization is currently conceived of as a broad umbrella coveringmany forms of institutional change in the organization of NFPEs. In general,however, the overriding principles are an orientation towards a corporatestructure and culture and an emphasis on profitability. While this is suit-able for many of the public enterprises, particularly those under Federalownership, it is less amenable to handling the requirements of social objec-tives that lie behind the creation of many NFPEs, notably those under StateEconomic Development Corporations and State Agricultural DevelopmentCorporations. Because of the difficulties attached to privatization of thesetypes of enterprises, high priority should be accorded the development of aperformance evaluation system to provide correct signals to NFPE managers, setobjectives, determine targets and review performance. The current datacollection system introduced by CICU, however, is still young and evolving andneeds additional refinement to become an adequate base on which to develop anevaluation system. One prime requirement is the ability to differentiatebetween financial profitability, which may be determined by many factorsoutside the control of an enterprise manager, and efficiency for which heshould be made responsible. As a first step to evaluate efficiency, a databreakdown between prices and quantities is required. This would includevariables additional to those readily accessible by CICU. For example, volumeof sales, volume and value of material inputs, employment and total wage billfigures should be collected and analyzed, at a minimum. Details on transferpayments such as sales taxes paid on inputs or outputs as well as other taxesand exemptions would also be desirable. Full design of the data requirements,however, should be closely coordinated with and tailored to the development ofthe performance evaliation system.

3.39 The success of a performance evaluation system depends on an abilityto difterentiate clearly between commercial and noncommercial objectives. Thetendency to burden NFPE with noncommercial objectives must be resisted or, atleast, the costs involved in their pursuit must be calculated and due compen-sation made to the company. This principle has already been attempted in thecase of the railways, for uneconomic passenger service, and for some servicesperformed by NFPEs under the Ministry of Public Enterprises (MPE). Such asystem should be administered by newly created evaluation units within ICU and

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the MPE. Significant staff reallocation and training would be required,including perhaps the transfer of some managers of NFPEs to the evaluationunits, and the functional responsibilities of these agencies should shifttowards evaluation and away from information collection. This latter largelyduplicates work that is done by CICU in an efficient and centralized fashion.

3.40 To be effective, the performance evaluation system should becombined with an appropriate incentive system, with cash and prestige bonusesto reward good performance and the threat of dismissal to penalize poor per-formance. Other countries, notably Pakistan and Korea, have implemented suchsystems with success. Prestige awards, such as Manager of the Year, are use-ful instruments to promote the philosophy of efficiency at relatively lc*,#cost, if they are implemented at the highest level of government and accom-panied by generous publicity. The other side of the coin is the penalty thatshould be imposed for poor performance; the Board of Directors should be en-couraged to use the threat of replacing management more aggressively in theface of clear underperformance of agreed-upon targets, corrected for externalfactors by the evaluation units.

3.41 The remaining priority area for government reform is to act morequickly to close inefficient enterprises. As a result of access to Treasuryfunds in emergencies, justified in part on the basis of socio-economic objec-tives, there are few mechanisms to enforce the closure of inefficient publicenterprises. During the period 1981-86 only 32 out of a total 867 NFPEs wereliquidated; others were in various stages of closure, suspension, dormancy,and receivership. By contrast, the private sector is probably much more effi-cient and speedy about liquidation, with creditors unwilling to inject newfunds into operations of doubtful profitability. While some good companiesare unquestionably forced into bankruptcy, overall the private sector systemavoids the error of compounding initial resource allocation mistakes muchbetter than the public sector.

3.42 The performance evaluation system should be viewed as the logicalextension of current government efforts to restructure NFPEs. Government hasset up a special unit in the Treasury which has, as a first step, investigatedthe options for a few large inefficient firms. As a result, restructuringpackages for Perwaja steel and Pernas, for example, have already been imple-mented. The second phase is to expand the unit's functions to cover all otherFederal NFPEs. As these have almost no noncommercial objectives, they aremost easily privatized. The third phase of the policy is to gradually reducereliance on Federal budgetary support for State controlled NFPEs.

3.43 In the medium-term, this strategy will have to be complemented by aninstitutional mechanism for monitoring and evaluating performance. Forexample, the restructuring of the large NFPEs has been carried out as a resultof perceived losses and mismanagement, but monitoring of the new structureshas not yet been institutionally introduced. Furthermore, while it is rela-tively straightforward to identify and focus on the biggest NFPEs, the largerproblem is how to tackle the smaller, inefficient NFPEs. Reliance on privati-zation will impose a considerable burden on the government to evaluateproposals from private individuals. In particular, as divestiture will ofteninvolve government protection, guarantees and debt write-downs, it may not

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always be the best solution. Liquidation may be preferred from an economicpoint of view in cases where the costs of continued operation outweigh thebenefits. An evaluation system would be a useful mechanism for deciding onthe merits of divestiture versus liquidation and would further introducetransparency and objectiveness into the size of budgetary support offered tonon-privatized Federal and State NFPEs.

3.44 A cornerstone of the Government program to improve efficiency ofNFPEs is through privatization. The Privatization Master Plan will addressthe precise modalities of this operation. To date, however, despite thepriority given to privatization, only modest progress has been made; a totalof 71 companies have been privatized, and 45 more are under consideration, butonly 5 have been of significant size, accounting for over 90X of the priva-tized assets. Moreover, none of these have been truly exposed to privatemarket forces. Even where private sector appointed management is in place,there are monopoly privileges, government contracts and guarantees in placethat reduce financial pressures to increase efficiency. In fact, the mostsuccessful privatizations--those of HAS and MISC--have served primarily torecapitalize company balance sheets. The improvements in profitability thathave occurred in these companies after flotation can probably not be attri-buted to the privatization but to other market forces. Management personnelhave remained the same. Over the medium-term, however, the clear commercialobjective for MAS and MISC should help retain high efficiency in operation.

3.45 There are several hurdles to overcome in order to accelerate thepace of privatization and to ercourage complementary new private investment.First, many of the companies have large losses and are therefore unattractiveto potential buyers. Second, in many cases, the agency involved is unwillingto provide to potential investors the information necessary to formulate abid. Third, government has legitimate fears of retrenchment and of a cutbackin politically or socially desirable services (e.g. railways) and hence isunwilling to relinquish control. Fourth, there is as yet no adequate regula-tory framework to govern potential monopoly situations. Fifth, there may bedifferent objectives amongst Federal, State and Local governments all of whommay be involved in particuiar projects. Sixth, because of the thinness ofcapital markets and the guidelines imposed on new equity issues through theCapital Issues Committee, the scope for rapid privatization at fair marketprice may be limited. One example of the limitations on institutional inves-tors (pension funds, insurance companies, etc.), who are perhaps the largestsource of domestic private capital, is the requirement that they only holdTrustee stocks, i.e. those which have paid dividends f r at least fiveyears. Few NFPEs have ever paid Treasury a dividend;9 hence, none of theother NFPEs would be eligible as a Trustee stock. These obstacles must beaddressed before privatization can be expected to contribute to improved effi-ciency on a major scale.

9/ Dividends were paid to the Federal Government by the following:PETERONAS, MAS, Tabung Haji, LLN, Pernas International Hotels, FELDA,FELDA Oil Products and MISC. MAS and MISC have already acquired thestatus of blue-chip or tgrestee stocks on the KLSE.

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(ii) Tariff Reform

3.46 The average level of tariff protection in Malaysia is relatively lowcompared to other developing countries. Average nominal tariff rates in 1985were about 13.6Z while the same figure was 23.0Z for Indonesia, 21.9Z forKorea, 28.5Z for Philippines and 34.02 for Thailand (Table 3.5). The weightedaverage level of effective protection in manufacturing was calculated to beabout 23Z in 1982 by the Malaysian Industrial Policy Study of 1985 (MIPS).Relative to other developing countries, this is still not high, although thereis a wide dispersion in effective protection, between as well as within indus-tries, that is a source of concern. There are also signs that the dispersionmay be growing; the reason is that the involvement of public firms in sectorssuch as steel, cement and automobiles has led to an increase in nominal andeffective protection rates in these sectors in the early 1980s. In somecases, such as cement, tariffs and quotas may be viewed as an anti-dumpingdevice, but anti-dumping should be considered a short-term measure and shouldnot be invoked over the medium-term as it has been.

Table 3.5: AVERAGE TARIFF LEVELS(unweighted averages; percent)

Proportion of import itemsYear Average nominal tariffs subject to import restrictions

Indonesia 1980 28.081985 23.0 25.11987 23.0 15.6

Korea 1980 25.0 31.41985 21.9 12.31988 18.0 4.6

Malaysia 1980 11.6 1 less than 5Z1985 13.6

Philippines 1980 43.1 37.01984 28.1 36.11986 28.5 16.71988 -- 10.0 /a

Thailand 1981 31.0 } less than 521985 34.01

/a Of which 4.7% are due to health, safety and security reasons.

3.47 The precise impact of effective protection on efficiency is hard tomeasure quantitatively. Because EPR calculations use statutory tariff ratesand aggregate input-output data, there is likely to be a substantial variation

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in the level of protection across firms within industries and over time. Theexistence of other significant elements of protection, through governmentprocurement practices, licensing, exemptions from indirect taxes and other taxadvantages, further clouds any attempt to measure the true level of protectionin an industry and to relate it to performance. Nevertheless, a comparison ofEPRs at the two-digit level is revealing. When firms are ranked according tothe ratio of gross operating margins to fixed assets, the mean effectiveprotection rates of the m8y profitable firms is 20Z lower than the EPRs ofthe less profitable ones., Profitable firms, in addition, employed half asmuch capital per worker as less profitable firms. Thus, rather thangenerating surplus profits to induce investors into new sectors, EPRs appearto be compensating for unprofitable firms' inability to compete, and to besubsidizing capital. It is also noteworthy that EPRs are not selectivelyb;psed toward capital-intensive sectors or labor-intensive sectors, whichs I be expected if their purpose was to correct for some factor marketC. rtion. In fact, they appear to be haphazard and arbitrary.

.48 Reform of the tariff structure is under consideration by the specialAction Comittee on Incentives. In undertaking reforms, the Committee shouldbe guided by the principle that tariffs should be viewed primarily as a devicefor protection. Other objectives, including revenue collection, should beaccorded second priority as they can be pursued more effectively with otherfiscal policies. Specifically, the burden of revenue-raising should beshifted to the overall indirect tax system which would levy taxes equally onimported and domestically manufactured goods. Once the indirect tax system isimplemented at the retail level, rather than at the manufacturing level,administration of indirect taxes on imports could be further separated fromtariff collections.

3.49 A focus on the protective nature of tariffs necessarily implies thatreforms should be directed at rationalizing the EPR structure rather than thenominal tariff structure. There may not, however, be major differences inpractice, if the objective is limited to reduction in the highest EPRs, con-centrated in a small number of industries. These are almost always associatedwith a combination of high nominal tariffs on output and low or zero tariffson inputs. A reduction in high nominal tariffs is the best way to reduce highEPRs, as tariffs on inputs and capital equipment create a cascading sequenceof economic costs borne both by downstream producers and by consumers of thefinal product. Attention should therefore be focused on the 210 BTN codes(out of a total of 6,457) governing i-ports with statutory nominal tariffrates greater than 30X.

(iii) Industrial Licensing and Restructuring

3.50 Reform of the tariff structure would only lead to greater efficiencyif complemented by greater competition within industries. Such competition is

10/ On notable exception is tobacco, where both EPRs and profits are high.Excluding the tobacco sector, the "profitable" sectors' EPR's would be36X lower than those in other sectors.

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affected by the system of industrial licensing and other elements of indus-trial policy, including restructuring efforts associated with implementationof the Industrial Master Plan (IMP). Licensing requirements have recentlybeen substantially liberalized, and bureaucratic delays reduced. Neverthe-less, further improvements could still be made.

3.51 An industrial license is required for the addition of most new prod-ucts or processes, and for the import of machinery which adds to capacity orreduces manpower. Licenses only apply to those companies with M$2.5 millionor above in equity or more than 75 full-time employees. They are typicallyapproved as long as the equity and employment criteria of the NEP are met.There are also a number of automatic exemptions that have recently beenintroduced. For example, an exemption is given to foreign companies exportingmore than 80% of their output. An exemption from the equity guidelines isalso given to foreigners exporting at least 50% of output, or thcse with 350full-time Malaysian employees, provided their domestic sales do not competewith existing products. In addition, no licences are required for expansionor diversification activities for export-oriented companies or for thosefulfilling the 30X Bumiputera equity requirements. In 1987, about 30% of alldomestic expansion and diversification programs were automatically approved.

3.52 In theory, the issue of licenses may be based on a variety offactors, including supply conditions in an industry. If implemented strictly,these could have serious consequences in limiting competition. In practice,however, licenses are granted liberally as long as NEP criteria are met. Theintent of the licensing system has become, effectively, to monitor industrialdevelopment rather than regulate it. Nevertheless, in practice, the licensingsystem may have had side-effects which could have reduced industrialefficiency in at least three ways.

3.53 First, the need to apply for licenses for new machinery can slow therate of technological upgrading. This partly reflects the additional costsand uncertainties in terms of time of processing applications through cumber-some bureaucracies. In many instances, minor improvements and upgradings maynot be deemed worthwhile. In addition, because licensing involves differentagencies with different approval schedules, it can unwittingly create protec-tion for certain activities at the expense of others. For example, animported consumer electronics product may only require a single license,whereas a domestic manafacturer who needs to import several components mayrequire several licenses. Thus, even if import-substitution production wereefficient, it may be unprofitable relative to imports of the final goodbecause of the additional licensing requirements.

3.54 Second, because the licensing and incentive system can be used tofavor regional and parochial interests, it has served to prevent economies ofscale in certain industries. The palm oil processing, cement and metalfabrication industries stand out as examples where lack of economies of scalehave led to inefficiencies. Biases against large, efficient projects arisebecause: (a) locational preferences favor several small, dispersed projects,rather than a single large one; (b) expansion investments are less favorablyreceived rhan new projects in other areas; and (c) it is difficult to findBumiputera investors necessary to meet the NEP criteria for large projects.

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3.55 A third source of inefficiency stemming from the licensing system isthe constraints imposed on more efficient firms' attempts to force out lessefficient firms. Particularly in industries with sizable excess capacity, newentrants may be discriminated against and old, inefficient plants continue tooperate. In some cases, licenses can act as significant barriers to entry andallow firms a quasi-monopoly position. This also depresses incentives toinnovate and upgrade machinery.

3.56 Recent efforts at liberalization of industrial licensing and atreduction of administrative delays and bureaucratic duplication are welcomemeasures. To foster greater efficiency gains, the priority areas for reformshould be: (a) eliminating the protective elements of licensing by streamlin-ing procedures and focusing on safety, health and environmental concernsrather than economic concerns; (b) abandoning de jure as well as de factoconcerns over industrial capacity and location; c movement over the medium-term towards price-based incentives to comply with NEP objectives rather thanlicensing approvals. A system of offering exemptions against the developmenttax for companies that comply with NEP regulations would be the preferredsolution. In this case, other tax credits and deductions should only beallowed against income taxes.

3.57 Government actions to liberalize licensing requirements for small-scale and foreign export-oriented companies are important steps in the rightdirection. Government has raised the threshold equity level below whichlicensing exemptions are granted to M$2.5 million. The full benefits of this,however, will not be felt because of the associated criterion of less than 75full-time employees which must also be met for firms to be exempted fromlicenses. The relative magnitudes of these ceilings do not correspond withaverage conditions in Malaysian firms. On average, a firm with eqyjyy ofM$2.5 million would be likely to employ 150-200 full-time workers. Theemployment ceiling should, therefore, be raised to this range to permit alarger number of small-scale firms to be exempt from licenses. This wouldalso bring the Malaysian categorization of small and medium-scale firms closerto other East Asian countries' definitions, such as Japan, Korea and Taiwan,China.

3.58 Licensing is an integral part of overall industrial policy which isincreasingly focused on industrial restructuring. Action programs for indus-trial restructuring on a subsector basis are being prepared under the auspicesof the Industrial Master Plan. Assistance for restructuring is also to bemade available from a new M$500 million Industrial Adjustment Fund. In boththe provision of finance and of fiscal incentives, care should be taken not to

11/ MIDA data indicate that a firm with equity of M$2.5 million would have,on average, fixed assets of M$5 million. Based on the 1985 manufacturingsurvey of the DOS, firms with fixed assets between 1-5 million ringgithad an average asset per worker ratio of 20,918. Those in the 5-10 mil-lion ringgit range had an asset per worker ratio of 33,547. The range150-200 workers would be appropriate for a firm with 5 million ringgitassets and an asset per worker ratio between 25,000-33,000.

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jeopardize the goals of long-run efficiency growth. The sectoral task forcereports indicate that protection is being sought for the textile sector, foun-dries, shipyards, upstream automobile parts, upstream electronics products,ceramics, roofing tiles, clay pipes, furniture and fish canning. Meanwhile,export-oriented sectors such as palm oil and rubber processing are pushing forreduced tariffs on intermediate inputs and export duties on raw-materialexports.

3.59 Assistance to ailing companies is often desirable because the socialcosts of bankruptcy can be high. Bankruptcy, however, is also the majorthreat that induces companies to strive for maximum efficiency improvements.In undertaking industrial restructuring, it is important to bear in mind thatall industries may not necessarily be competitive. The objective should be toassist those industries that can become competitive at world prices in areasonable span of time while allowing others to fail. Mechanisms, such astariffs and other protective devices, which ensure the financial security ofcompanies but which do not differentiate between efficient and inefficientfirms, should be avoided in favor of more automatic systems which only providetransitory assistance.

3.60 There are several alternative models in the world by which efficientcompanies are steered through difficult times. In the United States, forexample, manufacturing companies have relatively high equity participation.In essence, temporary reductions in company profitability are borne by share-holders; the company does not feel a squeeze in liquidity because the fixedcosts of servicing debt obligations are reduced. On occasion, extra liquidityis available by cutting dividend payouts. This system is diametricallyopposed to that in Korea. There, banks, under guidance from government, havelong-term credit relationships with companies and maintain credit lines opento cover transitory losses. In other countries, risky ventures are undertakendirectly by government which has the ability to provide additional finance inbad times, or in joint ventures with multinational foreign companies. Thiswas the model followed until recently by Malaysia. Dissatisfaction with theprogress towards an efficient and dynamic industrial structure, however, hasled to a reconsideration of government's role and a search for an alternativemechanism for sharing risk with private entrepreneurs.

3.61 The current program of industrial restructuring should be orientedtowards development of a sustainable long-term institutional structure whichwould allow companies leeway to steer through one or two difficult years, like1985 and 1986. At present, the industrial restructuring initiatives containmany useful sector-specific interventions to enhance efficiency. They alsoinclude, however, generalized measures to protect industries, through tariffprotection, low-cost loans and other fiscal incentives. These can offershort-term survival for industries, but are not supportive of longer-termefficiency objectives. Given Malaysia's open capital markets and liberalizedfinancial system, reliance on commercial banks for sharing industrial risk, asin Korea, seems unrealistic. That system is closely tied to tight governmentcontrols on domestic financial markets. Instead, it seems preferable to uti-lize Malaysia's developed financial system and to underpin industrial restruc-turing with a stronger equity base. This would involve removal of impedimentsin the stock market (see paras. 3.107-3.109), and greater initiatives in

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encouraging long-term credit and corporate bond markets, venture capitalfunds, joint ventures, leasing arrangements and other corporate financialstructures that are more flexible than existing arrangements.

(iv) Corporate Income Tax Reform

3.62 The statutory corporate income tax rate in Malaysia, at 40Z, isamongst the highest in East Asia. There is, in addition a 5% development tax.These, however, give a misleading picture of the true effective tax rate be-cause of the significant deductions allowed for depreciation, investmentallowances, and income abatement. A five-year tax holiday, applicable to com-panies with pioneer status, further reduces the tax rate. In addition, favor-able treatment of capital gains and an offset against personal income taxes ofcorporate taxes paid on dividend receipts act to lower the tax burden.

3.63 The complexity of evaluating the overall corporate income tax struc-ture stems from the diversity of incentives and the differences amongst firmsin their availment of incentives. Nor can the cost of the various allowancesbe quantified because only sketchy data exist. Survey data do indicate, how-ever, that pioneer status is the dominant element, accounting for three-quart-ers of the tax breaks issued between 1958-82. There is, furthermore, a gene-ral impression that the corporate income tax is no longer a buoyant revenueraising instrument and indeed significantly distorts the incentives to invest.

3.64 One useful way of assessing the impact of corporate taxes is throughthe use of a simulation model. It should be emphasized, however, that thisinvolves use of data which are purely hypothetical, albeit based on the actualparameters of the tax system and on the average capital /omposit ion of invest-ment projects. One model developed in the World Bank 2 computes a cash-flowstream before taxes and after taxes, making allowances for depreciation, inte-rest deductions, loss offsets, capital gains, personal income tax creditsagainst dividend payouts and other features. The percentage difference in therate of return generated by the before-tax and after-tax streams is designatedthe marginal effective tax rate (METR).

3.65 Simulations show that Malaysia's actual METR is significantly lowerthan its statutory rate, and about the same as other Asian countries (Table3.6). The actual rate depends on the percent of investment financed throughdebt. These calculations, however, only take into account the minimum allow-ances accorded all companies. Once additional possibilities for deductionsand exemptions are included, the rate can drop dramatically. For example, apioneer company with a 5-year exemption, would face a much lower METR, of only15Z, calculated for a typical manufacturing project, financed 50% by debt. Iflosses from a project can be used to offset income earned elsewhere by acorporation, then the METR falls to just 10%. Although Malaysia limits thepossibilities for offsetting losses in one company against profits in asubsidiary or parent by prohibiting group relief taxation, offsets are

12/ See A. Pellechio, G. Sicat and D. Dunn, "Taxation of Investment in EastAsian Countries," DRD Discussion Paper No. 261, World Bank, March 1987.

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feasible within a company, for an expansion or diversification project, forexample. If, in addition, pioneer status is extended from 5 to 10 years asoften occurs, the METS falls to a negligible level of only 4%. These simula-tions indicate that for significant numbers of new companies, especially inbroadly defined sectors such as manufacturing for which pioneer status isreadily obtainable, the effective tax rate on domestic companies is suffi-cientfi lov7 that it most likely does not serve as a deterrent to new invest-ment., {A fact, given the reduced tax burden after the major incentives aretaken, the value of minor credits and deductions, such as the old laborutilization relief credit and the double deduction for training, is so smallfor many companies that the impact of such measures is likely to be small.That is, the tax system has become very unresponsive to fine-tuning.

Table 3.6: MARGINAL EFFECTIVE TAX RATES IN SELECTEDEAST ASIAN COUNTRIES

(Z)

Marginal effective tax rateCountry Statutory rate All equity 50X debt financing

Malaysia 40.0 32.0 20.5Singapore 40.0 28.4 15.2Philippines 35.0 40.4 31.9Indonesia 35.0 41.6 34.1Thailand 35.0 24.9 18.6Japan 33.3 39.2 29.4Korea 30.0 33.1 24.6Taiwan 25.0 31.9 28.2Hong Kong 18.5 17.3 9.6

Source: Pellechio, Sicat and Dunn, op. cit.

3.66 Pioneer status is only one of the mechanisms by which companies canlower their effective taxes, although it appears to be the most popular.Under the Promotion of Investment Act, 1986, companies could opt for anInvestment Tax Allowance, which permits deduction from the adjusted corporateincome tax base of a certain percent of investment expenditures made in thatyear. The percent, which can be up to 100%, is determined by the Ministry ofTrade and Industry. The ITA tends to be favored by large, capital-intensive

13/ This corresponds to findings by D. Usher, "The Economics of TaxIncentives to Encourage Investment in Less Developed Countries", Journalof Development Economies, June 1977; and Dr. Abdullah Tahir, "Tax andInvestment Incentives in the Less Developed Countries: A Case Study ofthe Manufacturing Sector of Malaysia", Ph.D. dissertation, AmericanUniversity, Washington, D.C., 1984.

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projects. Alternatively, companies can apply for Reinvestment Allowances andaccelerated depreciation allowances under the provisions of the Income TaxAct. These options ensure that a broad range of companie: do indeed enjoysubstantial relief from Malaysia's high nominal statutory corporate incometaxes.

3.67 The low effective tax rate on capital may have contributed to anerosion of the tax base. It may also have had an unintended consequence inbiasing projects towards more capital-intensive techniques. Although the taxsystem has been moved away from an explicit pro-capital bias, through removalof the links between the length of a tax holiday and/or the size of investmenttax allowances with the magnitude of investment, an implicit bias stillremains. The simulation model shows that if corporate contributions to theEPF are viewed as an implicit tax on labor, then there is a sizeable increasein the effective tax rate associated with greater use of labor. In fact,imputing the full EPF corporate contribution as a tax on the corporation leadsto a rise in the METR from 15S to 30Z for a project where wages are 34Z ofgross value added (the manufacturing sector average). A project with a 50%labor share, but the same before-tax rate of return, would be subject to aMETR of 44%. By lowering the tax on capital through tax holidays and thedividend offset, while taxing labor through the EPF, the simulations indicatea strong bias towards increasing the capital-intensity of production inMalaysia, as observed in the 1980s.

3.68 The bias in the tax system towards capital-intenisity is most likelyunintended, and is the primary source of inefficiency introduced via thecorporate tax system. The problem is not that tax rates are too high or thatthey dissuade investment-in fact, a crude measure of the average tax rate,derived by taking the ratio of non-oil corporate income tax to the previousyear's gross profits, hovers around 12% in the 1980s, with no signs ofdecline. The issue, rather, is one of efficiency in production. The growingcapital intensity of manufacturing has sharply curtailed employment growth inthis sector. Furthermore, some types of investment in vehicles and inenterprises where capital gains rather than current income is the motive, arefavored by the tax codes, while other investments, including machinery andequipment are in effect taxed more highly. Similarly, because of the dividendoffset, domestic companies are favored over foreign companies, whose citizensmay not benefit from such treatment.

3.69 Simulations are based on purely hypothetical exercises. A financialanalysis carried out by the International Finance Corporation for a potentialaquaculture project in Sabah, however, shows how lax the corporate tax systemis in practice. Their analysis indicated that the expected economic rate ofreturn would be 18%, while the financial rate of return would be expected tobe 17X. The difference, of one percentage point, is the net impact of taxeson profitability. Clearly this is insignificant in any corporate decision-making.

3.70 As the corporate income tax is playing neither an important revenue-raising role, nor enhancing efficiency, an overhaul is desirable. Given thatother countries in the region, notably Singapore, are moving towards corporatetax structures with lower nominal rates, Malaysia would be well-advised to

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follow suit. It must take care, however, not to exacerbate the bias towardscapital-intensity in so doing. For example, simulations show that the METRwould be reduced from a base rate of 6% to -6X if the statutory tax rate werelowered from 451 to 30% with a full offset provision. Thus, any reduction innominal corporate tax rates must be countered by removal of exemptions andinvestment allowances.

3.71 One final point is worth noting about the current corporate taxsystem. Because of the low effective rate associated with pioneer status,there is little gain to companies from additional tax incentives. Thus,several tax devices designed to further specific government objectives, suchas the labor utilization relief, locational abatement of income, abatement ofincome for compliance with NEP and double deductions for labor training, haveproven to be highly ineffective. A tax structure with fewer exemptions wouldpermit more effective, selective tax incentives than the present system.

Investment Trends

3.72 When new capital formation is efficiently allocated, it can comple-ment factor productivity growth rather than substitute for it. In Malaysia,however, following an investment boom in the early 1980s, there has been asustained decline in new capital formation, particularly in the private sec-tor. Private sector gross fixed capital formation in 1987 amounted to just13.51 of GDP; excluding oil and gas investments, the figure falls to 11Z.This is still well below the average rate during the 1970s which remainedrelatively constant until 1981 (Figure 3.2).

3.73 Current levels of private investment are barely sufficient to coverannual wear-and-tear and obsolescence, let alone increases in the capitalstock per employed worker. Considering that about one-fifth of private non-oil and gas investment goes into residential housing, only some M$8.6 billionor 10.91 of GDP actually went towards new plant and equipment in 1987; aboutone-quarter of this came from foreigners. This decline in capital formationwould be of less concern if it reflected a fall in construction activities,following the overbuilding of office space in 1980-84. The data, however,indicate that the trend is exactly the reverse. Spending on machinery andequipment has fallen even faster than total capital formation. Machineryaccounted for 50% of investment at its peak in 1981 and has since seen itsshare decline to 45% in 1986. While this is due in part to a slow-down ofinvestment in the capital-intensive NFPEs, it underscores the decline ofprivate investment in productive assets.

3.74 At an aggregate level, insufficient resources are now being devotedto capital formation to permit a resumption of rapid growth in the long-term.At its peak in 1981-83, Malaysia was devoting over 371 of GNP to new capital.In part, this is an abnormal figure reflecting two cyclical phenomena: first,large-scale investments in the infant oil and gas sector, which accounted forover 5% of GNP; and second, an increase in public infrastructural spendingwhich grew to over 13% of GNP from a historical level of about 81. Withinvestment in these areas returning to more normal long-run sustainablelevels, the investment/GNP ratio required for 6Z GDP growth would be around28-30%. This figure is significantly higher than the investment ratio during

COMPOSION OF CAPITAL FORMATION(% of GNP)

0.4

0.35

/ ~~~~Total gross ie

0.3 /capi formaton

0.25

0.2 Private GFCF U

0.15 k P. -nn

0.1

i ~~~~~~~~~~~~~~~~~~~Foreign direct

1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987

0.05 k y | !~~~~~~~~~m s

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the booming 1970s, but is nevertheless appropriate given the transitiontowards manufacturing as the leading grcwth sector. In general, manufacturinghas a higher capital/output ratio than agriculture (excluding land), so theshift in growth from agriculture to manufacturing will require greater invest-ments. If the private non-oil sector in Malaysia were to regain the invest-ment spirits of the 1970s and return to a level of capital formation of 15% ofGNP, both the composition and overall magnitude of investment would be broughtclose to a long-run equilibrium.

3.75 Data showing the sectoral decomposition of investment, especially ofprivate investment, is incomplete and has been gathered from several differentsources, including EPU, Treasury, DOS and MIDA. For the most part, surveysare only available upto 1985, precluding analysis of the most recent period ofthe collapse in investment. Despite the data discrepancies and incomplete-ness, some broad trends emerge: the boom in the early 1980s favored nontradedgoods sectors such as construction, trade and financial services. Growth infixed assets in manufacturing, while steady, has been less spectacular.Investment in the important commodity sector, too, was flat.

(a) Oil vs Non-oil Private Investment

3.76 The breakdown of private investment between oil and gas and othersectors is shown in Statistical Appendix Table 7.9. Oil and gas investmentsinclude both upstream exploration, development and production activities anddownstream processing. During 1985 and 1986, the investment in oil and gas,particularly downstream activities, has been substantially reduced, fallingfrom M$3,190 million in 1984 to M$1,219 in 1986. Non-oil and gas investmentalso fell but not as fast as oil investment. It fell from M$10,155 million to$6,421 million. As a result, the share of oil and gas investment in totalprivate investment fell from 23.9% in 1984 to 16.0% in 1986. Oil and gasinvestment is expected to recover somewhat in 1988, however, owing to plansfor big gas projects, but then would likely stagnate or decline in the medium-term.

(b) Investment by Industry

3.77 Decomposition of investment data by industry can only be doneindirectly. There are several sources which provide indicators of investmenttrends in each industry. One is the Department of Statistics which conductsannual surveys of Manufacturing and Construction, and a census of StoneQuarrying and of Rubber Estates. However, these censuses do not cover allindustries and are only available at an aggregate level for the years 1978,1979, 1983 and 1985 (Statistical Appendix, Table 7.8). Another source is theFinancial Survey of limited companies conducted by DOS, which covers companieswhose annual revenues are $M5 million and above. This reports the investmentin fixed assets by each industry, and covers more than 4,500 firms inMalaysia. The data do not correspond to investment in the national incomeaccounts sense since they include the purchase of used equipment and land.The data also do not include investment in certain other sectors such ashousing and real estate. Nevertheless, they should at least reflect thetrends of investment in selected sectors.

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3.78 The breakdown of investment by industry is shown in the StatisticalAppendix Table 7.7. The financial survey covers about 701 of private invest-ment. Although the yearly data fluctuate as the number of respondents varies,the broad trends are similar in the two data bases. The data show that thelargest share of investment (about one-third) goes into manufacturing. Mininghas, on average, accounted for another quarter, with petroleum and gas repre-senting 951 of the sector. Agriculture and trade each gave a further 101.

3.79 Investment in manufacturing had grown steadily in the early 1980s,although it fell slightly in 1985 and, based on MIDA approvals, may have

i fallen by another 10% in 1986. Year-to-year figures, however, must be inter-preted with caution as they can be strikingly affected by a few large

; projects. According to approvals data, during the period of 1981-86, indus-trial chemical and chemical products got the highest share (14.4%) of invest-ment approval followed by nonmetallic products (13.5X), food manufacturing(9.9Z) and petroleum and coal industry (9.3%). Electrical and electronics andtransport equipment also had a steady and substantial amount of projects

* approved. During 1985-86, food manufacturing, and petroleum industries hadbig increases in project approvals, while wood and wood product and basicmetal industries experienced a decline.

3.80 The investment data signify that major structural shifts in theMalaysian economy are occurring. Three notable features stand out as contri-buting to the observed decline in private investment. First, there is aplateau or decline in investment in traditional commodities, including rubber,palm oil, petroleum and tin. Partly this can be attributed to the decline incommodity prices; but partly it signifies the completion of major phases indevelopment--the decline in importeice of tin mining and the completion of therapid expansion phase of palm oil and petroleum. In agriculture, only cocoainvestments are growing rapidly and these aie still small in size.

3.81 The second feature is the interruption of the growth in manufactur-ing investment after 1980. This coincides with the period of rapid apprecia-tion of the real effective exchange rate and the growing entry of publicenterprises into manufacturing. In terms of subsector approvals, large publicenterprises in fertilizer, cement and automobiles account for the dominance ofthese sectors in project approvals. Sectors where the private sector is moreactive were less buoyant, except food manufacturing. This sector, however,enjoys very high protection because of the agricultural diversificationprogram and is consequently highly distorted. There are a substantial numberof bankruptcies in the food sector that have resulted from the particularstructure of incentives prevailing on both the manufacturing and food produc-tion sides.

3.82 The third feature concerns the rapid development of the nontradedsector during the early 1980s. Construction, wholesale and retail trade andbanks all expanded fixed capital at a rapid rate. The extension of newbranches by the banking system was initiated by substantial liberalization oflicenses by the Central Bank. Total commercial bank branches grew from 509 in1978 to 837 by 1986. These sectors are now all less likely to grow as rapidlyas before.

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3.83 Determinants of Investment. What are the determinants of privateinvestment and what policy options are open to government to support it? Toaddress this question, it is useful first to take a macroeconomic perspectiveon investment. This gives an interpretation of how iT u stment moves inresponse to changes in other macroeconomic variables.- A more detailedsectoral and firm-level perspective can then be used to evaluate how policyreform may influence the major variables of significance for investment.

3.84 In the analysis below, private domestic investment is isolated bysubtracting public investment and foreign direct investment from total invest-ment recorded in the national income accounts. Public investment is derivedfrom budget figures. It includes the investment of federal and state govern-ments, statutory bodies and NFPEs. Prior to 1980, only 10 major NFPEs areincluded. After 1980, coverage is extended to 40 NFPEs. This does not,however, create a major distortion in the data because prior to 1980 there wasrelatively little capital formation by public enterprises.

3.85 Data for foreign direct investment is taken from the balance ofpayments. The series includes net new flows of investment plus reinvestedearnings of foreign corporations in Malaysia, plus changes in other foreignliabilities of foreign companies. For the most part, foreign investment hasgone into separate export processing zones and is subjected to a very differ-ent set of incentives, tax regulations and capital market restrictions. Forthese reasons, it is treated separately from domestic investment.

3.86 Regression analysis was used to explain the determinants of privateinvestment. Several factors were found to have a significant impact. Themost important of these is the level of profits in the economy. The higherthe level of profits, the higher the level of investment. The regressionresults suggest that about one-third of all profits are reinvested. The cred-ibility of this result is strengthened by the fact that this is very close tothe proportion of shareholders' funds in total liabilities computed in thefinancial survey of the Department of Statistics. To a sizable degree, therecent collapse in private domesLic investment can be explained by the fall inprofits in the economy as national income has shrunk and the wage share risen.

3.87 Profits are important for investment decisions for three reasons.First, they indicate the returns that may be expected from new investment,assuming the current environment remains constant. Second, they generallyfollow the domestic business cycle and are a proxy for capacity utilizationrates. During a boom when capacity is fully utilized, profits rise. Thus,through signaling tight capacity, high profits indicate the need for capitalexpansion. Third, profits provide the revenue with which to undertake capitalexpansion and the basis on which leverage through borrowed funds may beobtained. Confirmation of the importance of this is given by data in theBusiness Expectations survey conducted by the DOS which indicates that 80-90Zof capital investment by firms is financed through their own funds.

14/ The detailed methodology is presented in Appendix 5 to this Volume.

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3.88 The second most important variable in explaini ̂ private investmentis government investment. Based on details of the sectoral composition ofpublic development expenditure, government investment has been decomposed intotwo elements. Production investments are those which directly contribute tovalue-added in the future through their own activities: agriculture, housing,commerce and industry are examples. Infrastructure investments are thosewhere returns are only realized through complementary activities: land devel-opment, drainage, irrigation, health, education, water supply, transport andenergy. The analysis demonstrates that private investment responds stronglyand positively to infrastructure investment. As public investment in infra-structure has been sharply curtailed in recent years, private investment hasalso declined.

3.89 Production investments have no such complementary effect withprivate investment. In fact, the analysis indicates that s.me substitutionoccurs--public investment in areas like housing development, steel and cementcrowd out private investments in these fields. Such substitution takes placein several ways; it may be in the same industry or in industries with upstreamor downstream linkages. For example, public investment in cement and steelproduction has created excess capacity and effectively barred potentialprivate investment in these sectors. To avoid losses throughout the industry,prices have been controlled and set to cover average domestic costs. Duringthe 1980s, these have been on average 20-50% higher than the potential c.i.f.import price. Thus, all downstream industries, especially construction, havebeen negatively affected. In some instances, such as automobiles andhousing, public enterprises have competed directly with their private counter-parts for a share of the domestic market. In still other instances, govern-ment procurement practices have favored other public firms, squeezing outupstream private firms.

3.90 At the macroeconomic level, the substitutability betweea public andprivate firms, while evident, does not appear strongly in the data. Partly,this may be because public production investment is still small compared tooverall private investment. In some large sectors such as agriculture, com-merce and trade, the public sector has only a token presence. It is in manu-facturing that the greatest competition exists. In fact, the size of publiccorporations in the manufacturing sector is about equal to the size of privatedomestic corporations.

3.91 Exogenous factors also enter into investment decisions. The pullof domestic demand is captured through an accelerator term that measures thechange in GNP. This term has imparted a consistent downward impulse toinvestment in recent years which should now be reversed as the recovery takeshold and strengthens on the back of more favorable commodity prices. Competi-tiveness, proxied by the real effective exchange rate, is also important. Therecent real effective depreciation of the currency, following the US dollar'sfall, has helped prevent an even larger drop in private investment in 1986 and1987.

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Policies to Encourage Private Investment

3.92 Private investment is partly subject to autonomous forces, overwhich the government has little control. The short-term prognosis for theseis positive. Favorable terms of trade, rising incomes, falling wages andinterest rates and a depreciating currency will serve to boost private invest-ment without any intervention by gover-nment. Recently, Government has under-taken several new initiatives to encourage investment. Liberalization ofindustrial licensing, reduction of administrative delays, and new and expandedcredit schemes are examples. The full impact of these measures has yet to befelt, but initial indications are that more needs to be done to supportprivate investment over the medium-term. A concerted effort by government tocoordinate macroeconomic, structural and firm-level policies is required.

3.93 Macroeconomic Policy. At a macroeconomic level, government policyshould be aimed at restoring international competitiveness, which would likelyinvolve raising the share of profits in national income to historical levelsand reorienting government expenditure to support private investment.Government influences the distribution of income between profits and wages intwo ways. First, as it is a large, perhaps dominant, force in formal labormarkets, public pay and employment policy sets the tone for other wage agree-ments. The labor market is presently adjusting to the excess wage awards ofthe early 1980s, and it is important that government assist this adjustment bycontinuing to ref 1 e,t market signals in the wage increases announced forpublic employees.-

3.94 One important determinant of wages should be labor productivity inmanufactur.ng, in order to ensure that international competitiveness is main-tained. Because of Malaysia's policy of floating the exchange rate and itsopen capital markets, the real effective exchange rate is likely to continueto be volatile in the future. It cannot be used as a direct instrument tocounteract any incipient wage pressures on competitiveness, except to a limi-ted degree via mana&ement of foreign exchange reserves. In such an environ-ment, wage negotiations take on more importance and a greater degree of flexi-bility in wages is required as a buffer against international shocks andexchange rate developments. Government should encourage the greater use ofvariable compensation packages in the private sector, which have a significantportion of annual payments dependent on productivity and profitability mea-sures.

3.95 The second important action government c&r take is to reduce EPFcontribution rates. The empirical evidence from Malaysia and other countrieson the incidence of EPF contributions between profits and wages does notdemonstrate in convincing fashion that lower EPF contributions would necessar-ily result in higher profits. Nevertheless, there is a clear coincidencebetween the time of increased EPF contribution rates and the period of declin-ing profit shares that suggests a causality. Civen current conditions of

15/ More detailed recommendations on government interventions in the labormarket are discussed in Volume II, Chapter 3.

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excess labor supply, reflected in the unemployment numbers, it is likely thata cut in EPF contributions would increase demand for labor, reduce the averagecompensation package paid by corporations, and generate increased output andprofits.

3.96 Another macroeconomic adjustment that needs to be made is in thecomposition of government expenditure. In recent years, the bulk of adjust-ment to the financial problems facing the public sector has come from a reduc-tion in infrastructure Investment. This was appropriate to some extent, asinfrastructure investment had risen to unreasonably high levels during thgearly 1980s; for example, the recent World Bank transport sector report -concludes that the Malaysian transport system, except for some additional roadrequirements, is adequate to meet expected needs through 1995 without majornew investments. Other big-ticket infrastructure spending, such as on irriga-tion for padi, has also been appropriately scaled back. But in some cases,sueh as communications, flood control and drainage, infrastructure cuts andpostponement have probably contributed towards the worsening climate forprivate investment. Furthermore, there are indications that reduced mainte-nance expenditures have already begun to take their toll in the form of deter-iorating infrastructure. Urgent actions are required, particularly in roadmaintenance, to salvage the benefits from past infrastructure investments.Reorienting government expenditure towards maintaining and improving infra-structure would boost private investment.

Structural Policies

3.97 Many of the structural policies to improve efficiency, discussedabove (paras. 3.29-3.61), will also have a favorable impact on private invest-ment. In addition, government policies could help reduce further the costs ofinvestment and the risks associated with investment by reform of pricingpolicy and regulation of construction and construction materials and institu-tional corporate funding structures.

3.98 Construction Costs. Since 1979, the prices of steel bars and cementhave been under control. These are the two most important materials forconstruction, accounting for 25% to 75% of the material used. Construction,in turn, is about one-half of fixed capital formation. Table 3.7 compares thelocal controlled price of steel bars with an estimate of the cost of importedsteel bars, derived by taking the Japanese f.o.b. export price and adding 20%for freight, insurance and handling. The imported price is expressed as arange from -10% to +10% of this estimaL;. t:o compensate for differentproducts. Since 1982, the estimated domestic price has been about 50% greaterthan the import equivalent price. Since local prices 3re ex-railyard, whilethe import price contains a generous provision for delivery on-site, the truedifference to an end-user may be even greater.

16/ "Malaysia: National Transport Policy Review," The World Bank, 1988.

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Table 3.7: LOCAL AND INTERNATIONAL PRICES OF STEEL BARS

Year Range of local prices Range of International Prices Difference(M$/ton) /a (M$/ton) /b (X) /c

1980 730 - 818 772 - 944 +6% - +1511981 830 - 917 787 - 962 -4Z - +511982 917 - 1,024 614 - 751 -331 - -25%1983 891 - 995 559 - 683 -37X - -31Z1984 891 - 995 589 - 720 -34% - -28%1985 891 - 995 603 - 737 -32% - -2611986 891 - 995 613 - 749 -31% - -25X1987 891 - 995 552 - 675 -38X - -32%

/a The prices of steel bars with diameters of 3/8", 1/2", and 7/8", ex railyard in Peninsular Malaysia.

/b Staff estimates. Based on export prices of reinforced bars from Japanplus 201 for freight, insurance, and handling charges. The range repre-sents -10% to +101 of the average price.

/c Percentage difference of the international prices over the local prices.

Source: Staff estimates; Master Builders Association, Kuala Lumpur.

3.99 Undertaking a similar price comparison for cement is less reliablebecause of the greater relative importance of transport costs on which littleinformation is available. Nevertheless, available evidence suggests that thelocal price range of M$160-180 per ton may be 20Z to 30% higher than thepotential import cost. While import prices may reflect dumping due to excesscapacity in East Asia, the medium-term nature of the price differentialssuggests that tariff and quota protection have been costly, and that a moreefficient solution would involve deregulated prices and other forms of indus-trv prCtection. Efficient import substitution would be reflected in anarrowing over time of the differential between domestic and internationalprices. This has clearly not happened. The issue of how long to protect afledgling domestic industry against import competition, whether "dumped" ornot, must be addressed.

3.100 The cost of regulated steel and cement prices has been twofold: first,there is a substantial cost associated with the inappropriate levels of addedcapacity and with the failure to allow a shake out in yM,ch the limited demandwould be met by the most efficient domestic produces; - second, there is thedownstream cost of higher investment prices that is borne by the wholeeconomy. A deregulation of steel and cement prices should, therefore, be

17/ See Vol. II, Chapter 1 for a discussion of the cost differentials betweenprivate and public producers of steel and cement.

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considered. The impact would be to lower the cost of investment by 4-52.That is, the same dollar amount of investment would purchase a 4-5X increasein real capital formation, twice the gain actually recorded in 1987. On theother hand, prices are regulated in order to cover the operating costs ofpublic enterprises producing at low capacity. Deregulation would requirefurther government subsidies to the industry and cause a higher deficit unlessa program of consolidation and restructuring to improve efficiency 8as to beimplemented at the same time.

3.101 Other government policies also affect the cost of investment. The mostimportant of these is land-use regulations. The complexity of prccedures toalienate land for industrial use lengthens the time period for investments tomature and slows down the response time of new investment to market signals.As a result, chauges in the investment climate are felt in sharp speculativeprice movements for industrial land and factory buildings. Table 3.8 shows arange of price movements for industrial land and property in Selangor State.Because these prices vary greatly according to location, size and condition--variables which may not be represented equally in the samples on which theannual valuation reports are based--they should be treated with caution. Thetrend, however, is clear: the same factory building which cost M$100 in 1981might have cost over N$280 by 1985 and be back to its 1981 price at present.These swings imply that often the financial success of an investment has hadmore to do with the timing of the venture than with the efficiency of themanufacturing process itself. Some States have already liberalized land-useregulations, and have established Committees or Task Forces onIndustrialization to expedite approval of applications for land and factorybuildings. Within some industrial estates, approval is now very rapid. Inother areas, however, more concerted efforts are required to coordinate land-use licensing, industrial site planning, infrastructure, and other code andlicanse requirements. Speeding up the elapsed time from project initiation toproduction would help stimulate investment by reducing uncertuinty and bygenerating a more competitive investment process which would iron out pricecycles and force producers to compete on the basis of the efficiency of pro-duction rather than on the ad hoc timing of investment decisions and licenseprocurement.

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Table 3.8: PRICE TRENDS OF INDUSTRIAL PROPERTIES /a AND LAND /bIN SELANCOR STATE

(Z change over previous year)

1982 1983 1984 1985 1986 1987/c

Property n.a. +20 +5 to +10 0 -24 to -30 -30 to -40

Land +5 to +15 +20 to +40 +20 to +30 0 -15 to -20 -30 to -35

/a Factory buildings without equipment installed.rb Vacant land developed for industrial use.T7 Estimate.

Source: Property Market Report, various issues, Ministry of Finance; preli-minary 1987 estimates from Selangor branch, Evaluation Department,MOF.

3.102 Funding Structures. Perhaps because of the dominance of government andforeign corporations, the private domestic manufacturing sector in Malaysiahas not relied on credit financing mechanisms for expansion. Most fixedinvestment is financed through own funds, that is retained earnings or newequity--only about 20Z is borrowed. This has resulted in a very conservativedebt structure; overall, the manufacturing sector had a debt/equity ratio of1.3 in 1985, compared with 3.6 in Korea, 3.2 in Japan, 2.4 in the Philippinesand 2.1 in Turkey.- This is perhaps the main reason why monetary condi-tions, such as availability of domestic credit and the average real lendingrate, do not seem to have had a significant impact on aggregate privatedomestic investment.

3.103 Government attempts to stimulate private investment through the financialsystem have focused on credit programs and directed credit guidelines forcommercial banks. Special funds, such as the New Investment Fund, theproposed Industrial Adjustment Fund, the Export Credit Refinancing Scheme, andschemes to foster small-scale enterprises and the Bumiputera community havehad, as one objective, the infusion of credit into manufacturing. Yet despitethe success of these schemes, in terms of the amount disbursed, the share oftotal credit allocation by the banking system to the manufacturing sector hasslipped from 20Z in 1980 to 15Z in 1986. This suggests that while government-induced lending schemes have been attractive, perhaps because of the favorableinterest rates charged, they have likely substituted for other banking systemcredits.

18/ Comparator country data refers to 1983.

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3.104 The problem does not appear to lie with the banks per se. The survey ofmanufacturing companies by Bank Negara suggests that overall tightness incredit has eased subs-.v-ially since 1981, and that banks' lending attitudeshave become .ncreasingly tolerant and less tight (Table 3.9). During 1987,there is additional evidence of ample liquidity in the banking system andfalling domestic lending rates which now average about 8% in real terms, butlittle demand for loans.

Table 3.9: DIFFICULTIES IN BORROWING FROM BANKS(X of total firms surveyed)

Credit situation 1981 1982 1983 1984 1985 1986

Overall Funds Position

Easy 11 13 19 20 14 22Not so tight 35 55 51 46 46 44Tight 54 32 30 34 40 34

Banks' Lending Attitude

Easy 7 16 24 23 22 31Not so tight 42 58 52 43 45 41Tight 51 26 24 34 33 28

Source: Manufacturing Survey, Bank Negara Malaysia.

3.105 The financial problems ;acing firms, therefore, seem not to be in tradi-tional credit markets, but in the market for risk capital and other long-termfinancing. Given the volatility of manufacturing profitability in an economywhere the real exchange rate and domestic wages swing with terms of tradechanges and other international developments, there is a need for a conserva-tive debt/equity posture. Well-managed companies are unwilling to take onmore debt without additional equity or retained earnings.

3.106 Structural problems in obtaining long-term and risk capital are at theheart of the financial constraints on manufacturing growth. Unless these areaddressed, there is little prospect that the scaling-back of public investmentwill be replaced by a sustained surge in private investment. The demand forrisk capital c-n be indirectly gauged by the phenomenal growth in the cor-porate securities market until 1984. In that year, M$2.4 billion, or 10% oftotal investment, was raised in corporate securities compared to M$0.2 billion(1.3X of investment) in 1980. But fraud and scandals at home and in Singaporehave completely undermined this market. Adding to the problem is the lack ofaccess to long-term credit; development banks are small, comprising only 2-3%of financial assets, and there are no strong relations between banks andindustry as in countries such as Japan and Germany.

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3.107 Three factors have created a squeeze on risk capital that has damagedmanufacturing investment in the 1980s. The first, a decline in corporateprofits, has already been touched upon above; the second is the distortionsgenerated by the regulations governing new public offerings; and the third isrelated to the equity requirements of the NEP.

3.108 Although the market capitalization of the KLSE is one of the highest inAsia, the annual t.iading value is small in comparison. This indicates thatthe secondary market for shares is quite small, and that large blocks ofshares are closely held. It also contributes to the volatility of stockprices, with the result that the market is viewed by investors primarily inspeculative terms and not in terms of providing long-term capital for invest-ment. Thus, over the last decade, the number of companies listed on the KLSEhas only risen by 21.

3.109 A major source of thinness in the market is the unwillingness of manysuccessful companies to go public. A Capital Issues Committee (CIC), chairedby the Governor of the Central Bank, in practice controls the new issue priceof corporate stock in a range that varies by sector (Table 3.10). For manu-facturing, the price of a new issue can range between 4.0 and 5.5 timesprojected maintainable pretax earnings. Given the fact that the averagemarket P/E ratio was 32 in December 1987 (after the global crash), the subsidyelement in these guidelines is evidently substantial. As a result, few newissues are brought to market. Those that are, are heavily oversubscribed andusually see a meteoric rise in value. Table 3.11 shows the initial price andthe price after five business days of the five new issues during 1987; thecapital gains ranged from 108Z to 398x.

Table 3.10: THE CIC-GUIDED P/E RATIO

Price/EarningsSector Ratio

Trading/services 3.5 - 4.0Property 3.5 - 5.0Manufacturing 4.0 - 5.5Contracting and construction 4.0 - 5.5Transportation 4.0 - 6.0Tourism 4.5 - 6.0Plantations 5.0 - 6.0Insurance 5.0 - 7.0Finance companies 6.0 - 8.0Commercial banks/merct, -t banks 8.0 - 12.0

Source: Ministry of Finance.

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Table 3.11: CAPITAL GAINS FOR NEW ISSUES, 1987

Karket price atend of fifth day X

Offer price following listing gain(M$) (NO)

MISC 2.40 5.00 108Dreamland Holdings 1.00 3.10 210Sports Toto 2.00 9.95 398Southern Bank Bhd. 2.20 5.05 130Georgetown Holdings 1.00 2.86 186

Source: "Malaysian Securities Market Departments," M. Merican, processedpaper presented at a conference on Recent Securities MarketDevelopments, Kuala Lumpur, October 19-20, 1987.

3.110 The CIC also fixes prices of shares that may be swapped in a mergeragreement (ior both companies, whether currently listed or not), and preventecompanies from acquiring temporary loss-making or nonincome-generating assets,since guidelines specify that there should be no earnings dilution. It alsogoverns Rights issues. CIC policies, taken in combination, serve to reducethe supply of listings on the exchange, thereby perhaps boosting the prices oflisted companies and generating windfalls for selected investors in newissues, but penalizing new entrants to the market and investors unlucky enoughnot to win the lottery that rations applications for new shares.

3.111 The ytderpricing of new shares is not a phenomenon exclusively observedin Malaysia,- -nor is it always a negative symptom. Regulators have aresponsibility for protecting investors and fledgling underwriters andensuring a smooth market. When the underpricing becomes excessive, however,important public policy and social welfare consequences arise. First, thereis a burden on firms' financial structure as they receive less from a newissue than otherwise. Second, where public corporations are involved, thesystem is open to charges of selling public goods at artificially lowprices. Underpricing is partly a result of administrative control, but alsoreflects the institutional structure under which shares are allocated. Givenunderpricing, shares become oversubscribed; but this raises investor's costsas they must finance large credit lines with only a low expectation of beingallocated new shares. In order to enjoy a fair return, then, the degree ofunderpricing is accentuated. Several schemes could be considered by the

19/ See "The Underpricing of initial public offerings in Singapore: Publicpolicy issues and possible solutions". J. Lim and A. Saunders, New YorkUniversity Working Paper No. 487, August 1988.

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authorities to reduce initial underpricing and the ensuing volatility of shareprices (both up and down). A competitive auction could be used, as inFrance. The disadvantage of this is that the underwriting risk is borne bythe issuing firm. Alternatively, an over-allotment option could be given tofirms, as in the USA, where the underwriter would have the option to expandthe quantity of offered shares in the event of oversubscription.

3.112 The third constraint in company generation of risk capital stems from theimplementation of the NEP. In part, this is linked to the guidelines onpublic listing of new securities. Any firm which goes public must meet NEPcriteria of at least 30Z ownership by Bumiputeras, in addition to the minimum10-15% that must be publicly offered. Thus, a non-Bumiputera investor canretain only just over one-half of incremental shares from a new listing. Thisexacerbates the subsidy element implicit in the CIC guidelines. A moreserious problem, however, emerges for private companies because of problems inmatching the incentives of Bumiputera and non-Bumiputera investors with theNEP equity guidelines. With the rapid development of an entrepreneurialBumiputera class, there is a growing incentive towards 100% or majority-controlled Bumiputera firms. These firms benefit from various governmentloan, tax and preferential procurement privileges and have the managerialsophistication and business experience to thrive. On the other hand, thesmall Bumiputera saver, who does not want to participate actively in a busi-ness venture, has access to a series of mutual funds (such as ASN and LUTH),which offer returns commensurate with equity investments combined with minimalrisk. There is, therefore, a shrinking pool of Bumiputera investors preparedto participate as minority joint-venture partners, and a gradual shrinkage ofnew equity mobilized from non-Bumiputera Malaysians. According to MIDA surveydata, the actual new equity generated from non-Bumiputera sources ha fallenprecipitously since 1984 and turned negative in 1986 (Table 3.12)± ±I As non-Bumiputera Malaysian residents still own about ;0% of the manufacturing sharecapital of limited companies, their participation in future growth is essen-tial.

20/ Note however that other sources of data, such as proposed called-upcapital, do not show the same decline. Data weaknesses, therefore, donot permit firm conclusions to be drawn.

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Table 3.12: ESTIMATION OF ACTUAL EQUITY GENERATEDIN INDUSTRIAL ACTIVITIES

(million ringgit)

1980 1981 1982 1983 1984 1985 1986

Bumiputera 394.9 428.9 683.8 633.6 783.1 1,327.4 904.8(Z) 28.60 35.58 37.41 43.42 37.80 73.35 73.91

Non-Bumiputera 566.8 358.9 576.3 642.5 855.8 25.4 -85.3(X) 41.05 29.77 31.53 44.03 41.31 1.40 -6.97

Foreign 419.1 417.7 567.8 183 432.8 456.9 404.7(Z) 30.35 34.65 31.06 12.54 20.89 25.25 33.06

Total 1,380.8 1,205.6 1,827.8 1,459.2 2,071.7 1,809.8 1,224.2

Note: Data are only for projects approved by MTI and are laot representative of theentire industrial sector (small projects are excluded). Sample may alsosuffer from non-response bias. Some reclassification occurred in 1986 as aresult of improved survey coverage and detail.

Source: MIDA.

3.113 Government policies in supporting investment financing should shift fromtheir current emphasis on directed credit towards support for mobilizing riskcapital and long-term credit. Reform of stock market procedures is a highpriority, particularly for large firms. It takes on added importance in thelight of the privatization program. It is unlikely, however, that medium andsmall companies will benefit in the medium-term form such reforms. Thesecompanies would be best assisted through the development of venture capitalcompanies which, through equity participation, could help achieve NEP objec-tives and help ease the problems faced by non-Bumiputera investors in comply-ing with the NEP at reasonable cost without giving up operational control.

Foreign Direct Investment

3.114 Foreign direct investment remains crucial in stimulating industrialgrowth. The foreign-owned corporate industrial structure is about one-thirdof the total industrial base. At around M$2 billion annually, foreignerscontribute about as much to total industrial capital formation as do privatedomestic investors. Because of its prevalence in FTZs and its export-orientation, foreign investment reacts to a different set of incentives thanprivate domestic investment. External factors, such as international competi-tiveness and past levels of foreign investment are important, whereas internalfactors like domestic demand and public investment are less relevant. Asexpected for exporting companies, the level of the Malaysian real effectiveexchange rate is also highly significant.

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3.115 Regulations governing foreign direct investment have recently beeneased. Export-oriented foreign companies have been exempted from the NEP, toall intents and purposes. The impact of this liberalization, however, isstill uncertain. While there has been a modest increase in foreign directinvestment in 1987, much of this can be attributed to an impulse stemming fromcurrency movements and from the fall in interest rates. Overall, foreigninvestment into Malaysia remains depressed. In fact, after a boom in 1981-83,foreign direct investment in Malaysia has collapsed to half this level(Table 3.13). This pattern is generally shared by Singapore and thePhilippines, and seems to be attributable to the decline in major commodityprices, discouraging resource-based investments especially in oil and gas, andto the worsening competitiveness of these countries vis-a-vis other East Asianeconomies. -

Table 3.13: INFLOW OF FOREIGN DIRECT INVESTMENT(Million SDRs)

Phil- Singa-Malaysia Thailand ippines pore Indonesia Korea Taiwan

1970-74 (ave.) 184 73 2 241 77 69 521975-79 (ave.) 362 52 92 444 258 59 611980 718 146 -82 860 138 6 1281981 1,073 249 146 1,195 113 86 1281982 1,266 175 14 1,260 205 62 941983 1,179 327 98 931 270 65 1391984 778 394 9 862 221 109 1961985 684 159 -11 959 304 227 3351986 452 219 86 574 221 365 278

Source: IMF, Balance of Payments Yearbook, and the Central Bank of China.

3.116 DeveJoped countries seem to find Taiwan and Korea relatively moreattractive as they adjust their global production and marketing strategies.These economies have fairly strong industrial skills and technological sophis-tication which permit them to absorb new techniques easily. Coupled withexcellent work ethics, a well-developed infrastructure and a sizable domesticmarket, there are clear advantages to investment there. Japan, for example,is expected to rapidly deepen intra-industry specialization with the AsianNICs in sectors such as electronics and machinery. It may also move the pro-duction of many finished products, for Japanese and export markets, out ofJapan.

3.117 The shift towards the NICs is particularly apparent in the projectcommitments of Japanese direct foreign investment (Table 3.14). Malaysia hasclearly lost out in the battle to attract new Japanese investors despiterecent moves to liberalize the economy. Hong Kong has been the greatestbeneficiary, but Indonesia, Singapore, and even Thailand have attracted

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increasing numbers of Japanese foreign investors in recent years. Malaysiaseems to be more successful in encouraging second-tier foreign investment,from the foreign-ezchange rich "four tigers." Much of this is likely to begeared to reducing trade frictions on the part of these countries, particu-larly vis-a-vis the United States. With its open economy, passage of theCopyright Act and small bilateral surplus with the United States, Malaysia isin a strong position to challenge successfully future attempts at protection-ist legislation aimed at products from its shores. The strategy to attractforeign investment should build on this national advantage. This implies thatgreat care must be taken to avoid "shell" companies that simply reroute pro-duction, sometimes without the goods even being transshipped through Malaysia.It also implies that Malaysia's success in trade diplomacy, in both multilat-eral and bilateral form, will become a more critical component of its indus-trial strategy.

Table 3.14: JAPAN'S DIRECT INVESTMENT TO ASIAN COUNTRIES(US$ million)

1984 1985 1986 1987 (1-6)Number Amount Number Amount Number Amount Number Amount

Hong Kong 119 412 105 131 163 502 131 644Korea, Rep. of 57 107 75 134 111 436 99 295China (Taiwan) 68 65 68 114 178 291 138 136Singapore 108 225 110 339 85 302 83 259Indonesia 82 374 62 408 46 250 33 397Malaysia 63 142 60 79 70 158 36 37Thailand 76 119 51 48 58 124 79 91

Source: Ministry of Finance, Japan, "Statistics of Applications for OverseasDirect Investment."

B. Growth Outlook--the Demand Side

3.118 The potential output growth reflects Malaysia's capacity to produce.As the past few years have shown, however, actual output may fall well belowpotential output. During the 1980s, growth was achieved almost entirely onthe basis of external demand. Only 29Z of the incremental production between1980-87 was absorbed domestically; of this, 23 percentage points were absorbedby the public sector. The miniscule level of private demand, which grew at anannual average rate of only 0.4% in 1980-87, must be raised for effectivelong-term growth. The central problem for demand management is, therefore,clear: with sluggish private investment, cutbacks in government spending toreduce the deficit and modest growth from the external sector, how will growthmaterialize?

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Private Consumption

3.119 In four of the five years since 1983, private consumption growth haslagged behind national income growth. This has been a period of generallytightening fiscal policy, with the major exception of 1987, which has resultedin a decline in the share of private disposable income in GNP. Furthermore,it has been a period of expanding coverage of the EPF. Until 1980, only about3% of private disposable income was unavailable for consumption, locked in EPFdeposit accounts. By 1987, this had risen to 8a.

3.120 To some extent, the failure of private consumption to track CNPgrowth more closely is related to government's and individuals' attempts toprotect against external shocks. As discussed above, government has attemptedto smooth private income through countercyclical wage and fiscal policies.The analysis of private behavior, however, suggests that this has been unnec-essary. Even with fluctuations in their income, the private sector tends tosmooth out its consumption expenditures; both past and present income arefound to be important determinants of 2i7asumption. This accords with theeconomic concept of permanent income.- Furthermore, transitory incomecaused by fluctuations in current income from its trend level does not affectconsumption. Such transitory income is typically associated with terms oftrade changes. Thus, when GNP growth is linked to temporary movements in theterms of trade, consumption does not necessarily follow suit (Figure 3.3).

3.121 Despite the fact that contributions to the EPF and income earned onaccumulated EPF assets are not available for consumption directly, the dataindicates that some substitution between funds occurs. That is, the buildupof financial wealth in the EPF encourages individuals to reduce their savingsout of discretionary income. In this way, total private consumption reacts tothe wealth created in the Provident Fund. Another interpretation is that thebreakdown of total private income between discretionary and nondiscretionarycomponents reflects a shifting distribution of income. As a higher fractionof income goes to wages, EPF contributions and surplus increase. If the pro-pensity to consume out of wages is higher than out of profits, then thereshould be a close correlation between the EPF surplus and consumption, asfound empirically.

3.122 It is difficult to identify quantitatively the precise impact on consump-tion of income saved in EPF accounts because of the variety of channelsthrough which the influence is transmitted. It is reasonable to suppose, how-ever, that there is some impact on consumption associated with a substitutionof income between cash-in-hand and earnings in EPF accounts. A policy thatpermitted individuals greater control over their own resources would give animportant stimulus to consumption.

21/ See S. Bhalla, "The Measurement of Permanent Income and its Applicationto Savings Behavior," Journal of Political Economy, Vol. 88, August 1980,for a discussion of the relationship between permanent income andobserved annual incomes.

PERSONAL INCOME AND CONSUMPTIONMnlaysla, 1973-87

80-

3 GNP

70 - O Private Income

+ Discretionary Income

A Permanent Income

60 X Private Consumption

650

~40-

30-

20

10 7 773 74 75 76 77 78 79 80 81 82 83 84 as 86 -X

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3.123 Two other important determinants of consumption are the real effectiveexchange rate and the real deposit interest rate. As is typically the case, areal depreciation of the currency negatively affects consumption; thedeclining value of domestic assets depresses spending. There also appears tobe a response to the real deposit interest rate, but the effect is quite smallquantitatively. A one percentage point reduction in deposit rates boostsconsumption by only 0.41.

3.124 With significant changes in interest and exchange rates having alreadyoccurred in 1987, more stability in these variables is expected for 1988.Thus, most of the growth in private consumption will come from real incomegrowth. Given the recent pattern of income growth, a further growth of, say,61 in 1988 would be expected to support a 6.5X growth in consumption. Thelong-term relationship between consumption and income, however, suggests thatit is unrealistic to expect consumption growth to lead income growth inMalaysia, without measures being taken to reduce the significant forcedsavings now in place.

Government Spending

3.125 Real government spending in 1988 for operating purposes should stabilizeclose to 1987 levels. This is an inevitable consequence of the need torestore stability in public finances and the need for control over NFPE expen-ditures. This would still not be the end of adjustment. If public investmentexpands as a result of "catch-up" to the shortfall in spending in 1987,however, the deficit would grow again. A steady reduction in the deficituntil 1991 is likely to be necessary, reaching a taraget level of about 81 in1991.

3.126 The impact of government deficit reduction on growth will iepend on themechanics of adjustment. Regardless of how the deficit is brought down,however, one implication is that private disposable income will fall as ashare of GNP. Because much of the anticipated growth in 1988 will be absorbedby government in the form of higher revenues for PETRONAS and higher taxes,even a 61 increase in nominal GNP will only generate a 2.3% increase indiscretionary private income.

3.127 Government's continued reliance on investment cutbacks in response to itsfinancial difficulties is particularly harmful to growth. During 1987 therewas substantial underspending of the development budget. Some increase iscalled for, along with a strategy of holding the line on other expenditures,while waiting for growth to restore balance in public finances.

3.128 Within the permissible deficit, there will have to be important changesin the composition of spending. Because of a likely increase in both totaldebt and interest rate levels, interest payments on total public debt willrise faster than growth; they could be M$2 billion more in 1991 than in1987. Maintenance expenditures, particularly on roads, will also have to riseby about M$500 million per year. There may be some loss in revenue collectionif oil prices remain at current weak levels. Any gains from a broadening ofthe sales tax base (or the introduction of a VAT system) could be offset inthe short-run by small transitional losses that would occur in any reform of

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the corporate tax structure. In fact, because of these offsetting revenueeffects, it would be advisable to link the introduction of a VAT with corpo-rate income tax reform. Overall, however, the potential for major nondistor-tionary revenue increases is small and so fiscal stability depends onGovernment's ability to hold total expenditure, ot;her than maintenance andinterest, below the growth of output.

3.129 Three areas should receive priority in the search for lower ' vernmentexpenditures: (i) subsidies and transfers; (ii) debt management; and kii)reform of loss-making public enterprises. A detailed budgetary analysis ofthese is beyond the scope of this report, but order of magnitude calculationssuggest that progress in these areas may be sufficient to meet fiscal objec-tives without requiring further cuts in real government spending beyond 1988.

3.130 Subsidies and Transfers. If all subsidies in the budget were direct andtransparent, such as those listed under current expenditures in the budget, itwould be straightforward to tabulate and track down government subsidies. Inthe case of Malaysia, however, there are sizable implicit subsidies. Theseoperate, for example, through budgetary transfers to agencies for purposes ofequity capitalization or loans which never get repaid and through fundingoperational expenditures for activities which do not recover costs throughuser charges. A direct estimation of these indirect subsidies is almostimpossible; it would involve estimating the difference between market-determined costs of government-provided services and user prices. Especiallyin the context of the NEP, government programs in agriculture, housing, trans-portation, credit, health care, education and industry provide some element ofsubsidy.

3.131 The major explicit government subsidy program up to 1983 was in the areaof petroleum products (see Volume II, Chapter 2). With the reform of thisprogram, explicit subsidies have fallen sharply to total just M$500 million in1987. This decline, however, may mask an increase in implicit subsidies.

3.132 One way of calculating implicit subsidies and transfers is to subtracttotal government expenditure, recorded in the budget, from government demandfor real goods and services as recorded in the national income accounts.While there are some clear inconsistencies in moving between accounts in thisfashion, due to differences in coverage and in concept between the cash-basedbudget figures and the accrual-based national income data, the trend isindicative of what is happening to subsidies.

3.133 Figure 3.4 shows the pattern of total government expenditure and thesubsidy and transfer component defined as above. Since 1979, the portion ofall government spending--Federal, State, local and enterprises--that has gonetowards expenditure on real goods and services has been only about 60%. Theother 40Z has been absorbed in implicit subsidies and transfers. Of this,less than one-half is accounted for by net interest payments, pensions andgratuities; the remainder should reflect implicit and explicit subsidies.Controlling these expenditures is the most effective way of achieving sustain-able public finances. In general, the subsidy programs induce distortions inthe economy that restrict growth and efficiency.

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Figure 3.4: Total Expenditure, Subsidies and Transfers

40~

30-

25 I

20-

to

19701971 197219731974197S19076177197019,791g01s1 1 gt 1 937OtI F

O EUP .S$__

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3.134 Four government programs stand out as the largest and least cost-effective recipients of public subsidies: the support of padi farmers;subsidized housing credits; subsidized transport; and subsidized education.

3.135 Total support to padi farmers currently runs around M$200 million peryear, approximately equal to half the total income of padi farmers in 1987.In addition, there are implicit subsidies through the absence of full recoveryof water charges, fertilizer distribution and loans to cover the operatinglosses of LPN. These would be even higher except for the cross-subsidizationof milling and padi price support programs by taxing imported rice. Theoverall savings from a rationalization of the rice production, milling,2distribution and import system could be in the order of M$500 million.-_

3.136 The Treasury has four types of lending programs for civil servicehousing. These bear an interest rate of between 4-6% which, when comparedwith commercial mortgages, contains a subsidy of about 51% on average. If thecurrent annual expansion of M$l billion per year in outstanding loans were tocontinue, the subsidy equivalent would be M$510 million ver year. While thisreflects the expected savings to the Treasury from moving to market-basedlending rates, it does not reflect the savings from reducing the size of theloan program. The latter is given by the differential between the rates atwhich the Treasury borrows and on-lending rates. Under current market condi-tions, this is a much smaller, but still significant, figure of M$100-200million.

3.137 Reform of the Housing Loan Program is appropriate because with thedevelopment of a secondary mortgage marke- and increasing liquidity in thebanking system, the rationale for the program seems less evident now than atits inception. Raising interest rates on housing loans has proven to bedifficult, however, as civil servants perceive such loans as part of theiroverall compensation package. The preferred option would be to sell theexisting portfolio of loans to a housing finance company such aa MBSB, and touse the cash proceeds, which would probably only cover some 50% of the facevalue of the loans, to retire existing debt and to compensate civil servantswho have not yet ta2r out loans. Following this, the program could beabolished entirely.-

3.138 The transport sector is another major recipient of government funds.Malayan Railways (KTM) has consistently run on an operating loss and itsoverall net income loss, after accounting for interest expenses, reached M$77million in 1986. Although the government has not directly subsidize KTM'soperations, the railway is totally dependent on Government for its survival.Government has provided loans totalling M$514 million between 1981-85, hasreimbursed KTM for 50% of its losses on uneconomic passenger services, hasexempted it from all sales taxes and duties since 1982, and has released it

22/ The World Bank and EPU are currently studying this issue; a report isexpected shcctly.

23/ See "Malaysia: Housing Sector Report," World Bank 1988.

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from its pension liabilities. One striking feature of KTh's performance isthat despite its sustained losses, it has increased its fixed assets inservice by 502 since 1981. Government should act quickly to reduce KTM'sannual cash drain by (i) reform and decentralization of procedures to settariffs; (ii) reform of employment policies and absorption of railway workersinto other government departments; (iii) reappraisal of uneconomic passengerservice, particularly where alternative modes of transportation exist; and(iv) modification of the balance sheet, includi' write-down of debt, as aprecursor to corporatization and privatization.-

3.139 By far the largest government subsidy program is in the educationsector. Total expenditures on education amount to over $M4 billion. Theseinclude teacher salaries, support to universities, scholarships for overseasstudents and public training institutions, mostly of a technical nature. Theriajor potential areas for savings are in the latter three areas.

3.140 University education in Malaysia is heavily subsidized. Cost recoverythrough user-charges, which has recently been introduced, only suffices for2.5-10Z of the marginal operational costs. Furthermore, there is a widedisparity between the cost of alternative programs which is not fullyreflected in differentials in user charges. Although a student loan programis now in operation, its collection potential has yet to be tested and ampleopportunity exists for conversion to a grant.

3.141 The financing structure in university education has had several adverseconsequences. Lack of funds has constrained potential expansion. Somestudents go abroad on scholarship or private funds, but many are unable toparticipate in further education and enter the job market. This has created abulge in the supply of 15-19 year olds in the labor force and, consequently,the highest incidence of unemployment is in this group. The excess demand foruniversity education can be measured by the degree of rationing of entryapplications--only one in three applicants are successful nation-wide.

3.142 Increased use of user charges in universities, coupled with an enhancedstudent loan program to defray all cash outlays, would achieve several desir-able objectives, without jeopardizing government support for the principle ofaffordable and universally-accessible education. Particularly if loans weremoved off-budget to a separate agency (see Volume II, Chapter 3), there wouldbe a positive cash-flow benefit to the Treasury.

3.143 Similar problems exist in government training programs, especiallyvocational training. There, only one out of ten applicants is enrolled.Despite this, there is a high drop-out rate, with some 60X of the studentintake failing to graduate. Even for those that do complete the courses,there is little difference in their subsequent ability to obtain jobs relativeto those not trained. Only 5% of trainees are thought to obtain jobs usingskills developed in the courses. To assist in student placement, the Ministryof Labor now offers firms an additional inducement--payment of wages for one

24/ See "Malaysia: National Transport Policy Review," World Bank 1988.

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year for on-the-job training in firms. There is a substantial element ofwastage in these programs of both budgetary and manpower resources. Closerlinkages with the private sector and industry are desirable, going well beyondthe current advisory and consultative role played by the private sector in theManpower Development Board and the National Industrial Training and TradeCertification Board. Greater industry participation, sensitivity to labormarket conditions and accountability of course coordinators must be developed.

3.144 Debt Management. Interest payments on public debt are likely to total11.41 of GNP by 1991, or about one-third of public expenditure. Sizeableamounts of principal on domestic currency debt are also starting to fall dueand will grow exponentially in the medium-term. The public sector can hope togenerate considerable savings on its debt service obligations through moreactive debt management.

3.145 Active debt management is not a new concept for Malaysia. The countryaggressively and successfully refinaned much of its high interest externaldebt in 1983/84, reducing interest and smoothing principal repayments. It hasrecently embarked on a program to prepay M$5 billion of foreign loans in 1987and 1988. Such a program is attractive because of the relatively low levelsof domestic interest rates, particularly for short-term bills, and the favor-able foreign exchange reserves position. The Government has announcedexpected savings from this program to total M$528 million, which implies anaverage interest rate reduction of 2.5Z. This is unlikely to represent truesavings, however, because if the ringgit continues to appreciate against theUS dollar, as it has of late, then currency movements would anyway lead toreduced debt servicing in ringgit terms. Given the size of the debt, existingprograms should be thought of as only a first step in a mor! 5 omprehensiveliability management system that Government should develop.-

3.146 The volatility in world interest and exchange rates is directly reflectedin volatile debt service payments and obligations. Recently, for example,despite a prepayment of US$1 billion, the external debt of Malaysia continuedto rise marginally because of the appreciating value of yen-denominateddebt. Such problems beset many countries and multinational corporations. Asa result, there has been an explosive development in financial mechanisms toalleviate risk-eurodollar futures, options on eurodollar futurs, forward rateagreements, and interest rata caps are amongst the new instruments used forshort-term hedging, while futures and options on futures for Treasury notesand bonds are used for medium- to long-term hedges. These are useful to lockin a given interest rate, or to reduce the uncertainty associated with theinterest rate to be paid on future, prospective borrowings.

3.147 Beyond these well-developed instruments, there are additional, morefledgling markets, such as those in commodity bonds, that could prove usefulfor Malaysia, particularly given the reliance of government revenue on petro-

25/ The World Bank is prepared to assist Malaysia and other developingcountries in developing the necessary expertise for active liabilitymanagement.

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leum prices. Commodity bonds link either or both interest and principalpayments to a physical quantity of the commodity. For example, if the govern-ment had issued petroleum-based commodity bonds, its debt service obligationswould have declined along with the price of oil, relieving the pressure on thebudget to some extent. Commodity bonds have been used by the French andMexican governments, antd by a variety of corporations. In the 12 monthsending October 1987, there were some 45 commodity bond issues, two of whichinvolved public entities. Most were liLk7d to gold or silver, but othersincluded links to oil, copper and zinc.-2

3.148 The scope for commodity bonds in Malaysia is particularly great becauseof the country's dependence on primary commodities. Partly, such bonds can beused internationally, to hedge against commodity price movements. At present,the scope here is limited because of the thinness of the international marketand the lack of liquidity in commodity bonds. Of greater potential is thedevelopment of a domestic commodity bond market. Long-term institutionalinvestors, such as EPF, may be willing to hold such bonds because of thepotential for greater returns. In this way, the fortunes of commodity priceswould be directly and broadly transmitted to individuals throughout thecountry in an efficient manner. By contrast, individuals are now affected bycommodity prices, for example for oil, through indirect channels such as cut-backs in government expenditure and declining employment and job prospects.This "real" adjustment is much less efficient than the proposed financialadjustment.

3.149 Reform of Loss-making Public Enterprises. In 1986, over half of allpublic corporations on which data exist posted losses in their net profitsaccount. There were 311 such firms operating in every segment of theeconomy. In addition, a half-dozen companies, including the railways (KTM),the Urban Development Authority, and Sabah electricity, that are not corpora-tized are known to have made losses. The cumulative total of these lossesequalled about M$2 billion. This figure is larger than the sum of all theprofit-making public enterprises excluding Petronas and its two largestsubsidiaries.

3.150 The net loss figures quoted above are an underestimate of the true costof operations of these companies. Government has sunk some M$33.9 billion intotal assets into the loss-making companies, most of which must realisticallybe considered as a write-off. The loss-making firms carry only a slightinterest burden, (M$600 million--they have total outstanding loans of onlyM$9.8 billion, low in comparison to the size of assets), and pay almost notaxes (M$60 million) or dividends. In several instances, including theimportant examples of steel and cement, financial losses have been minimizedby setting regulated prices above world prices for these goods. In othercases, such as railways, important rental income is earned from non-operatingprofits. In all but thirty-nine cases, companies with negative net profitsalso had negative operating profits. In addition to ftunding these losses,

26/ See "Commodity Bonds: A Risk Management Instrument for DevelopingCountries," T. Privolos, World Bank (processed), November 1987.

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Government or parent NFPms must also provide financing for additional capitalexpenditure.

3.151 The implication of these statistics is striking. First, remedies thatrely solely upon financial retructuring and tax breaks are unlikely to providea cure. The greater problem lies in efficiency of operation as a result ofsome combination of poor management, excessive employment, poor technology orinappropriate location. Privatization would only be suitable if losses stemfrom the first two causes. Otherwise, liquidation must be considered.

3.152 Second, despite the recent Government initiative to set up a unit in theTreasury to study alternatives for dealing with the ten largest loss-makers,there remains a sizeable probi v that is essentially excluded from publicsector scrutiny and controls._, These latter cost the Treasury some M$800million in 1986. Thus, while Government efforts are correctly focused on thelargest firms, it cannot afford to set aside the problems of smaller firms.Introducing incentives for privatization and liquidation as part of a perfor-mance evaluation system should be considered as a mechanism for dealing withsmall loss-making firms.

3.153 To a significant degree, the Treasury must continue to bear losses as aresult of interest payments, labor pensions and other commitments, even if afirm is liquidated. A lower bound on the savings to the exchequer is thetotal operating loss of companies that are candidates for closure. Thistotalled M$420 million in 1986. To the extent that (a) some revenues may berealized from the sale of assets; (b) some non-operating expenditures wouldalso be reduced on closure; and (c) some of the interest burden would beshared by other equity holders, the savings could substantially exceed thisfigure.

Off-budget Government Programs

3.154 In addition to its budgetary operations, government influences theeconomy through a series of off-budget programs. The most important of theseare credit programs and the Special Low Cost Housing Program. But a varietyof other activities, such as setting of smallholder agricultural prices, arealso important. The tendency has been to use these programs in a counter-cyclical fashion. There is some danger, however, that implementation of theseprograms generates distortions and amplifies business cycles in an unwarrantedfashion.

3.155 The Special Low Cost Housing Program (SLCHP). The SLCHP proposed that240,000 low cost housing units be constructed by private developers in threeyears, starting in mid-1986. There are no explicit budgetary provisions orformal mechanisms for achieving the target, but considerable incentives are

27/ Amongst the largest loss-makers are Perwaja Steel, Perusahaan OtomobilNasional, Kedah Cement, Sabah Gas, Sabah Forests, Sabah Shipyard,Malaysia Mining, Malaysia Shipyard and Engineering, UMW Corporation,Malayawata Steel and Mamut Copper Mine.

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given in the form of revised building and planning standards, provision of lowcost land by State governments and liberal rezoning permissions. Because ofimplementation lags and the sequencing of land acquisition, land developmentand construction, the number of completed units and investment in the firstyear of the program has been quite small--32,000 units complete1 by mid-1987for an estimated investment of under M$600 million. Many units, however, inthe intermediate stages of completion will be finished during the currentyear, so the pace of implementation is expected to pick up substantially. Anadditional M$1 bilion over the first year investment level should be forth-coming, giving a sizeable boost to the economy in 1988.

3.156 Despite its merits in terms of the social benefits from low-cost housingand the creation of a housing supply system that is more responsive to demand,the SLCHP has run afoul of a typical macroeconomic problem besetting publiccountercyclical programs; the need for a macroeconomic stimulus may have longpassed by the time the program comes fully on stream. The effects of a majorstimulus in 1988 are likely to be mixed as recovery is already well in hand,primarily because of commodity price increases and government's fiscal expan-sion in 1987. If investment is already recovering, then instead of addingincremental investment, the SLCHP may substitute for investment in other areasand may postpone adjustment in the labor market. It would be advisable toextend the life of the program so as to phase investments towards the next fewyears when external stimuli may be absent or negative.

Overall Impact

3.157 The overall impact of the measures decribed above would be to placepublic finances on a more solid and sustainable footing. The savings identi-fied could amount to M$1-2 billion, with almost no reduction in real govern-ment consumption or investment. More importantly, however, the changes wouldsignify a completion of government's fiscal adjustment, which has started withthe phasing down of spending on goods and services and should now continueinto the more sensitive area of grants and subuidies. The proposed measureswould instill a greater degree of financial accountability at a decentralized,program level, and make for a more effective delivery of government services.

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IV. ECONOMIC OUTLOOK AND INTEGRATED POLICY RECOMMENDATIONS

A. Economic Outlook

4.1 A growth scenario for the future and the corresponding investment,savings and balance of payments developments is projected below on the basisof supportive policy reform, as outlined above. In the short-run, the mostcritical variable to sustain recovery is private investment. In the medium-term, private consumption will play a more significant role. The emphasis onthe private sector as the engine of demand growth arises because of thelimitations on government imposed by current financial constraints and becausenet ezports should not be expected to improve beyond the record levels postedin 1987.

The External Environment

4.2 Having accounted for 72X of total demand growth in the 1980s, theevolution of the external environment is obviously critical for Malaysia. Themajor structural adjustments underway in the developed world and in parts ofthe devcloping world have consequences for trade, commodity price, exchangerate and capital flow behavior that will seriously affect Malaysian prospectsfor industrial growth.

4.3 The Global Setting. In its most recent World Development Report,1988, the World Bank forecasts growth in the developed countries of 2.31 overthe next eight years, inflation of 41 and trade growth of 42. The compositionof growth, however, is expected to adjust-the recent historical pattern ofexport-led growth in Europe and Japan coupled with consumption-led growth inthe USA will likely reverse itself. Japan, and Western Europe to a lesserextent, will become more internally oriented while the USA will become moreoutwardly-oriented. Given the fact that the US market is the most open in thedeveloped world, the expected growth of manufactured exports from developingcountries is likely to slow down to 5.81.

4.4 Sluggish growth in industrialized countries also implies thatcommodity prices will remain weak over the short-term, failing to keep pacewith general inflation. Added to short-term pressures on petroleum prices,this suggests that Malaysia's overall terms of trade may deteriorate slightlyin 1988 before steadily improving on the strength of palm oil, tin, rubber andpetroleum prices. In volume terms, petroleum exports will grow substantiallyin 1988, but thereafter palm oil, cocoa and LNG are the only commodities withmoderate growth prospects in the 3-4Z range. Environmental pressures andforest depletion will limit timber exports, particularly of logs; and slowdemand for rubber, tin and petroleum is expected to limit future growth ofthese commodities.

4.5 Because Malaysia's manufactured exports are so concentrated inelectronics and textiles, their prospects may well differ from the overalltrend in developing country manufactured exports. The short-term prospects inboth these industries are excellent, but medium-term trends portend rapidchanges in the structure of trade and nature of comparative advantage of LDCexporters like Malaysia.

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4.6 Electronics. Malaysia's electronics industry developed very rapidlyfrom virtually nothing in the early 1970s to the point where it accounts forover half of manufactured exports. The output structure is dominated bycomponents (80-85Z of output) and within that subsector, semi-conductors havepredominated accounting for 80-90% of component output. Malaysia has notdeveloped a sizeable electronic equipment industry, either for consumer orindustrial electronics products. The industry's growth has been inextricablylinked to investments by multinational semiconductor firms which cam toMalaysia in search of cheap labor for the assembly of semiconductors.

4.7 Trends in the industry worldwide since the early 1980s raise doubtswhether this growth pattern can continue for the medium term. Of criticalimportance is the continuing automation in semiconductor assembly. There isevidence that an increasing share of semiconductor assembly is shifting backtowards the developed countries. The trend is most striking in Dynamic RandomAccess Memory chips (DRAMs), the largest single segment of the semiconductormarket. Also acting against developing country procedures is the continuingshift toward more complex, application specific integrated circuits within theindustry's prodtuct mix. These lower volume, high-cost products depend onclose coordination between consumers and producers. Finally, there is a trendtoward use of surface mount components, which involve high density packagingand assembly technology, in a wide variety of electronic products. necessi-tating expensive automated equipment. These worldwide trends suggest thatMalaysia's competitive advantage based on low labor costs will be increasinglyless important. As the experience of the Philippines shows,- loss ofcompetitiveness can quickly hurt the industry.

4.8 In the short-run, however, growth in traditional semiconductorsshould continue to be rapid. These components have benafitted from the ever-increasing scope of applications, especially into consumer durables. Malaysiashould continue to benefit from this given two advantages relative to competi-tors such as the Philippines: political stability and the existence ofsemiconductor testing facilities that ensure high quality. Nevertheless,there will be stiff competition from other countries as currently, there issizeable global overcapacity in production of 64 K and 256 K semiconductors.

4.9 Global trends do not spell the end for the Malaysian electronicsindustry but they do suggest that a new strategy is required in order for thephenomenal growth in exports of semi-conductors to continue over the medium-term. The first element of such a strategy must be to induce foreigncompanies to make the required investments to produce new products at thenecessary qualitv levels. The second element should be to exploit theadvantages in quality that Malaysia possesses over lower-cost producers suchas the Philippines, due to its large semi-conductor testing facilities. Thethird step would be to take greater advantage of proximity to Singapore todevelop niche products that are closely tailored to the requirement of the

I/ The Philippines experienced rapid growth in electronics exports in theearly 1980s, which came to an abrupt halt when political instability andan appreciating real exchange rate caused a pull-out by multinationals.

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Singapore market. Finally, the marketing strategy should foster closerintegration with producers of engineering goods, automobiles and consumerdurables at home and abroad.

4.10 The advantage of developing a "niche" strategy is that it can beimplemented relatively quickly, at low cost, and with full focus of governmentand industry resources to ensure success. In the rapidly changing globaltechnological and marketing environment, this has the added attraction of notrequiring specific long-range planning and long gestation investments whichwould be difficult to modify even if future conditions warrant. Overall, itappears that the factors underlying the successful semiconductor export drivefrom Malaysia over the past decade are rapidly disappearing. In their placeare new opportunities for growth, but these require building on strategicadvantages, inducing a new round of major investments in plant and equipment,and exploring direct marketing involvements with new consumerp. Success inthis new environment is uncertain; what is clear is that simple provision ofan undistorted location in Free Trade Zones and an abundant supply ofrelatively skilled but cheap labor will no longer be a sufficient guarantor ofexporting success.

4.11 Textiles. The textile industry is also subject to major changes inthe structure of world trade. The industry currently employs about 142 of themanufacturing workforce and accounts for 11% of manufactured exports.Malaysia is a relatively small textile producer by world standards, but hasbeen highly successful in the garment sector, essentially commissioning workfor foreign clients on the strength of its well qualified and low cost laborforce. The country has a competitive supply of polyester fibre, but has toimport virtually all its cotton and has a surprisingly small spinning capa-city, which shows considerable age (three-quarters of the machines are morethan 10 years old). Weaving capacity is also relatively small and almost 90Zof it is older than 10 years.

4.12 Whereas the textile industry has catered to the domestic marketunder relatively high effective protection, the garment industry has developedpredominantly as an enclave industry for exports, where local labor is addedto imported inputs. The garments sector has continuously modernized andexpanded its share in the lucrative markets of the USA and the EEC. Now,however, the industry is increasingly subject to pressures from severaldirections. Overall world consumption of fibres is projected to growconsiderably slower in the future (1.62) than it has in the past (4.62 p.a.since 1950). Furthermore, quotas under the Multifibre Agreements (MFA) havebeen steadily tightened. For the products included under the MFA, Malaysiafalls within the category of countries for which growth is limited to 62.Because of quota restrictions, there has been growing surplus capacity in anumber of producing countries, which is resulting in increasing competitionfor the more limited non-quota market. In addition, recent and ongoinginvestments into highly efficient and largely automated equipment,particularly in developed countries and NICs, are likely to cause an evenstronger shift of supply of high quality, high fashion textiles and garmentsto those countries. Textile labor costs have also risen quickly in Malaysiaand are now well above those in some of its principal competitors--China,Indonesia, Thailand and Pakistan.

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4.13 In this increasingly competitive market, the ability to survive andexpand seems closely related to the type of equipment in use and the efficientmanagement of a highly automated process. Such an operation requires tech-nical and managerial skills of a high order, a dependable labor force and areputation for quality. Garment production in the upper and middle pricebrackets demanao excellent design, the ability to produce in small lots and awell developed marketing system built around respected brand names and withdeveloped channels for dealing with numerous retailers in importingcountries. Increasingly, fashion models can be designed with the help ofpersonal computers; cutting, which already is semi-automated on a commercialscale, can now be fully automated and computer-guided. Robots for sewing andmaking-up are still in an infant stage, but they are also expected to becomecommercially competitive during the 1990O. The ease and speed with whichpattern changes can be introduced under this technology is a critical competi-tive advar.tage that may cause a gradual return of garment manufacturing intoindustrialized countries, particularly for mass-produced high fashion itemswith short life-cycles.

4.14 One additional modernization trend is in the marketing of textilesand garments. Electronic media and telecommunication systems will permit amuch closer link between manufacturers of textiles and apparel and clients inwholesaling and retailing, with greater attention paid to high inventory turn-over and lower carrying costs. This will further detract from the advantageof cheap lyor that is still the basis for the garment industry in developingcountries._

4.15 While the long-term prospects for textiles and garment exports fromdeveloping countries are moderate at best, Malaysia has some important medium-term advantages. Foremost is the shift in quotas in the US from an item-by-item approach to a comprehensive agreement that permits a 6Z annual volumegrowth in exports. This permits greater flexibility in filling quotas andencourages a shift to higher value-added products. In addition, stricterquota restrictions on Malaysia's major competition, including Japan, Korea andHong Kong, limiting their growth to just 12 per year, should help divertinvestment from these countries to Malaysia. The new quota system has alsoassisted the US industry to reach full capacity and this, combined with therestrictions on imports, is liable to generate upward pressure on prices thatwould benefit small exporters.

4.16 Protectionism. Protectionist legislation provides the most severethreat to Malaysia's manufactured export potential. Legislation pending inthe US Congress would seek to cut textile and garment quotas to 1% growth peryear across-the-board. Recent atLempts to relabel palm oil are also areflection of this trend. Despite these potential threats to market accessfor Malaysian products, however, the country is in excellent shape to turnprotectionism into a benefit rather than a cost.

2/ See Kurt Hoffman, "Clothing, Chips and Competitive Advantage: The Impactof Microelectronics on Trade and Producticn in the GovernmentIndustry," World Development, March 1985.

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4.17 This somewhat paradoxical conclusion emerges clearly ifprotectionism is viewed from a political economy perspective. There is agrowing tendency to use trade policy for bilateral ends, demonstrated by thefavorable treatment afforded Caribbean and African countries, and the LLDCs.The other side of the coin is the trend towards retaliation against selectedcountries on a bilateral basis. The four Asian NICs are all being pressuredin this regard.

4.18 Garment and automobile exports are examples of two sectors whereMalaysia has benefited from global protectionism. In the textile and garmentssector, it is probable that without a quota system, or if MFA quotas are"globalized" in the next round of trade negotiations, the low-cost producersin China and India would sweep away the rest of the developing countrycompetition in the future, leaving behind only small high-fashion niches forothers to exploit. Similarly, the presence of voluntary export restraints onJapanese automobile exports to the United States, apd the danger posed toKorea of a too successful market penetration, makes it more probable that theProton Saga could hope to gain significant sales.

4.19 Malaysia is in an excellent position to ward off protectionistthreats against its products, even as other countries become more exposed.First, by virtue of its trade structure, Malaysia has a comparatively smallbilateral surplus with the UP\. By contrast, other East Asian economies haveseen their surpluses grow to unprecedented heights (Table 4.1). This trend iscontinuing despite US efforts at adjustment. While the overall trade deficitin America is declining in real terms, these gains have been made mostly atthe expense of Western Europe rather than the NICs.

4.20 A second favorable factor in Malaysia is the openness of domesticmarkets. The high share of imports in GDP and low tariff barriers on importsgives the country an edge in seeking favorable treatment for new quotas in thefuture. A third factor is the importance of semiconductor exports which arelargely free from trade restrictions. Finally, passage of the Copyright Actin 1987 and openness in the financial, insurance and other service sectors inMalaysia should also keep the country in good standing in its trade relationswith the USA.

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Table 4. 1: EXTERNAL BALANCES OF EAST ASIAN COUNTRIES(US$ billion)

1983 1984 1985 1986 1987

MalayfiaCurrent account balance -3.5 -1.7 -0.7 -0.3 2.3Trade balance wit' US -0.3 -0.1 0.1 0.3 n.a.

KoreaCurrent account btiance -1.6 -1.4 -0.9 4.6 9.8Trade balance with US 2.0 3.6 4.3 7.3 9.0

Taiwan, ChinaCurrent account balance 4.4 7.0 9.2 16.2 20.0Trade balance with US 6.7 9.8 10.0 13.6 16.0

Hong KongCurrent account balance -0.6 1.4 1.9 1.5 n.a.Trade balance with US 4.4 6.3 6.5 8.1 n.a.

SingaporeCurrent account balance -1.0 -0.7 -0.0 0.5 0.2Trade balance with US -0.3 0.6 0.8 1.4 n.a.

ThailandCurrent account balance -2.9 -2.1 -1.5 0.1 -0.2Trade balance with US -0.3 -0.1 0.4 0.3 n.a.

Source: Directory of Trade Statistics, IMF, various issues.

4.21 Malaysia will not be able to escape unscathed from protectionism.The shifting structure of trade will bring it face-to-face with markets in theEEC and Japan that rely much more heavily than the United States on non-tariffbarriers (NTBs) (Table 4.2). Still, in comparison with other East Asiancountries, and LDCs in general, Malaysia faces less protectionism in thesemarkets. To see the sectors where a shift in markets is likely to be diffi-cult, Table 4.3 presents the percent of imports of selected major commoditiesthat is subject to NTBs in the major importing countries. The table showsthat traditional exports such as garments and textiles are heavily regulatedin all major importing regions. Other products, however, such as shellfish,prepared fish and rubber, which are free from NTBs in the US, are faced withsignificant barriers in other markets. Imports of products such as wood,lumber and cork in Japan and footwear in the EEC and also largely governed byNTBs. Thus, diversification of exports in these areas will not be easy.

Table 4.2: NONTARIFF BARRIERS AGAINST IMPORTSFROM SELECTED ASEAN COUNTRIES, 1984

(US$ million)

Imports subject to nontariff barriers Share ofFiscal Volume con- Import Control of Technical total

measures trol measures authorization price level barriers All Total importsAmount % Amount Z Amount 2 Amount % Amount % NTBs Imports (2)

lmports of.1apan from:Malaysia 23.1 1.6 43.1 3.0 16.3 1.2 0.0 0.0 331.8 23.5 371.1 1,414.0 26.2Phtlippines 261.7 18.7 69.6 5.0 72.5 5.2 0.0 0.0 686.7 49.1 725.9 1,397.7 51.9Thailand 74.7 7.3 123.5 12.0 195.7 19.0 0.0 0.0 804.2 78.2 833.0 1,028.7 81.0Indonesia 655.97 5.9 47.0 0.4 245.7 2.2 0.0 0.0 4,329.9 38.9 5,042.9 11,123.7 45.3All LDCs 1,707.9 2.2 2,095.0 2.7 3,727.4 4.9 0.0 0.0 17,941.7 25.5 20,534.5 76,205.1 26.9

Imports of _EEC from:

Malaysia 445.6 20.8 63.4 3.0 138.9 6.5 8.' 0.4 0.02 0.0 827.6 2,139.8 38.7Philippines 278.9 28.2 49.7 5.0 93.8 9.5 22.4 2.3 0.0 0.0 610.2 990.0 61.6Thailand 723.0 49.2 608.2 41.3 805.1 54.7 65.2 4.4 0.26 0.0 1,112.7 1,470.9 75.6Indonesia 299.5 24.9 68.26 5.7 134.8 11.2 4.8 0.4 0.20 0.0 584.4 1,203.7 48.5All LDCs 5,640.6 5.0 16,398.2 14.5 11,317.2 10.0 3,209.6 2.8 249.6 0.2 39,510.8 113,214.8 34.9

Imports ofUSA from:Malaysia 1.90 0.1 0.02 0.0 0.06 0.0 153.9 5.7 0.0 0.0 156.2 2,682.1 5.8Philippines 169.4 7.0 130.6 5.4 0.02 0.0 27.2 1.1 0.0 0.0 255.0 2,417.9 10.5Thalland 114.4 8.7 20.9 1.6 0.01 0.0 250.0 19.0 0.0 0.0 370.6 1,316.6 28.1Tndonesia 7.0 0.1 0.0 0.0 0.0 0.0 200.4 3.7 0.0 0.0 219.5 5,381.2 4.1All LT)Cs 5,594.9 46.0 3,658.2 3.0 251.7 0.2 4,840.1 4.0 319.8 0.3 10,037.3 122,356.8 8.2

Souirce: IJNCTAD, Data Base on Trade Measures.

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Table 4.3: NON-TARIFF BARRIER PROTECTIONISMIN SELECTED COMMODITIES /a

Wood,Prepared lumber, Foot-

Garments Textiles Shellfish fish Rubber cork wear

ImporterJapan 82.4 71.0 100.0 100.0 100.0 31.2 0.0EEC 62.8 100.0 100.0 99.8 n.a. 8.7 23.7USA 90.3 99.7 0.0 19.1 0.0 0.0 0.0

/a Percent of exports from Malaysia to major markets covered by non-tariffbarriers in 1984.

Source: UNCTAD data base on trade measures.

4.22 Competitor Behavior. Malaysia's manufactured export performancedepends heavily on its competitiveness relative to neighboring East Asiancountries. As noted above, the competitive position deteriorated substan-tially in the mid-1980s but has been improving since 1985. A major impetuswill come from additional pressures on the unit labor costs of the successfulNICe. Large current account surpluses in those countries are being trans-formed into foreign exchange reserve accumulation and pressures to appreciatethe currency. This has already occurred to some extent in 1987 in Taiwan andKoreat and is likely to accelerate in 1988. In addition, wage increases inlocal currency terms in those countries are starting to outstrip productivitygains. Dollar-denominated unit labor costs in Korea and Taiwan could rise by20-30Z in 1988. Similar pressures are being felt in Hong Kong and Singapore,although these have, to date, been resisted by the authorities.

4.23 The NICs will also come under increasing pressure to adjust becauseof their large trade surpluses with the United States. In addition toexchange rate appreciation, these countries face increasing threats of non-tariff barriers including voluntary export restraints, anti-dumping charges,restrictive quotas and abolition of the generalized system of preferences(CSP), not to mention even more discriminatory trade bills pending in the USCongress.

4.24 Malaysia stands to gain from these external developments bothin terms of its ability to compete directly with the Asian NICs and throughthe foreign investment inflows it could capture in the future. The NICsthemselves have become major exporters of capital anu will look increasinglyfavorably on a location providing relative safety against protectionism, low-cost labor and few distortions affecting export-oriented industries. IfMalaysia continues to qualify in this regard, the recent growth in foreigndirect investment could accelerate.

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Prospects for Exports and the Balance of Payments

4.25 Taking into account the international setting, aggregate exports in1988 are forecast to grow by 9.11 in real terms and by 15.4% in nominal terms(Table 4.4). Export revenue growth would be led by petroleum (6.6%),manufactures (28.6%), and palm oil (22.91). In the latter case, however, mostof the growth is anticipated to come from price increases. After 1988,therefore, prospects for export growth are less favorable. Petroleum exportsare likely to plateau at the higher 1988 level; rubber, tin and sawlog volumegrowth is also expected to be flat. The sole remaining areas of dynamism willbe in palm oil, manufactures and other, minor exports. Overall, 1988-91,nominal export growth would decline to 8.3%, and maintain this levelapproximately thereafter.

4.26 The 1987 trade surplus of US$5.8 billion is projected to slowlydecline in the medium term. Imports would grow faster than exports asintermediate inputs for manufacturing pick up and as the structure of domesticdemand shifts towards private consumption and investment (see paras. 4.30-4.40below). Nevertheless, because exports start from a 1987 base that is 50Zgreater than the import level, the merchandise goods balance is projected todeteriorate systematically very slowly over the next decade.

4.27 The services accounts, on the other hand, are projected to continueto deteriorate. Non-factor service payments, principally related to insuranceand freight of Malaysia's expanding trade, are projected to grow in real termsfaster than overall GDP. reflecting the growing overall openness of theeconomy. Meanwhile, non-factor service receipts are projected to expand at amodest 4% per year. Should Malaysia initiate a drive to develop tourism or toincrease the capacity of its shipping fleet, better progress on non-factorservice receipts could be expected. In addition, net factor income paymentsare aLso anticipated to rise as growing profits in the foreign corporatesector are repatriated. Interest payments, however, are likely to decline inthe medium-term, as a result of Government's prepayment program. They wouldonly rise thereafter if a conservative foreign exchange reserve managementpolicy was followed. That is, if reserves are maintained at over six monthsof merchandise imports, additional foreign borrowing would become necessary toachieve balance in external payments after 1990. This is the scenarioindicated in Table 4.4. On a net basis, however, interest payments would notincrease as earnings on reserves would also rise.

4.28 The projected scenario shows a considerable long-term improvement inMalaysia's external debt position. Total medium- and long-term debt wouldfall from 74% of GDP in 1987 to 72% by 1997. The overall debt service ratio,temporarily raised by the prepayment program, would fall from 18.5% to 9%, ofwhich only 3.2% represents interest outflows. These indicators all point tothe continued strong creditworthiness position held by Malaysia, which shouldenable the country to obtain the finest of terms on bank credits and to moveinto new, more suitable and diversified, financial markets for its developmentrequirements.

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Table 4.4: MALAYSIA - BALANCE OF PAYMENTS(US$ millions at current prices)

Revised Projections1987 1988 -1989 1990 1991 1992

Exports of goods & NFS 20,154 23,262 25,456 27,011 29,551 32,376Merchandise (FOB) 17,711 20,603 22,600 24,106 26,505 29,183Nonfactor services 2,443 2,659 2,856 2,905 3,046 3,193

Imports of goods & NFS 15,830 19,166 22,310 24,335 27,017 29,967Merchandise (FOB) 11,823 14,664 17,283 19,096 21,387 23,909Nonfactor services 4,007 4,502 5,027 5,238 5,630 6,058

Resource balance 4,324 4,096 3,146 2,677 2,534 2,409

Net factor income -2,043 -2,140 -2,060 -2,049 -2,077 -2,054Factor receipts 715 803 812 808 880 976Factor payments 2,758 2,943 2,872 2,856 2,957 3,030(interest payments) 1,428 1,466 1,391 1,329 1,336 1,307

Net current transfers 143 139 135 137 136 136

Current account balance 2,424 2,094 1,221 765 593 491

Long-term capital inflow -420 -1,636 -735 733 1,234 1,470Direct investment 576 618 647 632 638 643Net LT loans -996 -2,253 -1,382 101 596 827

Total other items (net) -854 -459 -486 -486 -486 -487Net short term capital -955 -56 -83 -83 -83 -83Capital flows N.E.I. -10 -403 -403 -403 -403 -403Errors and omissions 101 0 0 0 0 0

Changes in net reserves -1,149 0 0 -1,012 -1,341 -1,475

Source: Staff estimates.

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The Domestic Environment

4.29 Despite the rapid growth in exports that is forecast, especially ofmanufactured goods, it is domestic demand that will have to absorb all ofMalaysia's incremental output over the medium-term (Table 4.5). Net ofimports, the trade sector will surely impart a negative component to totaldemand growth. This follows from the fact that Malaysia cannot expect tomaintain or increase its trade surplus beyond the record levels posted in1987. If it were to try, it would face the same protectionist pressures thatcurrently beset other East Asian manufactured exporters, and the samepressures towards an appreciation of the ringgit. Nor could this be absorbedthrough a build-up of foreign exchange revenues as these already stand atsubstantial levels.

4.30 This logic indicates that Malaysia must itself make a significantadjustment as a result of the change in its external accounts. Furthermore,the troublesome overall fiscal deficit, combined with high public debt levels,imply that the public sector will be ill-advised to take the lead role indriving domestic demand growth upwards. Instead, it is the domestic privatesector that must sustain the recovery. The base case scenario presented belowenvisages 6% growth for 1988 continuing at this level over the medium-term.

4.31 Private Investment. The economic fundamentals driving privateinvestment are extremely favorable. During 1988, private investment shouldbenefit from a cyclical upswing as well as from positive medium-term develop-ments. These should combine to generate a growth that could reach 15-20% over1987.

4.32 A strong cyclical effect should be felt in 1988. This stems fromthe lag between the decision by firms to invest and the actual implementationof a project. A foretaste of this effect is given by the Business Expecta-tions Survey that indicetes a major surge in corporate managers' plans toundertake new capital expenditures. The strength of the 1987 recovery, juxta-posed against the weakness of growth in 1986, suggests that the impetus toinvestment imparted by the business cycle may be substantial--in the order ofM$l billion. An equivalent amount of stimulus will also be derived from theSpecial Low Cost Housing Program.

4.33 The medium-term fundamentals also bode well for investment. Bothreal interest rates and the real exchange rate are at favorable levels. Afterseveral years of slackness, oil and gas investment is likely to rise byperhaps M$500 million. Foreign direct investment should also contribute anadditional M$100 million. The real key, however, lies in the boom in profitsthat appears imminent given the trend towards moderate growth in nationalincome and the increasing share of profits in this income.

4.34 Based on the recent dynamics of the labor market, average real wagesin 1988 are likely to decline, perhaps by as much as 3%. This shift reflectsthe interaction of two trends. On the one hand, wage growth for existingworkers and new entrants will continue to be negligible, or only slightlypositive, due to the pressure of unemployment. On the other hand, an increas-ing fraction of the labor force will be comprised of workers whose salary and

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Table 4.5: NATIONAL ACCOUNTS IN CONSTANT 1978 PRICES(M$ million)

Prelim. Projections1987 1988 1989 1990 1991 1992

Gross domestic product m.p. 61,008 64,975 68,907 73,003 77,406 82,143Import duties lessimported bank servicecharges -525 -462 -490 -519 -550 -584

Agriculture 13,323 13,629 14,038 14,459 14,893 15,340Industry 23,420 25,976 28,365 30,720 33,303 36,139(of which Manufacturing) 13,323 15,567 17,435 19,353 21,481 23,844Services 24,790 25,831 26,994 28,343 29,760 31,248

Resource balance -10,630 -10,344 -9,156 -7,904 -7,042 -6,211Exports of GNFS 41,706 45,487 48,269 51,199 54,403 57,957Imports of GNFS 31,076 35,142 39,113 43,296 47,361 51,746

Total Expenditures(A-B) 50,378 54,630 59,750 65,100 70,364 75,933

Total Consumption 36,392 38,961 42,330 45,969 49,585 53,443

Private consumption 26,666 29,131 32,302 35,641 38,843 42,164General government 9,676 9,831 10,027 10,328 10,741 11,278

Gross domestic investment 13,986 15,669 17,420 19,131 20,780 22,490Fixed investment 13,627 15,606 17,224 18,926 20,559 22,253Changes in stocks -359 63 197 205 220 237

Memo itemsTerms of trade adjustment -2,141 -2,834 -3,642 -3,141 -2,601 -2,050

Gross national income 54,878 58,155 61,601 66,136 71,059 76,417

Gross national product 57,019 60,989 65,242 69,272 73,660 78,467

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compensation base was determined after the 1985 collapse of new-entrantwages. It is this rising proportion of low-wage workers that will bringaverage wages down in 1988, and will initiate a fall in the share of totalwages in national income and a rise in the share of profits.

4.35 In the short-run, employment will respond positively to the fall inwages. It will also increase as a direct result of output growth. In themost probable scenario, total employment would rise by 4.5% in 1988, fasterthan the rate of growth of GDP. Nevertheless, the total wage bill would onlyrise by 1.51 over 1987. This implies that total profits will surge by almost1OX, providing an additional boost to investment.

4.36 The five major positive forces behind investment noted above--thecyclical demand increase, the SLCHP, renewed oil and gas interest, higherforeign direct investment, and the profits bonanza-are not all independentphenomena, but to some extent represent different ways of accounting for thesame expenditures. Overall, private investment should grow by around M$2billion. With public investment remaining approximately constant, this wouldgenerate a 141 growth in total domestic investment.

4.37 Over the medium-term, investment growth should continue to outstripGDP growth, although by smaller amounts. Fixed investment growth shouldaverage about 9Z over the next decade. This would be made possible only as aresult of private consumption growing faster than GDP, providing the demandstimulus to support investment. Additionally, public investment should startto pick up once the public finance situation stabilizes in 1991. Foreigndirect investment should also continue to be a prime mover in investmentgrowth over the medium-term.

4.38 Private Consumption. As is the case for investment, privateconsumption should also benefit from a strongly positive cyclical effect whichwould outweigh the negative structural forces affecting private disposableincome. Private consumption behavior in Malaysia appears to respond to thetrend in long-run sustainable income which is currently beset by two counter-vailing forces. On the one hand, private disposable income is being squeezedby the trend towards reducing the fiscal deficit. The expected improvementsin federal tax collections as a result of elimination of exemptions andloopholes and the measures to improve public enterprise operating surpluseshave, as counterpart, a decline in the share of national income remaining inprivate sector hands. A 6% growth in GDP in 1988 would only generate a 2.3%growth in private disposable income, after allowance is made for the addi-tional expected public sector take. On the other hand, as consumers' memoriesof the 1985 recession recede, they are likely to revise up their estimate oflong-run sustainable income, closer to the levels represented by 1987 and1988. Overall, long-run income growth will be 5-6%. On this basis, privateconsumption is forecast to grow by 7-9Z. As general government consumptionwill be restrained, with forecast growth of 1.6% , total consumption growthwould be only 7.11 in 1988 (Table 4.6).

4.39 Over the medium-term, consumption can grow faster than GDP, withoutjeopardizing the nation's finances. Malaysia posted a savings rate of almost33% of national income in 1987, a performance largely responsible for the

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substantial surplus in the current account of the balance of payments. Ifthis were to be slowly brought down to 28%, it would provide the leeway forthe necessary consumption growth over the medium-term. Within this level,however, public savings should recover its previous positive contribution.Thus, private savings could fall even more steeply and private consumptionrise even faster at the rates indicated in Table 4.6.

Major Uncertainties

4.40 The macroeconomic scenario presented abov~:e is just one of manypossible outcomes. It represents a balance between the need for restraint inpublic expenditures and the desire to assist more rapid growth. By stressingthe role to be played by the private sector, however, the scenario isinevitably speculative in nature. Two additional sources of uncertaintyshould be stressed--public sector policy and the external environment.

4.41 In order to generate sustained growth, the base case scenarioimposes short-term constraints on public expenditure that are then relaxed inthe medium-term. This is desirable to bring public finances under control.In the short-term, it would be feasible for the public sector to be moreexpansionary, but the resulting build-up in debt would make future growth lesslikely. Investment response to public demand, furthermore, would involve asectoral allocation of resources that would differ from that induced byprivate demand growth. Hence, inefficiencies would begin to emerge, slowinggrowth in the long run.

4.42 The other major source of uncertainty lies in the internationalenvironment. Stock market volatility in the OECD points to considerablevariability in expectations for future growth. As indicated above, commodityprices are forecast to improve after 1990, providing some leeway for realconsumption growth to expand rapidly without jeopardizing the balance ofpayments. In the absence of such improvement, the trade surplus could dis-appear much more quickly than envisaged. To some extent, this could be offsetby stimulating even more rapid export growth in manufactures. It would also,however, imply that growth and consumption should be slowed to bring downimports.

B. Integrated Policy Recommendations

4.43 Although Government has undertaken substantial reforms and initiatednew adjustment programs aimed at reducing market distortions in several areas,the results to date have been muted. For example, government has liberalizedindustrial licensing, moved on privatization, reduced bureaucratic delays inlicensing, engineered a fall in interest rates and so forth, but until 1988,when the external environment improved, there was little response from privateinvestment. This should not, however, be taken as a sign that thesedistortions were unimportant or that a more active interventionist stance isrequired from government. Rather, the preceding analysis suggests that thelack of response is a function of overlapping constraints. In many instances,Government has moved in an ad hoc fashion without sufficient consideration ofhow policy reform in one area can offset programs in another area. In orderto achieve the growth scenario outlined above, the benefits of past reform

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Table 4.6: NATIONAL ACCOUNTS GROWTH RATES (X) AT CONSTANT PRICES

1988 1989 1990 1987-92

Gross domestic product m.p. 6.5 6.1 5.9 6.1Agriculture 2.3 3.0 3.0 2.9Industry 10.9 9.2 8.3 8.9(of which Manufacturing) 14.0 12.0 11.0 11.7Services 4.2 4.5 5.0 4.8

Exports of GNFS 9.1 6.1 6.1 6.6Imports of GNFS 13.1 11.3 10.7 10.7

Total Expenditures 8.4 9.4 9.0 8.6

Total Consumption 7.1 8.6 8.6 8.1

Private consumption 9.2 10.9 10.3 9.7General government 1.6 2.0 3.0 3.1

Gross domestic investment 12.0 11.2 9.8 9.9Fixed investment 14.5 10.4 9.9 10.1Change in stocks -82.5 212.0 4.2 5.0

Memo itemsGross national income 6.0 5.9 7.4 6.8Gross national product 7.0 7.0 6.2 6.6

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should be unlocked by rationalizing er*' .orv`ving policies and how furtherreforms structured in a comritementary f6jsbioit tu contribute to objectives ofefficiency, macroeconomic stability and growtk3

Consistency in Policy Programs

4.44 A few examples of areas where go-ernment programs conflict with eachother, reducing the effectiveness of each, illustrate the need to approachpolicy reform from a well-developed economy-wide perspective. One of the mostimportant concerns the interaction between policies for mobilizing savings andprograms to promote investment.

4.45 There are two significant ways that Government has intervened topromote savings. One is through the "forced saving" contributions to theEmployee Provident Fund, the Social Security Organization, the Armed Forcesand the Teachers' Provident Funds. Between them, the surpluses genorated bythese funds is about 7Z of GNP. In addition, there are government-sponsoredsavings schemes, including ASN, which pay high returns, made possible throughimplicit Government subsidies, yet involve very low risk. These fundsprimarily channel savings towards the public sector.

4.46 In an environment of heavy direct government intervention in theeconomy, it was appropriate to institutionalize mechanisms to generate govern-ment financing. These captive funds have been primarily responsible for thesuccess achieved by Government in running large overall deficits to financeinvestment without recourse to excessive monetary financing, pressure on thebanking system or an overload of external debt. Presently, however, the fundsare continuing to increase in size while Government financing requirements arefalling as a result of the decision to reduce the direct role of the publicsector in the economy. Given the absence of effective mech-anisms forchannelling these funds to the private sector, an imbalance in the flow-of-funds has arisen, and is expected to persist into the future. The magnitudeof the imbalance is difficult to predict. Although the largest fund, the EPF,makes some projections of its future surpluses, these are inadequate for usein macroeconomic planning as they implicitly assume no population growth after1990 and no growth in average income over time. Nevertheless, it is apparentthat the mechanisms to generate savings act against the ability to transformsavings into investment and against government programs to encourage privateinvestment.

4.47 A second example of policies that counteract each other is to befound in industrial and labor legislation. On the one hand, Governmentpolicies to promote industry have favored capital-intensive investments. Thisis true of the design of the corporate tax structure, wherein the mostimportant incentives--tax holidays, investment and depreciation allowances-interact to subsidize capital. Equally, it is true of the programs forindustrial diversification and the push towards heavy industry development byNFPEs. These, by nature, have been highly capital-intensive. On the otherhand, Government has tried to promote labor utilization (unsuccessfully)through tax incentives and (more successfully) through a reorientation ofgovernment expenditure towards labor-intensive projects.

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4.48 Similarly, Government attempts to promote private investment throughliberalization of licensing have been stymied by the offsetting impact onprivate investment of public enterprise operations and of various wage promo-tion and labor protection programs of government. Inflexibility in wages,public countercyclical policies and taxation of corporate employment via EPFcontributions have served to reduce profitability and deter private invest-ment.

4.49 A final example concerns privatization of NFPEs and controls on thedomestic capital market, especially regulation of the Stock Exchange. Amongstother objectives, privatization is designed to bolster Government finances andto restructure the balance sheets of public corporations where operatinglosses, heavy investments and strong currency external debt revaluations haveincreased debt/equity ratios. Yet both these objectives are difficult orcostly to meet in an environment of strict controls on the price at which newshares can be issued, and take-overs or mergers performed.

4.50 Malaysia's growth potential can best be unlocked through packagingpolicy reforms in a cotuplementary fashion, avoiding the conflicts mentionedabove. Emphasis should be on microeconomic reforms that enhance efficiencywhich, taken together, simulate a macroeconomic adjustment program. Anexample of this would be removal of mandatory EPF contributions for theyoung. This would foster a more efficient labor market and improve thematching between the earnings-expenditure distributions for individuals whilealso stimulating private demand. On the other hand, short-term macroeconomicremedies that do not foster efficiency should be avoided. These includereflationary public expenditure, subsidized directed credit programs andgeneralized tariff reform to protect ailing industries.

Business Confidence

4.51 With the diminished role of the public sector and the difficulty inexpanding net exports beyond their record levels in 1987, private sectordemand will play a leading role in growth. For this to occur, businessconfidence must be strengthened. It is only in a dynamic private environmentthat government programs such as privatization can be expected to yield thebenefits envisaged. Government can send a clear signal to the private sectorby reforms which clearly indicate official intentions to withdraw from theprovision of gocds and services in areas where private activities could beencouraged. Privatization, reduced government spending, lower subsidies,liberalized industrial licensing, corporate income tax reform and tariffreform would all demonstrate the consistency of Covernment's commitment togrowth and efficiency that is necessary to foster confidence in the economy.They would also indicate the strategic directions envisaged for economicpolicy after 1990.

Amendments to the EPF

4.52 Because of its size and importance in the labor market, severalrecommended reforms involve the EPF. Clearly, reduction in EPF surpluses mustbe made contingent on an equal reduction in public deficits in order not toburden the banking and monetary systems. As discussed below, these public

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sector reforms should also be tailored towards efficiency and growth-enhancingmeasures.

4.53 Reforms affecting the EPF in four areas should be considered: alowering of average contribution rates by the corporate sector; a voluntaryexemption for those under 25 years in age; a deduction from corporate EPFcontributions for 50% of firms' costs of approved training; and a mandate towithdraw funds for approved education and training. Hypothetical simulationsindicate that the current corporate contribution to EPF, at 11%, imparts asignificant bias against labor that may be in part responsible for the lowoutput elasticity of employment displayed by the manufacturing sector in the19809. The coincidence between the period of high manufacturing emplcymentgrowth and low EPF contributions in the 1970s, on the one hand, and lowemployment growth and high EPF contribution rates in the 1980s, on the otherhand, also suggests a casual relationship. Reduction in corporate EPFcontributions would improve microeconomic efficiency at a firm level and helpbring Malaysia's wage costs more in line with other East Asian competitors.

4.54 Exemption for the Young. The voluntary exemption from participationin EPF by the young is recommended as an instrument to improve the employmentprospects of this group, to reduce the wedge between the take-home pay of newentrants and those hired prior to 1984, and to induce the young to gain valua-ble work experience, even at lower overall wages. In theory, the exemptioncould reduce the effective wage costs to the firm of hiring a new entrant byas much as 20%. In the current slack employment market, the actual effectivewage reduction may approach this. As the labor market tightens, however, asis expected in 1988 and 1989, che exemption should result in higher take-homewages for the young. This a'-oup probably discounts retirement savings at avery high rate, so the loss of accruals in the EPF would not be of greatconcern. Thus, the total perceived compensation package would rise, inducinga greater willingness by the young to work. In so doing, valuable workexperience is gained that should reflect on later career earnings. Thismeasure is expected to benefit more highly educated, secondary school leaversand new college graduates in particular.

4.55 Financing of Training. One of the most severe drains on theGovernment budget comes from its support of higher education and vocationaltraining programs. A mandate to permit use of EPF funds for such purposes, aswell as approved on-the-job training programs, would help take these programsoff-budget completely, either through privatization of programs or throughgreater use of user-charges. The EPF should have institutional interest inthis: the support of human capital formation is a natural adjunct to finan-cial capital accumulation and physical capital formation that are alreadysupported by the institution (the latter through the Housing withdrawalscheme). Further, it has a natural comparative advantage in administering astudent loan program. It could automatically deduct repayments fromindividuals' future contributions, avoiding the problems of collection thatbedevil other loan schemes. Also, through its detailed information base onwages, the institution could provide valuable inputs into an understanding ofthe rates of return to alternative education and training schemes, careerdevelopment paths and such-like. It would thereby bring market signallingcloser to the discussions on curricula development and course preparation thanthe present system allows.

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4.56 As far as on-the-job training is concerned, EPF participation couldemerge in two forms. First, it could participate in an Employment TrainingPanel, that would approve courses for which payment by an individual from hispersonal accumulated contributions to a private training contractor could bemade. Approval would only be granted when an individual has been trained,placed and retained in a job (say for 90 days) for which training wasundertaken. Second, similar approval could be granted for within-firmtraining. Experience suggests such a system can significantly help theunemployed and sharply reduce retrenchment rates for those employed but inianger of being laid off. Such a system adds competitiveness to the deliveryof training systems that is absent under current vocational trainingschemes. It also energizes firms to provide on-the-job training for employeesand induces them to meet the dislocations brought about by acceleratingeconomic and technological change via retraining rather than retrenchment.

4.57 Implementation of these measures would have four desirable macro-economic consequences: (i) it would boost employment overall, and selectivelyfor the young; (ii) it would reduce the EPF surplus, add discretionary incomeinto workers' hands and stimulate private consumption; (iii) it would reducethe effective tax on corporations, raise profits and spur private investmentin socially desirable labor-intensive sectors; and (iv) it would reduce thepublic sector deficit without reducing access to education services.

Public Finances

4.58 Reduction in EPF surpluses would not be appropriate without measuresto reduce the government deficit. One problem that is faced, however, is thatthe deficit seems intractable without growth, as real expenditures havealready been slashed to the bone, while growth may remain elusive if thedeficit is cut by traditional fiscal means. From an efficiency stand-point,government may actually need to increase expenditures, especially formaintenance of the sizeable infrastructure network that was created in theearly 1980s. On the tax side too, reform of corporate income taxes andintroduction of the value-added tax in place of the sales tax are bothwarranted from an efficiency point of view but may both involve revenue lossesduring a transitional period.

4.59 Rather than introduce new distortions or inefficiencies through useof the existing tax structure, imposition of new tariffs or cut-backs in realexpenditure, this report suggests attention be focused on reducing explicitand implicit subsidies to public authorities, statutory bodies, NFPEs, and thelike. One such measure has already been discussed, namely the raising of usercharges in education and vocational training coupled with a broader studentloan program. Other measures include targeted cuts in the Treasury housingloan program, in rice growing, milling and distribution subsidies, and in therailways, to mention a few. Of these, only padi coupons and the fertilizersubsidy appear explicitly as budget subsidies. Others are listed only underindividual public programs. Identification of subsidies is, therefore,complicated.

4.60 One continued drain on the budget, and a reason for sluggish overalleconomic performance, is the non-financial public enterprise sector. This

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sector contains several hundred loss-making units whose operations largelyescape institutional oversight. The financial losses may even disguise theirtrue costs of inefficiency as additional relief in the form of tax exemptions,price fixing, public procurement and tariff protection is often first pro-vided. Government has the capability to study the top ten or so largest moneylosers. The larger problem, however, is how to tackle the myriad of smallercompanies and how to ensure that even those that are financially solid areoperating efficiently rather than benefiting from specific privileges. Thereport recommends (i) privatization and (ii) establishment of a performanceevaluatior system for NFPEs. The latter takes on additional importance if thepace of privatization proceeds slowly, or where privatization is unlikely toresult in efficiency improvements because of specific monopoly, guarantee, oreconomics of scale issues that preclude competition even for a privatizedcompany.

4.61 In spite of recent improvements in the public deficit, total publicdebt in Malaysia remains higher than in most other countries. To some extentthis is offset by considerable public assets. Nevertheless, interest expensesare still expected to amount to over 1OZ of GNP over the medium-term. This isnot only a significant cost on the budget, but it also exposes the publicsector to considerable volatility in its finances. In addition, the revenueside of fiscal accounts is also volatile, depending to a large extent onpetroleum and other commodity prices. Until now, government has reacted toits financial situation by adjusting real expenditures, particularly develop-ment spending. This is, however, a highly inefficient way of responding toexternal shocks. Government should use new financial instruments to reduceits average borrowing costs and to reduce the volatility that it faces. Suchfinancial hedging can be pursued both with respect to external debt andinternal debt.

4.62 Stability in public expenditures and reduced fiscal deficits willallow for more efficient public investment planning. They will also providestability in the macroeconomic environment that is necessary to stimulateprivate investment. Unlike in other countries, Malaysia has not witnessedmuch crowding-out of the private sector as a result of public sector borrowingfrom the banking system and a resultant rationing of credit or high interestrates. Yet the public sector has displaced p- -late investment in importantways; first, by direct competition in productive activities; and second, bybidding up investment costs--of labor, materials and land-through policies ofprotection, licensing and unwartanted expansion. A better delineated role forthe public sector, perhaps outl;ned in the Privatization Master Plan, wouldaddress these issues.

Conclusion

4.63 The recommendations outlined in this report would provide the basisfor respectable, sustainable medium-term growth in Malaysia. As a result ofunfavorable prospects for real growth in rubber, tin, petroleum and forestry,the projections suggest a slow-down in overall growth relative to the 1970s,even with a rapid growth in manufacturing. As manufacturing expands, however,and if efficiency and productivity improve, growth could well exceed theconservative scenario depicted. In fact, with an improved private sector

- 123 -

orientation, Malaysia could well position itself to enter the ranks of the NewIndustrializing Countries by the end of the sixth Malaysia Plan. It is fromthis perspective that the recommendations focus on efficiency. They shouldnot, therefore, be thought of as dependent on growth, nor should a desire formore rapid growth lead to substantial deviation from the policy agendaoutlined here. Given its strong external position, Government has the abilityto force growth to a higher level for a few years but, as the experience ofthe 1980s shows, such performance cannot be sustained indefinitely and servesto undermine the diversity and flexibility that private sector developmentbrings, qualities that are crucial to long-run growth in a world with rapidlyadjusting trade and industrial structures.

Appendiz 1-124 - Page 1 of 2

MULAYSIA

ASSESSINC THE VARIABILITY OF NONOIL PRIMARY COMNODITY EXPORTS

1. Malaysia has a diversified portfolio of primary commodity exports,the most important of which are rubber, palm oil, sawlogs and timber, tin andcocoa. Diversification helps to limit the volatility in export earnings whenthe prices of individual commodities are uncorrelated (or negativelycorrelated) with each other. The ability to diversify, then, depends onwhether the same underlying forces affect all commodity prices (such as aglobal recession, for example), or whether unrelated coamodity specific events(such as a drought in India driving up palm oil prices, or a frost in Brazilboosting cocoa prices) are more important determinants of prices.

2. The analysis below is based on monthly commodity prices from June1973 to December 1987. A longer historical series is available, but theresulting variance in the rate of change of prices proved to be unstable overtime. Consequently, the shorter time period is used as this more accuratelydepicts the randomness in commodity prices today. All commodity prices weredeflated by a manufacturing unit value index, to remove the globalinflationary component. We have assumed that the resulting monthly percentagechange in real prices is driven by a Wiener process, that is:

dp= -ldt + o dzp

where i is the expected trend increase over time in the price and a isthe standard deviation.

3. The means, variances and correlations of the percentage change inreal prices was calculated and found to be as below. In general, thecorrelations are small, indicating that commodity specific events mostlydetermine price fluctuations. The most volatile conmodity price has been palmoil, but rubber, logs and cocoa also exhibit sizeable swings. On average,commodity prices have been trending downwards with the exception of logs, forwhich real prices have risen by an average 6X per year.

- 125 - Appendix IPage 2 of 2

Table A.1: MEANS, STANDARD DEVIATIONS AND CORRELATIONS OF COMMODITYPRICE GROWTH

(Z)

Mean S.D. Correlation Matrix

Rubber -2.775 23.48Palm oil -0.149 32.37 .0104Logs/timber 6.005 22.88 .0566 .1609Tin -2.386 17.47 .0886 .1038 .0904Cocoa -1.065 23.51 .0515 .0705 -.0291 .1587

/a Figures are annualized and refer to the growth of prices.

4. An example illustrates the table's contents. Rubber prices onaverage have fallen by 2.8Z per year, but two-thirds of the time (one standarddeviation), the annual change in rubber prices has been between-26Z to +21X.Through diversification, however, the volatility exhibited by individualcommodity export earnings has been reduced. Based on the value shares inexports in 1984, the ringgit value of the sum of these commodity exports(totalling around M$13 billion) is less volatile; the standard deviation ofthe rate of change in export earnings due to price changes is calculated to be15.76Z, and the mean increase is 0.22X per year. This implies that one-thirdof the time, export earnings are likely to differ from their expected value bymore than M$2 billion (one standard deviation), and one-sixth of the time,there will be a shortfall of this magnitude.

Data

5. The commodity prices are defined as below:

(a) Rubber: RSS No. 1, US, in bales, New York, spot;

(b) Palm oil: Malaysian, 52 bulk, cif NW Europe, nearest forwardshipment;

(c) Logs: 1973-76, Philippines, Lauan, 3.6 m or more x 60 cm,Tokyo delivered, importers sale price to wholesalers.Beginning 1977, Malaysian, Meranti, Sabah SQ BestQuality, sale price changed by importers, Japan;

(d) Tin: 1973-September 1984, official settlement price, Penang,ex-smelters for Straits, Min. 99.85Z purity. BeginningOctober 1984, Kuala Lumpur Tin Market settlement price forStraits;

(e) Cocoa: ICCO Daily Price, average New York and London, nearest 3future trading months.

Appendis 2

- 126 - Page 1 of 3

MALAYSIA

Construction of the flow of Funds Table

1. Malaysia does not produce flow of funds tables for the wholeeconomy. We have constructed approximate tables for 1980, 1985 and 1986. Theyear 1980 was taken as the year before serious internal and externalimbalances developed. Although 1979 may have been a better year for it, datalimitations precluded that choice. The years 1985 and 1986 represent theperiod of distress, especially in the private corporate sector.

2. Overall Structure. The economy is divided into four real sectors:Government (Federal, State, and local governments, plus statutoryauthorities), NFPEs, private corporations, and households. The first two formthe public sector and the last two the private sector. For 1980, however, itis not possible to separate NFPEs from private corporations. The financialintermediaries are divided into the banking sector (commercial banks, financecompanies, merchant banks, discount houses, and Bank Negara), provident funds,and other financial intermediaries. Included in "other financialintermediaries" are insurance companies, National Savings Bank, cooperativebanks, Bank Rakyat, development banks, Building Society, farmers'organizations, PNB, and Tabun Haji (Pilgrims Fund). The flow of funds tablewas constructed as follows.

3. Overall Savings and Fixed Investment. The overall savings figures,gross national savings, are available from the national accounts. Theconsolidated public sector account gives current surpluses of the Governmentand NFPE sectore (but Government only for 1980). Making allowances for thedifference between the development budget (on which the consolidated publicsector account surpluses are based) and the fixed capital formation figures inthe national accounts, true public sector savings are derived. The balance ofgross national savings is generated by the corporate and household sectors.

4. Total private sector savings and fixed capital formation are distri-buted to the household and corporate sector as follows. The corporate sectorfigures are derived as residuals.

(a) Using financial statistics from various subsectors of the financialsystem, total financial investment and financial liabilities of thehousehold sector are identified and the net financial investmentestimated. Household savings in the EPF include both the excess ofcontributions over withdrawals and interest earned on investments.It is derived from changes in the end period amounts outstanding tocredit of contributors.

(b) Fixed capital formation by the household sector is estimated on asimple assumption that new residential housing investments areequivalent to total fixed capital formation by this sector. Theremainder of private fixed capital formation is assigned to thecorporate sector.

Appendix 2- 127 - Page 2 of 3

(e) Adding the net financial investment and fixed capital formation, thetotal savings of the household sector are estimated.

(d) Subtracting household savings from total private savings, corporatesector savings are estimated.

(e) Specifics. For the Government sector, a broad breakdown offinancing is known from the consolidated accounts. Specifics, forinstance about which sector holds government bonds, are availabLefrom Bank Negara Annual Reports and Quarterly Bulletins. Sometransactions that have no obvious counterparts in other sectors areassigned to the NFPE sector (see below).

5. For the financial sector, uses and sources of funds are availablefrom Bank Mega-a publications by the type of assets (not by economicsectors). The available aggregate statistics, e.g., for the banking sector,are incorrect in that sources and uses of funds within the sector are nonetted out. After correcting for this, the sources and uses according toeconomic sectors were identified, with an element of guesswork. In thisprocess, the retained earnings of Bank Negara was added to Government savingsand private sector savings were reduced accordingly. The counterpart to theGovernment savings is the increase in equity investment by Government.

6. For the UPPE sector, both sources and uses include items that aremore or less balancing items. For instance, unidentified domestic loans toGovernment were all assigned to the NFPE sector, for PETRONAS is the mostlikely source of such financing. Likewise, liquidation of assets by theGovernment that does not show up in the financial sector statistics isassigned to NFPEs. Finally, the changes in deposits belonging to NFPEs is thebalancing factor against the changes in corporate deposits. (The totaldeposits of business enterprises are known. First, the private corporatesector portion is estimated by using this as one of the fine-tuning entries toensure adequate funding for the corporate sector. Then the NFPE portion isobtained as the residual.)

7. Transactions with the foreign sector that are not already capturedare added to the picture. Incidentally, the errors and omission line in thebalance of payments is believed to consist of two elements: Bank Negara'scapital gains from foreign exchange holdings and unrecorded private capitalmovements. The latter is treated as an increase or decrease in the householdsector's deposits held abroad.

8. Changes in inventories (negative in all three years) are recorded asa source of financing for the NFPE and corporate sector.

9. Some Cautionary and Technical Notes. The table fails to capture thedirect equity investment from the household to private corporate sectors.However, since the two sectors are linked directly through the estimateprocess for the corporate savings, any increase in such direct investment willincrease household savings and reduce corporate savings by the equal amount.Therefore the balance between sources and uses of funds will remain intact.

- 128 - Appendix 2Page 3 of 3

10. In the flow of funds tables, sector breaidowns are shown for fivetypes of financial transactions2 deposits, loans, securities, equity, andother. For deposits, the sectors refer to the direction of use, and for theothers, the sectors refer to the direction of source.

11. For 1986, "other financial" registered a large decline in capitaland reserves and a large increase in "other" source of funding. They wereboth assigned to households.

Appendix 3- 129 - Page 1 of 7

EPF: Life-Time Accumulation by the Individual

1. The accumulation of assets by individuals in tIeir EmployeeProvident Fund accounts is the single most important source of savings byindividual members. In the aggregate, the EPF is also a major source ofnational savings. The magnitude of EPF surpluses and the size of individualretirement accounts depend importantly on macroeconomic variables, whichdetermine wages, the growth of wages over time and interest rates, as well ason microeconomic variables such as the contribution rate, the age of entry andof retirement, training and education. This Appendix explores how individualsand the EPF might be affected under alternative scenarios.

The Base Case

2. Estimatins Life-Time Income Profiles. The EPF has readily availabledata on average contributions per member for each age. These are listed inColumn 1 of Table 1 below. The average income for this group may be derivedby multiplying this figure by 5 (as the contribution rate is 201). Anyindividual, however, may have a different educational level than the averageEPF contributor. To derive an individual-specific profile, therefore, it isnecessary to correct for this education effect. Data on average income for aHigh School Certificate graduate, taken from the Department of Statistics'Income and Labor force survey, 1984, was compared with that for the averageEPF contributor and found to be 1.458 times higher (for an MCE graduate, theadjustment factor was 1.076). Thus, average income for a HSC graduate, shownin column 3, is derived by multiplying the average EPF member's income by1.458. An HSC graduate is assumed to start work only at age 18.

3. The cross-section data, showing wages by age, do not exactlyreplicate an individual's expected earnings, because they do not factor inpotential productivity growth. Over the long-run, wages in Malaysia havemoved closely in line with productivity growth. In the base case scenario, weassume productivity growth of 1 percent per year. The overall expected incomestream, incorporating productivity growth, is given in column 4 of Table 1.Note that the impact of inflation on higher nominal wages is not included--alldata are implicitly expressed in 1986 ringgit.

4. Accumulation Process. Given the expected life-time income profile,an individual's annual contribution can be calculated (20Z). This is creditedto an account (column 7) at the end of the working year. Intetest is earnedon the outstanding balance at the beginning of the year. Interest isexpressed in real terms rather than nominal terms. In the base case, a realinterest rate of 3.0 percent is used. This is the average real interest ratein Malaysia between 1970-86 (3.02Z), excluding the two high inflation, outlieryears of 1973 and 1974. Interest is also credited to the individual'saccount.

5. Benefit Level. The individual is entitled to withdraw hisaccumulated contribution at age 55. As this is expressed as a stock amount,however, it is difficult to compare it with the income cash-flow earned priorto retirement. We assume that the individual converts his contribution into a

Appendix 3Page 2 of 7

- 130 -

Table 1: INDIVIDUAL EPF CONTRIBUTION PROFILE

Overall income growth - IZ p.a.Real interest rate - 3XEducation level - HSC

Average EPF Income Expected Expected Accumula-contribution adjustment Average incom contri- Interest ted con-

Age in 1986 factor income stream bution earned tribution(1) (2) (3) (4) (5) (6) (7)

16 185 0 0 0 0 0 017 237 0 0 0 0 0 018 323 1.458 2,355 2,355 471 0 47119 387 1.458 2,821 2,849 570 14 1,05520 485 1.458 3,536 3,607 721 32 1,80821 584 1.458 4,257 4,386 877 54 2,73922 703 1.458 5,125 5,333 1,067 82 3,88823 835 1.458 6,087 6,398 1,280 117 5,28424 991 1.458 7,224 7,669 1,534 159 6,97725 1,155 1.458 8,420 9,027 1,805 209 8,99126 1,345 1.458 9,805 10,617 2,123 270 11,38527 1,517 1.458 11,059 12,095 2,419 342 14,14528 1,672 1.458 12,189 13,464 2,693 424 17,26229 1,805 1.458 13,158 14,680 2,936 518 20,71630 1,897 1.458 13,829 15,583 3,117 621 24,45431 1,958 1.458 14,274 16,245 3,249 734 28,43732 2,011 1.458 14,660 16,852 3,370 853 32,66133 2,056 1.458 14,988 17,401 3,480 980 37,12134 2,094 1.458 15,265 17,900 3,580 1,114 41,81435 2,125 1.458 15,491 18,346 3,669 1,254 46,73836 2,151 1.458 15,681 18,757 3,751 1,402 51,89137 2,171 1.458 15,827 19,120 3,824 1,557 57,27238 2,187 1.589 15,943 19,454 3,891 1,718 62,88139 2,200 1.458 16,038 19,765 3,953 1,886 68,72040 2,211 1.458 16,118 20,063 4,013 2,062 74,79441 2,221 1.458 16,191 20,355 4,071 2,244 81,10942 2,231 1.458 16,264 20,651 4,130 2,433 87,67343 2,231 1.458 16,264 20,857 4,171 2,630 94,47444 2,231 1.458 16,264 21,066 4,213 2,834 101,52245 2,231 1.458 16,264 21,277 4,255 3,046 108,82346 2,231 1.458 16,264 21,489 4,298 3,265 116,38547 2,231 1.458 16,264 21,704 4,341 3,492 124,21848 2,231 1.458 16,264 21,921 4,384 3,727 132,32949 2,231 1.458 16,264 22,141 4,428 3,970 140,72750 2,231 1.458 16,264 22,362 4,472 4,222 i 9,42151 2,231 1.458 16,264 22,586 4,517 4,483 158,42152 2,231 1.458 16,264 22,811 4,562 4,753 167,73653 2,231 1.458 16,264 23,040 4,608 5,032 177,37654 2,231 1.458 16,264 23,270 4,654 5,321 187,35155 2,231 1.458 16,264 23,503 4,701 5,621 197,672

Notes: (1) Source: EPF.(2) Actual average income for HSC level workers divided by average of (1)

for ages 18-55.(3) - (1) x (2) x 5.(4) - (3) multiplied by (1.01) raised to the power of (age - 18).(5) - (4)/5.(6) - previous (7) x real interest rate.(7) - previous (7) + (5) + (6).

Appendix 3- 131 - Page 3 of7

20-year annuity-that is, we calculate the constant amount an individual canwithdraw from his account every year, such that the total fund is exhaustedafter 20 years. Naturally, in the years prior to exhaustit'i, interest isstill earned. The annuity figure gives an estimated retirement income whichcan be compared to income during an individual's working years.

6. Sensitivity to Interest and Crowth Rates. A comparison betweenretirement income and peak working year disposable income is shown in Table 2below for various interest and growth rates. In the base case (row 2), theannuity value of the accumulated contribution of M$197,672 is M$13,287. Thisis 62% of the highest disposable income during working years (income shown inCol. 4 of Table 1 less the 9Z individual contribution to the EPF). With alower real interest rate of 2.5% real per year, the annuity falls by 12%. Ata higher interest of 3.25%, however, close to the average between 1977-86, theannuity rises. At 1987 interest rates of 6%, the annuity would exceed thehighest working income (not shown).

7. Two other sensitivities are shown in Table 2. If productivitygrowth averages 2X per year rather than 1Z, the annuity income rises sharply,by 22Z. However, the higher wages earned imply that the highest workingincome grows by even more, by 44Z to a level of M$30,795. Thus, the ratio ofretirement income to working income falls as growth rises. This is true atall interest rates and at different education levels. Finally, Table 2 showsthe impact of making the more realistic assumption that individuals workbeyond age 55 upto age 60 and, even if they no longer participate in the EPF,behave as if they do. The additional 5 years of work and contributions raisesthe annuity income by 29 percent to M$17,130 in the base case. The ratio tohighest disposable work income also rises to 76 percent.

S. The sensitivity analysis demonstrates that retirement incomes arelikely to have risen relative to highest disposable working income in the1980s as a result of two main macroecinomic changes: (i) the rise in realinterest rates and (ii) the slowdown in wage and productivity growth. Atpresent contribution levels, particularly if the realistic assumption is madethat individuals work until they are 60, retirement incomes from accumulatedEPF contributions are likely to exceed the highest disposable income attainedby an individual during peak working years. This is considered to be ananomaly of the system.

9. Two schemes are recommended for reducing individual retirementincomes and total EPF surpluses: allowing withdrawals for training andexemptions for those under 25. First, assume an individual is allowed towithdraw one year's contribution (i.e. 20X of annual income) to financetraining, which yields a rate of return of 15 percent. The change inaccumulated contribution will arise from the deduction for training, and fromthe higher contributions in future years resulting from higher wages aftertraining. The net effect depends on the age at which training isundertaken. Table 3 shows the net effect is to reduce the accumulatedcontribution by a relatively small amount. The amount approaches 1 percentfor training at age 25. It is about the same regardless of the educationallevel of the trainee.

Appendix 3Page 4 of/

- 132 -

Table 2: RETIREMENT INCOME AND WORKING INCOME

Annuity Highest AnnuityReal Accumulated payments disposable as Z of

interest rate contribution (20 years) income (HDI) HDIM%- (M$)

Base Case

2.5 182,102 11,681 21,387 54.6

3.0 197,672 13,287 21,387 62.1

3.25 206,088 14,174 21,387 66.3

2% AnnualWage Growth

2.5 223,569 14,341 30,795 46.6

3.0 241,609 16,240 30,795 52.7

3.25 251,337 17,287 30,795 56.1

Age 60 Retire-ment

2.5 231,478 14,849 22,478 66.1

3.0 254,855 17,130 22,478 76.2

3.25 267,652 18,409 22,478 81.9

Appendix 3

- 133 - Page 5 of 7

Table 3: IMPACT OF EPF WITHDRAWAL FOR TRAINING

Real interest Accumulated contributionrate (Z) No training Training M$ $

-- (in 1986 M$) -

Training Age - 20

2.50 135,547 135,161 -386 -0.283.00 147,296 146,743 -553 -0.383.25 153,645 153,006 -639 -0.42

HSC2.50 182,102 181,579 -523 -0.293.00 197,672 196,951 -721 -0.363.25 206,088 205,252 -836 -0.41

Training Age = 22MCE

2.50 135,564 134,958 -606 -0.453.00 147,296 146,489 -807 -0.553.25 153,645 152,722 -923 -0.60

HSC2.50 182,102 181,304 -798 -0.443.00 197,672 196,605 -1,067 -0.543.25 206,088 204,867 -1,220 -0.59

Training Age - 25MCE2.50 135,564 134,507 -1,057 -0.783.00 147,296 145,943 1,353 -0.923.25 153,645 152,125 -1,520 -0.99

HSC2.50 182,102 180,693 -1,409 -0.773.00 197,672 195,866 -1,805 -0.913.25 206,088 204,058 -2,029 -0.98

Appendix 3- 134 - Page 6 of 7

10. Impact of exemption of those under 25. Another option is to exemptthose under 25 from the EPF. Alternative scenarios with exemptions for justemployers and both employers and individuals are shown (Table 4). With atotal exemption, an individual's retirement income would only be brought downby 9.71, from M$13,287 in the base case to M$12,114 with the exemption. Theexemption from employers only would lead to a reduction of just 5.1Z. Theresults for alternative interest rates are also shown. As the interest raterises (falls), the reduction in the retirement annuity rises (falls).

11. Civen that an exemption would only marginally affect the retirementincome of the young, an additional issue is the macroeconomic effect on totalEPF contributions. The data on contributions by age was not made available tothe mission directly. Nevertheless, from data on the age distribution of thepopulation, the EPF participation rate by age, and the number of contributingmembers, the aggregate contribution of those under 25 (i.e. age 24 and below)can be estimated. This amount is M$448 million in 1986 or about 14.21 oftotal contributions in that year. If only employer contributions areexempted, the total reduction would be M$247 million. If the exemption agewere lowered to under 21, the loss to the EPF would be M$127 million.

Appendix 3Page 7 of 7

- 135 -

Table 4: UNDER-25 EXEMPTIONS FROM EPF

Annuity Highest AnnuityReal Accumulated payments disposable as Z of

interest rate contribution (20 years) income (HDI) HDI(X) (M$)

EmployerExemption

2.5 173,946 11,158 21,378 52.2

3.0 188,079 12,642 21,387 59.1

3.25 195,686 13,459 21,387 62.9

Full Exemption

2.5 167,272 10,730 21,387 50.2

3.0 180,230 12,114 21,387 56.6

3.25 187,176 12,874 21,387 60.2

Appendiz 4- 136 - Page 1 of 4

Methodology for Calculating Total Factor Productivity Growth

Following the Gollop and Jorgenson (1986)11 methodology, aproduction function may be written:

Q = F(K,L,X,t)

Where Q is gross output, K is capital input, L is labor input, X isintermediate good input and t is time.

With profit maximization, value share of each input is equal to theelasticity of output with respect to each output:

= L _aln QL qQ a ln L

..PkK a ln QK qQ a ln K

S= - = a In Qx qQ 1 n X

Where q is price of output and PL, PK and P. are the respective prices of theinputs.

Differentiate Q with respect to t,

d ln Q = 3 ln Q d ln K + a In Q d ln L + a ln Q d ln X + 1 a ln Qd ln t a ln K dt a In K dt a ln X dt t a ln t

S d ln K + S d ln L + S d In X + Sk dt L dt X dt t

where St is the residual and rate of total factor productivity change.

For changes between discrete points in time, this can beapproximated by:

la Q -ln Q = [IK [n Kt- ln Kt-l i [In Lt - ln

+ S [ln Xt ln Xt-4] + St

I/ Gollop and Jorgenson (1986), "Productivity and Growth in Sectoral Outputin the Us", Harvard Institute of Economic Research, Discussion PaperNo. 1217.

Appendix 4- 137 - Page 2 of 4

where SK [S S I and so on

Notes on Data Used

All the data are from surveys or censuses of manufacture publishedin the Yearbook of Statistics. The capital input data reflects the survey'sassessment of fixed assets. While this is not satisfactory, alternativemethods for estimating the capital stock by summing gross investment forexample cannot be used with the existing data. The profit share is derivedfrom the diff rence between gross value of output less cost of inputs lesswages and salaries. The labor input data reflects wages and salaries paidwhich should take into account changes in age, sex, hours worked andeducational composition.

Results

Survey data collected by the Department of Statistics tabulateoutput, input, fized assets and wage statistics for 28 manufacturing subsec-tors and for the sector as a whole. By comparing the growth in output betweentwo dates with the weighted growth in each input, a residual measure, definedas the total factor productivity change, is obtained. This procedure wasfollowed for a series of subperiods. The results are suumarized in TableA3.1. Although these should be treated with caution because of the residual-based methodology And inherent data oroblems. two important trends emerge.The first is that the growth of labor inputs, defined as the salary and wagebill, has been extremely low in both periods, and the contribution of labor tooutput growth has been correspondingly negligible. The second trend is thereversal in annual total factor productivity growth from 3.8Z per year in1975-79 to -1.91 annually in 1981-84. These figures imply that whileproductivity change contributed over 121 to output growth in the late 1970s,comparable to the long-run performance in other newly industrializingcounties, its contribution became negative in the 1980s.

- 138 - Appendix 4Page 3 of 4

Table A3. 1: GROWTH AND CONTRIBUTIONS TO GROWTH IN MANUFACTURING(X)

1975-79 1981-84X contri- X contri-

Growth /a but-on /b Growth /a bution /b

Total output 22.9 100.0 9.2 100.0Capital input 3.4 11.2 5.0 52.2Labor input 0.8 2.6 0.0 0.3Intermediate inputs 18.2 73.9 6.3 66.0Total factor produc-Livity change /c 3.8 12.4 1.9 -18.5

/a Annual average compound growth rate.7i Contribution of input to increment in output.7T Residual.

The statistical reason for the negative productivity growth isclear: fixed assets in manufacturing in the 1981-84 period accelerated to anannual growth of 51 per year. Based on the average profitability of capital,this should have produced over 50X uf the actual output iacrease. In addi-tion, under normal circumstances, an increase in fixed capital should be asso-ciated with an improvement in total factor productivity as technology isimproved and techniques of production are adapted to local conditions.Instead, the growing capital intensity in manufacturing seems to have substi-tuted for technological advance.

For the manufacturing sector as a whole, efficiency improvements canbe explained partly as a result of developments in each subsector of manufac-turing, and partly as a result of a change in the composition of resourceallocation. When resources are shifted from a less efficient to a more effi-cient sector, the overall efficiency is improved even if each sector performsthe same as previously. To distinguish between these two effects, TFP growthrates were calculated separately for 27 subsectors identified in the DOSSurvey of Industrial Companies.u' During 1975-79, 23 out of the 27 subsectorshad positive total factor productivity growth. The most dynamic sectors weretextiles, apparel, wood, nonindustrial chemicals, petroleum and coal, plas-tics, glass, cement and scientific instruments. By 1981-84, however, only tensubsectors had positive TFP growth. Of these, only leather and print had afaster TFP growth rate than in 1975-79. Thus, the decline in productivitygrowth was almost universal across subsectors.

2/ One subsector, nonferrous metal basic industries, was excluded for lackof comparable date over time.

- 139 - Appendix 4Page 4 of 4

It is possible to separate systematically the effects of specificsubsector performance from the effects of shifting resources towards lessefficient sectors (Table A3.2). The overall decline in manufacturing TFPgrowth is entirely attributable to a deteriorating performance within indus-tries. After posting sizable gains in the late 1970s, the sector-specific TFPgrowth trend was reversed in the 1980s. Over the decade 1975-84, each indus-try saw efficiency decline on average by 2.52 per year. Although the declinewas widespread, in quantitative terms the problems in manufacturing are con-centrated in a few specific subsectors. In terms of gross output, three ofthe largest subsectors are industrial chemicals, petroleum refineries and ironand steel. These are also among the most capital-intensive sectors in manu-facturing. Each of these three had very substantial declines in productivityin the early 1980s, associated in each case with a rapid expansion in capacitythat far outstripped actual production gains. If these subsectors areexcluded, the remainder of the manufacturing sector would have only averaged awithin-sector 21 loss in productivity over 1981-84.

Table A3.2: A DECOMPOSITION OF MANUFACTURING TFP GROWTH(1)

1975-79 1981-84 1975-84TFP growth TFP growth TFP growth

All manufacturing 3.8 -1.9 -0.2Within industries 6.7 -7.2 -2.5Between industries -2.9 5.3 2.3

Major subsectorsIndustrial chemical 2.8 n.a. n.a.Petroleum refineries 4.2 -11.4 -2.6Iron and steel 3.8 -21.0 n.a.

n.a. TFP change in greater than 100l per year.

Source: Bank staff estimates.

- 140 - Appendiz 5Page 1 of 3

Methodology underlying the calculation of the marginal effective tax rate

The calculations presented in this Appendiz use tax, financing, andeconomic factors to compute the cash flows that can be ezpected from aninvestment project. The cash flows combine the individual streams for eachasset (credits, depreciation, replacement investment) with the incomegenerated by the project and other project-wide flows (e.g., debt servicepayments) to yield a single before-tax cash flow and single after-tax cashflow for the entire project. These two cash flows are used to compute NETRfor the project as a whole.

The before-tax (BTCF) and after-tax (ATCF) cash flows can besuims rized as follows:

(1) BTCF.i - - Ei dki + Ri- Inti - Prini + NetSalesi

(2) ATCF. = BTCF. - t(l+s) [Ri - Depi - InvDed. - IntDed. - Carryover

i CapGain + BalAdjij + cDiv

where

Ei a amount of equity used to finance the investment in period i

d economic depreciation rate for capital stock

K = capital stock in period i

Ri = investment income, net of operating costs, in period i

Inti - interest payment in period i

Prini = principal payment in period i

NetSalesi = sales proceeds in period i

t = statutory tax rate

s = surtax rated

Depi = depreciation allowances in period i

InvDedi = investment deductions in period i

IntDedi = interest deductions in period i

Carryoveri = carryover losses in period i

CapGaini = capital gains in period i

- 141 - Appendix 5-141- ~~~~~Page 2 of 3

BalAdji = balancing adjustment in period i

c - dividend credit rate

Divi = dividends in period i

The equity used to finance the investment is a positive amount inthe period before the investment generates income, i.e., Eo > 0, and is zeroafterwards. The rate of return underlying the METR calculation is a return toequity.

Replacement investment is undertaken which reduces the before-tazcash flow. Repia cement investment equals the amount of economic depreciationfor each asset.i'

The investment project starts generating income in period 1.Investment income is the,marginal increase in net revenue that results fromthe investment project., Investment income keeps pace with inflation becausereplacement investment preserves the productive capacity of the project.

Interest and principal payments on debt used to finance the invest-ment are subtracted from the before-tax cash flow. When the investment isbOLuP Labe prtrcede &K are ucd Lu ; vesvte-; CSMh cas 1 f'v". N.£ts-A oe

equal the sale price minus the payoff of the balance of a loan, if applicable.

The after-tax cash flow equals the before-tax cash flow minus taxespaid and plus credits. The statutory tax rate, t, plus any surtax rate, s,are multiplied by taxable income to yield the regular tax liability. Taxableincome is given by the term in brackets in equation (2). Taxable income, inits most basic form, equals investment income minus depreciation allowances,investment deductions, and interest deductions. Investment deductions aregiven in addition to depreciation and are intended to serve as an incentiveZor investment. They may be given for the project as a whole or on an asset-specific basis. A positive taxable income may be reduced by losses beingcarried forward. If taxable income is negative and full loss offset is notassumed then the loss is carried forward. When the asset is sold, any taxablecapital gains or balancing adjustment are added to taxable income.

1/ As the investment project includes three asset3--buildings, machinery andequipment and vehicles--then dK represents the sum of the depreciationrates for each asset times their respective capital stocks.

2/ "Net" is taken to mean net of wages and purchases of intermediate goodsand services.

- 142 - Appendix 5Page 3 of 3

The last term in equation (2) refers to any special tax treatmentfor dividends. In parcicular, a credit may be given on dividends at thepersonal level to offset the taxation of dividends at the corporate level.This credit reduces effective corporate taxes and, therefore, is added to theafter-cash flow in equation (2).

If b denotes the real before-tax rate of return and a, the realafter-tax of return, then the margin effective tax rate is given as follows:

(3) METR - (b - a)/b

This formula has been 3jsed extenuively in the literature on thetaxation of capital investment.3

Note on Assumed Project

The calculations are based on a real interest rate of 101, and aproject which also yields 10. Inflation is assumed to be 3Z. The initialinvestment is comprised of 13.62 land, 32.651 buildings, 48.91 machinery and

equipment and 4.852 vehicles. These parameters are taken from the share ofeach in total fixed-assets in manufacturing reported in the Survey ofManufactures.

3/ A. Auerbach, "Taxation, Corporate Financial Policy and the Cost ofCapital," Journal of Economic Literature (September 1983), for a review.

- 143 - Appendiz 6Page 1 of 2

The Determinants of Private Fixed Capital Formation

Regression analysis has been used to analyze the determinants ofprivate domestic fixed e;apital formation in Malaysia over the period 1972-87. The results of the regression, which account for 99% of the variance inthe level of investment, are presented in Table A.1 below. Private domesticinvestment is found to depend strongly and positively on profits, governmentinfrastructure investment, the real effective exchange, and an acceleratorterm measured as the lagged change in GNP. On the other hand, foreign directinvestment and government productive investment affects private domesticinvestment negatively.

Table A.l: REGRESSION COEFFICIMNTS FOR PRIVATE INVESTMENT(Dependent variable is real private domestic investment)

Variable Coefficient T-statistic

Profits 0.344 14.5 R2 0.986Government infrastructureinvestment 0.253 6.3 D.W. = 2.101Real effective exchange rate 18.363 2.6 Sample - 1972-87Accelerator 0.087 3.5Foreign Direct Investment -0.351 -2.5Government Productiveinvestment -0.009 -0.0

All the variables were first calculated in nominal terms, and thendeflated by the consumer price index. The regression was also run in first-difference and percentage-change terms with very similar results to thosereported above. This robustness to specification changes gives added confi-dence in the results. Other explanatory variables were also introduced butfound to be insignificant. The most important of these, from a theoreticalstandpoint, were the real average lending rate of commercial banks and thereal supply of domestic credit. Both of these have been found to be signi-ficant determinants of investment in other countries.

Construction of the data

Host of the data were constructed from officially published datasources. Private domestic investment is the residual of total capital forma-tion less public fixed investment less foreign direct investment. Public in-vestment is calculated on the basis of development expenditure. The series ispublished in the Economic Report of the Treasury, but contains some inaccura-cies. First, it is derived from budgetary cash accounts not from accrualaccounts. Second, it includes expenditures on land and used equipment pur-chases which are not elements of gross fixed capital formation in the nationalincome accounts. Third, the coverage of public enterprises is incomplete and

- 144 - Appendix 6Page 2 of 2

changes over time. One major caveat is that oil and gas investments are notincluded in public investment. Public investment is further broken down intotwo components, one, labelled infrastructure investment, includes investmentin sectors such as transport, utilities, land development, education andhealth. The other component, labelled productive investment, reflects thoseinvestment which directly output destined for final consumption such as com-merce and industry, agriculture and housing.

Foreign direct investment is subtracted from private investment be-cause it mostly enters free trade zones and is oriented towards export mar-kets. The series is obtained from the balance of payments and includes theretained earnings of foreign corporations.

Profits are constructed as the residual of GNP less the wage billless net indirect taxes. The wage bill is calculated by multiplying sectoralwage data, available from the Ministry of Labor, by total employment in eachsector. Gross import taxes are taken as a proxy for net indirect taxes; adirect estimate is not available because of lack of data on implicitsubsidies.

The accelerator term is equal to (CNP_. - CNP_2 ), where thesubscripts refer to time periods. The real effective exchange rate is atrade-weighted average of Malaysia's bilateral real exchange rates with sixmajor trading partners, where the real exchange rate is the nominal exchangerate deflaLud by relacive price movements in each country's wholesale priceindex.

- 145 - Appendix 7Page 1 of 2

Private Consumption in Malaysia

Private consumption growth in Malaysia has not followed nationalincome growth closely throughout the 1980s. Yet this does not imply thatprivate consumption has been haphazard. It suggests rather that factors otherthan income have been important. The analysis below indicates that five majorfactors account for the divergence between consumption and national income.First, private disposable income because of the varied Government tax bite,the fluctuating performance of public enterprises and the programs institutedby government to shield the private sector from terms of trade losses.Second, consumers base their spending decisions on some notion of long-termsustainable income, and not current income alone. Third, a growing fractionof private sector income has been absorbed into forced savings accounts inProvident Funds and Social Security organization and is not available forconsunption. Fourth, private consumption has been sensitive to the realeffective exchange rate, which meaunres Malaysians' wealth holdings in termsof an international standard. Fifth, private consumption responds to the realinterest rate.

Estimation of a consumption function in Malaysia is complicated bythe £act that there does not exist any primary data on private disposableincome. Some analysts have used GNP as a proxy. An alternative is toconstruct a series on private income by making use of the national incomeaccounts identities. First, note that private income must equal privateconsumption (PC) plus private savings. Private savings equal national savingsless public savings. National savings equal total investment less net foreignsavings (the current account deficit (G.AD)). Public savings equal theconsolidated public sector deficit (G) plus public investment. Using thesedefinitions, private disposable income (PY) is equated to:

PY = PC + I + AS - CAD + Gp

where I is private fixed capital formation and AS is the change in stocks;and botR G and CAD are positive when there is a deficit.

Private income is then further broken down into a discretionary por-tion (PDY) and a non-discretionary portion by subtracting the investable sur-plus of the Employee Provident Fund each year (DEPF). Discretionary income isconverted into a measure of permanent income (PPY) by using a weighted averageof PDY over three years, such that PPYt = 0.37 * PDYt + 0.33 PDYt-l + 0.3 PDYt_2.The weights are taken from Bhalla's derivation of weighting schemes corre-sponding to a 102 discount rate.

The real effective exchange rate (REER) is a trade-weighted averageof Malaysia's bilateral real exchange rates with six major trading partners,where the real exchange rate is the nominal exchange rate deflated by relativeprice movements in each country's wholesale price index. Finally, a realinterest rate variable is included (RRD), defined as the three-monthcommercial bank fixed deposit rate less the percentage increase in the CPI.

Regression results are shown in Table A3.1 below. All nominalvariables are deflated by the CPI, the sample period covers 1973-87. Esti-

- 146 - Appendix 7Page 2 of 2

mation is done using two-stage least squares because the method for computingprivate income implies a correlation between income and the error term inconsumption. This proves to be an important qualification because somevariables which were significant using OLS estimation techniques, such as theterms of trade index, close their significance once the TSLs procedure isused. Instruments used for income are the logs of real exports, real invest-ment and real money supply (M2). Other variables were also initially in-cluded, but found to be insignificant. These were money supply (a proxy forwealth) and transitory discretionary income, defined as current income lesspermanent income.

Table A3.1: CONSUMPTION FUNCTION REGRESSION RESULTS

Sample 1973 - 1987; dependent variable is log of real private consumption.

Variable Coefficient T-Stat

Constant 2.7503193 4.6627620Private permanent income 0.7716098 9.8732375Change in EPF assets 0.0940418 2.5533511Real effective exchange rate -0.2917560 -4.3690617Real deposit rate -0.0043107 -2.4060107

R-squared 0.995367 Mean of dependent var 10.07587Adjusted R-squared 0.993513 . S.D. of dependent var 0.261491S.E. of regression 0.021060 Sum of squred resid 0.004435Durbin-Watson stat 1.708910 F-statistic 537.0771Log likelihood 39.66240

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