Knowledge Deepening and Industrial Change in Malaysia Shahid Yusuf and Kaoru Nabeshima DRG February 26, 2008

Recent Performance and Prospects Growth during has slowed averaging 5.0% per annum as against 7.3% during the 1990s. The growth of TFP averaged 1.3 percent per annum during Rate of saving was 36% of GDP in 2006 but investment rate had declined to 19%. Population/workforce is growing at about 2% per annum (not including migrants). Policy questions: Can Malaysia achieve higher growth in the 6+% range? If so, which industrial sector(s) (including services) could serve as the main engines of growth?

Growth Rates in East Asia

Sources of Growth In early 1990s, investment was mainly responsible for growth. Since mid 1990s, the contribution of investment to growth declined considerably, the slack taken up by exports (latter half of 1990s) and by consumption (early 2000s). Growth of services has replaced manufacturing as the main source of growth since 2000.

Long-run GDP Growth: Historical Cross-Country Experience Using Maddison’s data, the long-run growth rate of per capita GDP in Malaysia is 4.0% since 1960 (2.9% if the series is extended back to 1911). Adding the population growth rate of 1%-2% could yield average aggregate future GDP growth rates of 5-6%.

“Catch-Up” Model A “catch-up” model in which developing countries’ growth rates are a function of the difference in income relative to the United States, predicts average growth rates for Malaysia ranging from 4.5% to 6.7% depending on the sample of countries included.

Long-Run Growth Rates

Potential and Long-Run Growth For Malaysia, 6% per annum seems to be an attainable growth rate. Faster growth can be achieved, but requires improvements in productivity, increased R&D and higher levels of investment by private sector which will promote embodied technical progress.

Is Malaysian Industry shifting towards higher tech, higher value adding activities? Trends in Exports Trends in Imports Foreign Direct Investment Domestic Investments New Starts and Growth of Existing Firms Industrial Location Finance Innovation Capabilities

Export Composition

Export Composition (excluding Electronics)

Revealed Comparative Advantage Malaysia’s strength is in medium-tech resource-based products. By comparison, products with highest RCA for Korea shifted from resource-based products in 1995 to medium-tech products including ships, chemicals and electronic products in The highest RCA for Singapore is more solidly in high-tech electronic products and chemical compounds.

Top 10 Commodities with Highest RCA in Malaysia: 1995

Top 10 Commodities with Highest RCA in Malaysia: 2005

Top 10 Commodities with Highest RCA in Singapore: 2005

Top 10 Commodities with Highest RCA in Korea: 2005

Top 10 Commodities with Highest RCA in Thailand: 2005

Export Competition with Neighboring Economies Increasing concentration on electronics and rapidly intensifying competition from China (whose own production and trade in electronics has risen dramatically) is evident from the table below:

Exports of Electronic Components by China

Imports of Electronic Components by China

Recent Export Diversification by Malaysia and Other East Asian Economies Very limited diversification. Electronic and Electrical products, major export sector. In value terms, this was higher than only two other East Asian economies: Indonesia and Thailand. Source: UN COMTRADE

New Exports Malaysia had 132 commodities that it started to export in any year after 1995 (beginning year for this study) and continued to export positive amounts till Indonesia and India on the other hand, had 309 and 219 “new” products in their export markets.

New Exports of Malaysia (Top 10 by Trade Value)

Fastest Growing New Exports from Malaysia

New Electronics Exports from Indonesia, India, and Malaysia

Scope for Export Diversification “Product space” identifies whether future export diversification is “easier” for a country. X-axis measures the distance to new export opportunities. Closer to the origin, “easier” it is to start exporting this commodity. Y-axis measures the difference in PRODY of a commodity and the average PRODY of the current export basket. Positive number means moving up the value chain. China has more opportunities for upgrading into higher value-added items than Malaysia.

Product Space: Malaysia Source: Authors’ calculations

Product Space: China Source: Authors’ calculations

Product Space: Thailand Source: Authors’ calculations

Technology Transfer via Malaysia’s Imports Technology transfer embodied in capital imports may have diminished. Sources of imports of plant and equipment have changed, fewer imports from the United States and Japan and an increasing share coming from China and Singapore.

IRCA and RCA Comparison Top 5 Product categories with highest IRCA in 1995 and 2000, compared with Top 5 Commodities with highest RCA in 2005 Index of Innovation Comparative Advantage (IRCA) is the ratio of a country’s share of patents in a particular sector, to the country’s share of total patents in the world.

Foreign Direct Investment Overall FDI inflow peaked in Electronic components and telecommunication equipment receive the lion’s share of FDI. Other sectors receive FDI in bursts. But no apparent trends pointing to sustained diversification.

Sectoral Flow of FDI

New Starts and Growth of Firms New firm formation is most active in Kuala Lumpur/Klang Valley with 1,123 firms, followed by Johor, Penang, and Malacca. Main industries favored : publishing and printing, food manufacturing, plastics, and apparel. New starts in electronics and machinery most often seen in Penang.

New Entry of Firms in Kuala Lumpur

Exploiting Urban Agglomeration Economies Kuala Lumpur is the principal urban center in Malaysia, judging by the population, economic size, and growth, followed by Johor, Penang, and Malacca. FDI is highest in Johor because of its proximity to Singapore, followed by Penang. From the perspective of the knowledge economy, Kuala Lumpur has the edge in terms of size, the diversity of services it offers, the presence of research institutions, the headquarters of firms, and the quality of the IT infrastructure.

GDP of Four Cities in Malaysia

Knowledge Economy Potential

Logistics Capabilities Kuala Lumpur/Port Klang leads followed by IDR/Tanjung Pelepas/Senai Airport with Penang in third place. Port Klang has lowest logistics costs to Chennai, Dubai, and Munich, relative to Singapore, Hong Kong, and Shanghai. However, Kuala Lumpur/Port Klang trails far behind other logistics hub in the region with respect to Internet connectivity, air transport (passenger and freight), and container shipping capacity. In terms of network connectivity, Tokyo, Hong Kong, and Singapore lead with Malaysia ranked 18 th, making it a regional node.

Availability of Capital Malaysian firms do not have undue difficulties accessing credit. Risk capital is relatively abundant (US$900 million, 3% of total investment). Providers are mainly public bodies (41%). The number of deals peaked in 2000 at 20. For seed and start-up stage, the peak was only 5 deals in 2000 and Demand more a constraint than supply and technology focused VCs have few attractive deals to fund.

Availability of Credit

Number of VC Deals in Malaysia

Innovation Capabilities Innovation capability in Malaysia is weak. –Low R&D spending (0.71% of GDP) among East Asian economies, even accounting for the level of development. –Number of people engaged in research was small (12,800 in 2004), even after accounting for population size and per capita GDP. –Sectors of focus by private firms (auto and electronics), GRIs (agro- based and metallurgy), and universities (biochemistry and engineering) are all different. –Domestic patent grants dominated by foreign residents (98%). –USPTO patents: 131 in 2006, bulk of them assigned to foreign affiliates. –Licensing and royalty fees: 1% of GDP in 2006, compared to 7% in Singapore and 10% in Ireland. –Quality of education is middling and there is no improving trend. –IT capabilities lag those of Singapore, Korea, and Japan (e.g. international bandwidth is 3Gbps).

R&D spending

Research in GRIs and Universities

Policies and Business Environment Incentive policies for the knowledge economy have been introduced since early 1990s; Are broad ranging and comparable to other economies in East Asia. Sweetening tax incentives not a priority. Infrastructure superior to that of neighboring economies, except Singapore. “Doing Business” indicators relatively good and stable. But among policymakers, a sense that Malaysia is underachieving. It is not upgrading fast enough and risks losing momentum in the face of competition from China, India, and Vietnam.

Doing Business Indicators

Growth in “Alice in Wonderland” `Well, in our country,' said Alice, still panting a little, `you'd generally get to somewhere else -- if you ran very fast for a long time, as we've been doing.' `A slow sort of country!' said the Queen. `Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!' - from “Through the Looking Glass” by Lewis Carroll

Policy Suggestions: A Summing Up Malaysia should aim to double R&D spending from public and private sources over the next ten years. This must be supported by higher education policies and incentives that raise quality and volume of STEM training. The larger firms, public and private, need to take the lead role in industrial deepening through backward and forward integration and by stimulating knowledge assimilation as well as domestic innovation. Measures to strengthen the knowledge economy must be concentrated on at the most one or two urban areas where the main universities and corporate headquarters are located. Urban centers must create the environment and culture which will attract and retain talented people from Malaysia and overseas. This calls for a mix of policies including policies affecting urban design. A dynamic urban knowledge environment which is conducive to the exchange of ideas, to both research and business related networking, and to innovation, demands an IT infrastructure that is comparable to the best in Asia. Polices that enhance openness and market competition can reinforce technological upgrading. Better, more detailed and current data to monitor changes in innovativeness and productivity across subsectors and increasing access to public data to encourage research on socio-economic issues, would assist in policy formulation.