World Bank Document

ReportNo. 5906-MA Malaysia: Industrializinga Primary Producer OnTwo Volumes) Volume I Public Disclosure Authorized

June, 19%6 EastAsia and PacificPrograms Department

FOR OFFICIAL USE ONLY Public Disclosure Authorized Public Disclosure Authorized

the WorldBank Public Disclosure Authorized Docunent-of

Thisreport has a restficteddistribution and may be usedby recipients onlyin th performanceof ther officialduties. Its contents may not otherwise bedisdosed without World Bank authorization. CURRENCY EQUIVALENTS

Currency Unit - Ringgit (M$)

1985 March 1986 US$1 = M$2.48 M$2.53 M$1 = US$0.40 US$0.40

FISCAL YEAR

January 1 - December 31

ABBREVIATIONS

2MP - Second Malaysia Plan (1971-75) 3MP - Third Malaysia Plan (1976-80) 4MP - Fourth Malaysia Plan (1981-85) 5MP - Fifth Malaysia Plan (1986-90) ACI - Action Com,ictee for Incentives EPF - Employees Provident Fund FAMA - Federal AgriculturalMarketing Authority FAS - United States Dept. of AgricultureForeign Agriculture Service FELCRA - Federal Land Consolidationand Rehabilitation Authority FELDA - Federal Land DevelopmentAuthority FTZ - Free Trade Zone ICA - Industrial Coordination Act LMW - Licensed ManufacturingWarehouse LPN - National Paddy and Rice Authority MADA - Muda AgriculturalDevelopment Authority MAS - Malaysia Airlines System MIDA - Malaysian Industrial Development Authority MIPS - Malaysian Industrial Policy Studies MOA - Ministry of Agriculture MOPGC - Malaysian Oil Palm Growers' Council NEP - New Economic Policy NFPE - NonfinancialPublic Enterprise PERNAS - Perbadanan Nasional Berhad PETRONAS - Petroleum Nasional Berhad PNB - Permodalan Nasional Berhad RISDA - Rubber Industry Smallholder DevelopmentAuthority USDA - United States Department of Agriculture FOI eFmCI USE ONLY

This report was prepared by a team that visited Malaysia in July 1985. The mission consisted of S. Yusuf (mission chief), D. Bhattasali, W. Cuddihy, S. Faruqi, and R. K. Peters, Jr. The Institute of Strategic and InternationalStudies in Kuala Lumpur prepared reviews on four industrial subsectors. Ms. Helen Callaghan provided assistance in Washington. The report was discussed with the authorities in January 1986 and the final versicn reflects the comments received and is updated on the basis of fresh statistics provided in April 1986. Mr. Vikraz Nehru contributed to the revision.

Ths dowumenthu a timeddinrbuio and may be ued by rcipien ondyin te pefonne oftheir oiidudteL. Its ctent may not odrwe be dicked withut Word hnkauthoriatdon. ABSTRACT

The report examines Malaysia's prospects for developing export- oriented manufacturing industries on the economic base provided by its primary sectors while persevering with the adjustment program begun in 198S. Malaysia has an efficient tree crop sector and substantialpetroleum resources, but oil production is approaching its peak, rubber output is on a declining trend and earnings from palm oil and cocoa, the two most lucrative agriculturalexports of recent years, will take time to recover from the price slump that has afflicted commodity markets. During the remainder of the eightiea, the contributionof these subsectors to the growth of the GDP is likely to be modest. The cut in energy and raw material prices in 1985-86 has also eroded government revenues and the economy's potential for saving. Achieving balance-of-payments equilibrium and containing the increase in external debt make a further spell of fiscal austerity unavoidable,and this is underlined by the restrained investment program outlined in the Fifth Five-Year Plan. As neither government spending nor the primary sector will contribute significantly to growth, the report emphasizes the importance of broadening the industrial base and promoting manufactured exports through major institutional changes and a reform of incentives as a way of regaining growth momentum. MALAYSIA

INDUSTRIALTZING A PRIMARY PRODUCER

Table of Contents Page No.

SUN ARY AND CONCLUSIONSe.e e...... ei e......

I. TRENDS AND PROSPECTS..RS....C TS..1....e......

A Changed Environent ...... 1 Malaysia's Economy: Recent Developmnts...o...... 2 Sources of Growth: Demand Factors...... 5 Sources of Growth: Sectoral Contributiono...... 7 Decomposition of Gro w th.... 8 Approach to Industrialization...... o...o. 11

II. RESOURCE BALANCES AND THE PUBLIC SECTOR...... 14

Deficits and Their Fiin .. .. . 15 Revenue GenerationThrough the Tax Systemostem...... 20 Spending Cuts...us...... o...... 23

III. THE ROLE OF LABOR AND EXCHANCE RATES IN EXPORT-ORIENTED DEVELOPfEfTessoooooeeeooooeeooooo.oo.ooooo.Esoo.o.ooe Tsoooose 28

Labor Markets in East Asia... sia....00...... 28 Population and Industrial Progress...... ogr e...... 28 SectoralLabor Suppliesp....0..0...... 0...... * ..... 29 ~~~ 'ages ~~~~~~~~~~~30 Wage Competitiveness ...... 0. 00...... 0..... 35 ExchangeRate Policyo.....y 38

IV. THE FUTURE OF EXPORTS e...... 43

Export Prospects: Commodity Marketsr.k.e..et.s...... 44 Export Prospects: Petroleum...... 51 Export Prospects: Manufactures...... 00O...... 53 Malaysia's Export Trader...... 59 International Trading Environment...... 61

V. EXTERNAL BOnROWING AND CAPITAL FLS...... 69

International Financial Markets...... 0 . 71 Equity Purchases and Capital Flows 71 Regulating Capital Movementsv...... 72 - ii -

Page No.

VI. DIRECT FOREIGN INVESTMENT AND ECONOMIC MODERNIZAIION...... 74

Direct Foreign Investment in Malaysia...... o.o..oo ..... 74 MNC Strategy and the Future of DFI...... 77

VII. INDUSTRIALSTRATEGY AND DEVELOPMENT...... o 82

Strategy ...... 89 Market Efficiency ...... 90 Regulation ...... 93 Industrial Deepening.....4...... 95 Sectoral Constraints and Policies ...... ii..e....s 98 Textiles and Clothing...... 98 Electrical Machinery and Applianceso.....oo 101 Agricultural Machinery...... o**o. .0...... * 103 Electronics...... 104 Wooden Furniture ...... o ...... oG6....o6...... 108 Rubber Products .... o...... 109

VIII. THE FUTURE OF AGRICULTURE. .... -o...... ooee...... 113

Rubber...... o...... -...... 00...... e...... 00 .... 114 Palm Oil ..... o...... o...... 122 Cocoa ...... o...... oo...... oe.woo.ooe.. 126 Tree Crop Sector Summary ...... -... 129 Rice Sectoro...... oo...... 60-000 ...... 130 Overview ...... - ...... 13...... 136

IX. SIMULATINC THE FUT...... o...... 141

TABLES IN TEXT l.1 Malaysia: Principal Macro In dicators...... 3 1.2 Malaysia: Demand Decomposition, Sources of Growth ...... oo 6 1.3 Malaysia: Sectoral Decomposition, Sources of Growth ...... 8 1.4 Malaysia: Factor Decomposition, Sources of Gro wth ....g 9....- 1.5 Malaysia: Allocation of Credit by Sector...... 12

2.1 The Evolution of Resource Balances in the Economy...*...... 15 2.2 Public Sector RescurceBalance ...... 16 2.3 Nonbank Sources of Budget Finance ...... 17 2.4 Savings Performance of the Federal Government...... O.. 19 2.5 Public Enterprise Statistics...... 19 2.6 Structure of Public Sector Revenues ...... 20 2.7 Tax Revenue Buoyancies, 1960-85...... 21 2.8 Economic Classification of Federal Operating Expenditures..... 24 2.9 Federal Subsidy Expenditures ...... *...... 25 2.10 Federal Government Development Expenditures by Sector..o...... 27 -iii -

Page No.

3.1 Malaysia: Real Average Monthly Earnings in Manufacturing 31 3.2 Malaysia: Employment and Productivityby Sector.....ctor..... 32 3.3 Trend in Employment by Major OccupationalGroups, Peninsular Malaysia, 1962-70 ...... - ...... 34 3.4 Occupational Structure of Public Sector Employment and All UrbanEmployment in Peninsular Malysia yi.a...e9oee*.*9e 34 3.5 Nominal Average Monthly Earnings in Manufacturing.....o...... 36 3.6 Value-Added per Worker...... 37 3.7 Malaysia: Female Participationin Employment by Sectors, 1 9 5 7 -79oee.*oee**.a..ooooo... es.9 . 38 3.8 Malaysia: Index of Nominal and Real Effective Exchange 41

4.1 Growth of Exports to the USA...... 44 4.2 World Natural Rubber Demand, 1982-2000...... 8 49 4.3 World Productionof Major Oils and Fats...... 50 4.4 Annual Growth Rates of LDCs' ManufacturedExports...... 54 4.5 Share of ManufacturedExports in Total Exports...... 54 4.6 Share of Developed Market Economies in ManufacturedExports of LDCD...... C...... s...... 55 4.7 Largest ManufacturedExports from Selected Asian Countries to Major OECD Economies ...... 56 4.8 Fastest-CrowingManufactured Exports from Selected Asian Countries to Major OECD Economies...... 57 4.9 Malaysia: MerchandiseEs p os...... 59 4.10 Malaysia: Exportsby Destination...... 60 4.11 Malaysia: Largest Manufactured Exports to Major OECD E c o n .... o o.e.ooee..em i es-ooo...... ee..000 .... 0-900.04-.. 60 4.12 Malaysia: Direction of Major Exports.... 62 4.13 Average Pre- and Post-Tokyo Round Nominal Tariff Protection in the Developed Markets...... 63 4.14 Pre- and Post-Tokyo Round Sectoral Tariff Averages for the Developed Countries.....ou.n...... r ...... 64 4.15 Actual Level of Tariffs Faced by Malaysian Imports.66 4.16 Malaysia: Nontariff Barriers Affecting Exports...... 67

5.1 Structure and Level of Total Foreign Debt Outstanding and Disbursed ...... *...... 70 5.2 Ownership or Corporate Assets in Malaysia.72 5.3 Errors and Omissions in the Balance of Payments 73

6.1 Aggregate Direct Foreign Investment Statistics...... 76 6.2 Malaysia: National Distribution of Direct Foreign Investment 78

7.1 Industrial Sector - Basic Data...... t...... 84 7.2 MIDA - Project Approvals, 1981-85 (No. of Projects)...... 85 7.3 MIDA - Project Approvals, 1981-85 (Amounts). u.n..o...... 86 7.4 Structure of Protection: MIC Groups (2 Digits)...... o.... &... 88 7.5 Structure of Protection: End-Use Groups...... &... 89 7.6 Characteristicsof the Asian Electronics Industryu...... 105 7.7 Composition of Electronic Sector Output...... 107 -iv-

Page No.

8.1 Land Availabiity ...... e** 114 8.2 Planted Area and Production of Rubber in Main Producing

8.3 Malaysia: Cost of Production for Rubber Estates...... 117 8.4 Rubber Estate Workers - InternationalWage Comparisons...... 118 8.5 Variation in Cost of Production by Yield Category...... 119 8.6 Projections of Natural Rubber Production - Various Scenarios, 1985-95... oooeooeoeeeomasoeo...... 121 8.7 Malaysia: Basic Statistics on Palm Oil..o...... 123 8.8 Estimated Economic Performanceof Estates and Smallholdings, Malaysia, 1984 o e o ms o o oe e o e eo o o...... oo...... 124 8.9 Malaysia: Comparison of Tree Crop Coefficients ...... o 128 8.10 Potential Productionand Labor Demand for Major Plantation Crops, 1984 ooooo.ooo*oeoo.s ... on.o.o ... oo...... 130 8.11 Paddy Yield of Major Producers.o.o..o...... 132 8.12 Malaysia: Nominal Protection,Paddy, 1981 and 1985...... 133 8.13 Malaysia: Effective Protection, Paddy, 1981 and 1985...... 134 8.14 Malaysia: Domestic Resource Cost, Paddy...... 135 8.15 Malaysia: Grain Production, Import, Consumption...... 139

9.1 Selected MacroeconomicIndicators - Base Case and Low Case.... 143

CHARTS AND GRAPHS

Malaysia - Nominal and Real Effective Exchange Rates...... o 42 Malaysia - Composition of Merchandise Exports...... o...... 46

MAP IBRD 19374 Page 1 of 2

COUNTRY DATA - MALAYSIA

AREA POPULATION DENSITY

329,800 sq km 15.8 million (1985) 47.9 per sq km Rate of growth: 2.62 (from 1980-85)

POPULATION CHARACTERISTICS(1981-83) HEALTH

Crude birth rate (per 1,000) 29.1 Population per physician (1984) 3,005 Crude death rate (per 1.000) 6.4 Population per hospital bed (1983) /a 503

INCOME DISTRIRUTION (1970) DISTRIRUTION OF LANDOWNERSHIP

2 of private income received by: Z owned by top 10X of owners n.a. highest 52 of households 27.0 Z owned by smallest 101 of owners n.a. lowest 20X of households 3.3

ACCESS TO PIPED WATER(1980) ACCESS TO ELFCTRICITY (1970) lb

Z occupied dwellings without piped water 31.0 X of population - total 43.4 2 of population - rural 30.1

NUTRITION EDUCATION

Calorie intake as 2 of requirements 122.0 Adult literacy rate (2) 72.0 Per capita daily protein intake (grass/day) 66.0 Primary school enrollment (1982-84) (2) 95.0

GNP PER CAPITA IN 1984: US$1,990

GROSS NATIONALPRODUCr IN 1985 ANNUALRATE OF GROWTH(2, constant MS)

USS mln X 1975-80 19R0-85 1984/85

GUP at market prices 29,346 100.0 8.3 4.9 2.6 Gross domestic investnent 9,394 32.0 14.1 6.2 -9.1 Gross national savings 8,494 28.9 n.a. n.a. n.a. Current account balance -898 -3.1 Export of goods. NFS 17,291 58.9 9.6 8.0 4.4 Ioport of goods, NFS 15,842 54.n 15.3 5.5 -6.1

OUTPUT, EMPLOYMENTAND PRODUCTIVITY IN 1984

Value added Labor force Value added per worker Us$ min /c Z Mln 2 US5 /c Z

Agriculture 5,01n 20.1 1.9 35.2 2,637 54.; Industry 9.322 37.5 1.3 24.1 7,171 147.4 Services 10,541 42.4 2.2 40.7 4,791 9S.'

Total/Average 24,873 100.0 5.4 100.0 4,866 100._

GOVENMMENT FINANCE General government Central government MS mln Z of GOP MS =In Z of CDP 1985 1985 1981 1985 1985 1981

Current receipts 24,853 31.7 31.6 21,861 27.9 27.3 Current expenditure 20,635 26.3 26.4 18,353 23.4 23.7 Current surplus 4,218 5.4 5.2 3,50S 4.5 3.7 Development expenditure 7,892 10.1 21.9 6,505 8.3 19.3 Page 2 of 2

MDNEY,CREDIT ANDPRICZS 1980 1981 1982 1983 1984 1985 money supply 27,437 3.234 37,618 41.154 45.859 48,920 Bank credit to public sector 549 2,786 4,617 4,204 4,771 1,594 Bank credit to private sector 20,346 24,976 29,197 35,403 41,976 47.849

Percentage or Index numbers -

Honey as 2 of GDP 51.2 55.7 60.0 58.9 57.6 62.3 Consumer price index (1980-100) 100.0 109.7 116.1 120.4 125.1 125.5 Annual percentaSe changes In: Consumer price lndex 6.7 9.7 5.8 3.7 3.9 0.3 Bank credit to public sector - 407.5 65.7 -8.9 13.5 -66.6 Bank credit to private sector 39.0 22.8 16.9 21.3 18.6 14.0

BALANCEOP PAYMENTS(US$ aln) 1982 1983 1984 1985 MERCNANDISEEXPORTS (AVERAGE 1983-85) Exports of Goods, NFS 13.622 15.703 18.529 17,291 US$ mln I Imports of Goods, NFS 16.039 17,334 17.866 15,842 Resource Gap (Deficit - -) -2,417 -1.631 663 1.449 Petroleum 3.568 23.3 Logs and timber 1,611 10.5 Factor Services (net) -1,145 -1.814 -2.224 -2.295 Palm oil 1,603 10.5 Net transfers (net) -32 -9 -39 -52 Ruibber 1,434 9.4 Balance on Current Account -3,594 -3,454 -1.600 -898 Tin 627 4.1 Manufactures 4,739 30.9 Direct private foreign Other 1,752 11.3 investment 1,394 1,261 914 754 Net HLT borrowing /d 2.629 2,878 1,435 3,128 Total 15,334 100.0 Disbursements 2,886 3,164 1,949 3,652 Amortization 257 286 514 524/e EXTERNALDEBT, DECEMBER31 1985 US$ Mln Subtotal 4,023 4,139 2.349 3,882 Public debt, includingguaranteed 12,445 Other capital (net) and Nonguaranteedprivate debt 4,138 capital n.e.i. 2,586 2,175 819 1,439 Total outstanding and disbursed 16,583 Increase in reserves (+) 197 48 80 n.a. NET DEBT SERVICE RATIO FOR 1985 /f 1 Gross reserves (end-year)/e 3,98R 4.070 4,115 n.a. Petroleum livports n.a. n.a. n.a. n.a. Public debt, including guaranteed 9.3 Petroleun exports /g 3,103 3.354 3,734 3.617 Nonguaranteed private deot 5.2 ETotal outstanding and disbursed 14.5 EXCHANGERATE March 1980 1981 1982 1983 1984 1985 1986 IRRD LENDING (MARCH31, 1986) USS nln

USSi - MS 2.18 2.30 2.34 2.32 2.34 2.48 2.53 Outstanding and disbursed 736.82 MS - USS 0.46 0.43 0.43 0.43 0.43 0.40 0.40 Undisbursed 554.73

Outstanding Including Undisbursed 1,291.55

Not applicable n.a. Not available

/a Government hospitals. /b Peninsular Malaysia. 7W Constant 1978 US$. T7- Public/publicly guaranteed debt only. /e Excludes refinancing of HS5,478 million in 1985. W( Interest and amortization payments as a percent of exports of goods and nonfactor services. 2j Crude petroleum.

Note: All conversions to dollars in this table are aetthe average exchange rate prevailing during the period covered.

June 1986 - iii - a result of cuts in oil and commodity prices. Aside from the diminished flow of revenues attributableto levies on petroleum, the scope for savings by the Government has been reduced by revenue losses arising from changes in the structure of income taxes. The upward drift in the operating expenses of public enterprises,meanwhile, has been yet another force serving to bring down savings. A turnaround in private savings might occur if growth accelerates in the late eighties, but it would be only prudent to guard against the possibility of a shortfall by buttressing the revenue earning and savings potential of the government through appropriate tax changes. The task of rationalizingand simplifyingthe tax system must continue, but together with this, it is necessary to restore, at least partially, the revenue earning potential of direct and indirect taxes.

8. Domestic resource availabilitymight also be enhanced if the annual loss in gross domestic savings through dividends, fees, repatriated profits and capital flight, could be diminished. There are limits to how far an open economy, that is anxious to attract direct foreign investmentand cement linkages with world financial markets, can monitor or regulate capital flows, but policymakersmight reflect on two possibilities. The last few years have witnessed a sizeable drop in the percentageof corporate equity held by foreigners. Many factors have been at work, but probably the one most important is the deliberate campaign by public trust agencies to acquire corporate shares, which is central to the New Economic Policy (NEP). This may have induced foreign shareholders to sell some of their Malaysian assets and move the funds realized out of the country. Adjustment goals, the progress made towards the NEP targets and the dimensions already attained by the public sector would recoamend a partial suspension of this policy which is a drain on resources at a difficult time for the economy and may be undermining if not in fact coun- teracting Malaysia's policies to attract direct foreign investment.

9. In these crisis-riddenyears, unrecorded capital movements have been a thorn in the side of several debtor nations and have severely constrained the enterpriseof economic management under adversity. An analysis of the factors influencing such movements of funds has identified: fluctuating inflation, overvalued exchange rates, interest differentialsand political happenings. But it has also indicated that the two countries with large external debts - Brazil and Korea -- who were able to minimize the volume of capital outflow, may have derived substantial benefit from regulating capital flows in a systematic fashion. For a variety of good historical and economic reasons, Malaysia allows unimpeded capital flows in and out of the country and this policy cannot be lightly abandoned because the implicationswould be far reaching, but if the measures to balance investment needs against the supply of national savings run afoul of institutional,political or behavioral obstacles, and unrecorded capital movements continue, the Korean and Brazilian experiencemight serve as a guide on how the problem might be checked.

Labor Markets and Export Competitiveness

10. A;though in a narrow sense adjustment is tied to resource balances, it does eventually join forces with measures designed to engender manufactured exports. Savings facilitateadjustment, but it is the ability to export that ultimately closes the payments gap. If a country can develop efficient and - iv -

competitiveexportables., there need not be much tension between the goals of adjustment and growth. It was stated earlier that the aggregate labor supply situation in Malaysia is comfortableand wage pressures have been quite restrained. On closer examination the picture is not without blemishes.

11. The production of tree crops seems headed towards tro-uble. Migra- tion to urban areas is denuding the rural labor force of its younger elements, those who will determine whether the sector thrives in the late nineties and beyond. Spot labor shortages are being experienced by rubber, oil palm and cocoa estates, and it is evident that once the aging pool of workers retires, rubber productionwhich is difficult to mechanize, may not have a long future. Recruiting young men to harvest oil palm is also becoming harder and long before the sector feels the edge of a land constraint, it might have been brought to an halt by labor scarcities. A faster increase in wages might moderate the exodus. However, the rubber industry is in no position to pay more for its labor, as falling internationalprices and profitabilityalready puts it at a disadvantageto oil palm cultivation. Wages in the oil palm and cocoa estates have kept pace with productivityand the earnings of harvesters have risen more quickly, but even these industriesare hostages of international price movements and forced to take anxious note of their competitors' cost structures.

12. Agriculture's loss is industry's gain. The labor migration that is condemning the primary sector to slow growth will ensure that industry benefits from elastic supplies. All through the seventies the increase in real wages could, more or less, be paid out of the increments in productivity, but in the early eighties, the impetus provided by public expendituresand high public wage scales, resulted in a marked acceleration in the growth of wages in certain industria' subsectors. Where once Malaysian wages trailed those of the East Asian NICs by a wide margin, they have now moved much closer, even though, in terms of industrial activity and productivity,Malaysia is not on an equal footing with its industrializingneighbors. The suspicion that rising costs may be eroding the competitivenessof the manufacturing sector was reinforced by the trend in real effective exchange rates. Flexible exchange rate policies jpted in late 1984 have improved competitivenessand falling commodity prices in early 1986, combined with the depreciationof the US dollar, have contributed to this trend.

13. Wage movements have retreated to the trends followed in the seventies with the recent interim settlement for public employees allowing only a 3.5% p.a. increase. Further, falling raw material prices and expenditureson constructionand real estate will reduce pressures on relative prices that bias the scales against tradables. But it may still be necessary to follow exchange rate policies that (a) remove any cost disadvantagesMalaysian tree crop producers and industrial exporters face vis-a-vis their East Asian competitors; and (b) ensure that this equilibrium is sustained by compensatingfor differences in productivity,wage rates and expenditure patterns between Malaysia and its neighbors. Trade Patterns and Comparative Advantage

14. Labor and exchange rate issues bring us to the vezed question concerning the size and composition of future trade flows. For a number of well-known reasons the OECD countries may grow at a lover average rate in the future even after the benefits from lower oil prices are factored in. Combined with protectionismand changing consumer preferences,it suggests that export-oriented LDCs such as Malaysia should search for trade and industrial policies that might prevail in the face of slowly growing world demand for traditional items. Internationaltrade in the sixties and seventies appears to have favored the products of chemical, transport and engineering industries. The latter two have held their ground in the eighties. A survey of the most successful exports from the East Asian NICs shows that electronics, electrical equipment, office machines, metal products and precision equipment,have now joined the list. If we extrapolate this pattern into the future, it offers some very rough guidelines as to which industries might best serve export goals in the medium term. Some of these products are too research and capital intensive for a developing economy but certain types of machinery, metal products, petrochemicalsand the supply of parts for electrical, electronic and automotive industries should be within the capabilitiesof an industrial newcomer.

Direct Foreign Investment

15. Manufacturingindustry in Malaysia has attracted much attention from foreign investors. Firms producing semiconductors,conrumer electronics, telecommunicationsequipment, and garments in the Free Trade Zones (FTZs) or the Licensed ManufacturingWarehouses (LHWs) that account for close to two thirds of manufactured exports, are either foreign-ownedor have substantial foreign shareholding. But domesticallyoriented companies in lines such as food, beverages, tobacco, automobiles,chemicals and rubber products have also served as conduits for brand names, capital aud technology from abroad. Direct foreign investment (DFI) in all of these subsectors is likely to continue but the available evidence suggests, at least tentatively, that neither the skills nor the funds brought in by foreign corporationswill do much to advance Malaysia's industrial ambitions or ease her entry into new export markets.

16. In net terms, that is after subtracting profits and dividends repatriated from annual DFI, Malaysia has incurred large deficits for well over a decade. Further, foreign companies that have established assembly type operations either to derive cost advantages from using Malaysian labor or to utilize the country's textile quotas, have transferred few skills, limited technology and done virtually nothing for industrialdeepening. Malaysian firms are in no better position to establish an independent presence in the international markets for garments and electronic products today than they were five years ago.

17. If trade barriers continue to hedge the flow of textiles and other countries seem to offer superior wage bargains, spinning, weaving and garment making operations in Malaysia will not be attracting much new foreign investment. And should the electronics industry find it economicallyefficient and - vi - politicallydesirable to put up factories in the industrializedcountries, the developmentof the electronics subsector in Southeast Asian economies might also stabilize.

18. A country seeking to deepen its industrial sector, increase manufacturing value-addedand widen its export possibilitiescannot rely upon DFI to do the entire job. The objectives of multinationalcorporations and indus- trializingeconomies are not always congruent. One is searching for markets and a means of reducing production costs through efficient sourcing and obtaining the maximum return from its financial options. The other wants to develop its own independentindustrial capacitiesand appropriate as many of the benefits in terms of profits, employment, technology and linkages as is possible, benefits that the involvementof MNCs often transfers overseas. Malaysia must continue to try and attract DFI because of its effects on employment generation,the need for foreign borrowingand on technology transfer, but increasingly,this will have to be complementedby domestic efforts oriented towards industrial deepening and the assimilationof technology.

Industrial Strategy

19. A declining role for overseas investorsmeans that Malaysi: must find an industrial strategy that will harness domestic capital and skills, and give a direction to the development of the manufacturingsector that is fruit- ful in terms of future exports. From the discussion of internationaltrading patterns, the recent history of the manufacturingsector, the state of the incentives system and the projected supply of technicaland engineering skills, the report identifies a three pronged industrialsLrategy comprised of: privatization that will stabilize,if not reverse, the tendency of the public sector to enlarge its industrial role and induce it to concentrate capital and managerial resources in areas where its presence can contribute critically to the development process; a rationalizationof incentivesand licensing procedures to minimize distortions introducedby the wide dispersal of tax and tariff rates and regulations governing entry; and support for the manufacture of producer and intermediategoods that will lead to a deepening of the industrial sector and provide the basis f-- future export growth. The report concludes that:

(a) although the average level of effective protection in Malaysia (23Z in 1982) compares favorably with that of other developing economies, the wide dispersion of rates and the frequent recourse to quotas increasesthe likelihood of distortionsand inefficienciesin resource use. A move towards greater uniformity in rates of effective protection through the adjustmentof tariffs at the extreme ends, together with the substitutionof tariffs for quotas could advance the cause of allocative efficiencywithout compromisingthe growth of current infant industries or the possibility of creating new ones.

(b) a diversified industrial system made up of many amaller sized firms will not be possible without vigorous entrepreneurialactivity. Of late this has been conspicuouslyabsent. It is widely believed in business circles that the strict regulationof business investment - vii -

by the Government as a part of the Industrial CoordinationAct (ICA), might be to blame for the low level of private interest. In December 1985, the-Governmentresponded by raising the industrial licensing threshold from N$250,000 to M$l million and thereby strongly reaffirmed its commitment to developmentled by private industry. This is a major step but it may not be enough to crack attitudes towards investment and risk that have hardened after ten years under the ICA. A move to a M$5 million exemption limit which would remove four fifths of industrial projects from the purview of the licensing body merits considerationfor the medium run. Now that a different situation prevails and industrial initiative rather than rent-earning primary products must underwrite economic advance, the rules governing the actions of the various players have to be drafted afresh. Small changes in the architectureof the ICA, which open a few windows in the system while retaining much of the structure, may not bring about the decisive shift in business psychology called for at this juncture. To the extent allowable by the nation's politics, the Government might wish to divorce the goals of equity and enlarging the Bumiputra share of the national wealth from the pursuit of industrialdevelopment and rely upon fiscal and welfare policies to achieve the former. Malaysian businessmen are competing in an unusually tough envi.1 nment and the greater the burden of licensing, the larger are the social claims on their earnings, and the smaller their flexibility in allocating resources and using available skills, the more likely it is that the race to industrializesweeping the eastern margins of the Pacific will be won by countries where business endeavor is not too rigidly circum- scribed by social obligations.

(c) events in the world market argue against specializing in a narrow range of products. Amongst the East Asian NICs, those with highly diversified exports produced by energetic small- and mediumrsized firms have taken less of a bruising from protectionismand the swings in trade;

(d) in the early eighties, Malaysian industry has been moving into transport, machinery, metal and chemical industries. Past trends indicate that these subsectors,along with electronics,continue to have high export potential. Excluding some areas in electronics and automobile production, they also present a new entrant with relatively moderate technology, scale and marketing barriers. That is to say, the opportunitiesfor finding and widening export niches appear to be greater than elsewhere.

Industrial Micro Issues

20. Going beyond broad sectoral strategy, the Report looks at the state of six manufacturing subsectors and assesses their prospects. They are: textiles, electronics,rubber products, wooden furniture, electrical machinery and equipment, and farm machinery. With the exception of electronics, the problems of these industries are not dissimilar, although each confronts quite different learning curves and export possibilities. Electronics remain an - viii -

enclave in the industrial system with a future that is tied to the production strategies of foreign firms. If the economics of assembly in offshore plat- forms turns sour, the enclave will shrink; there is only a small chance of growth rivalling the expansion of the seventies and early eighties. Linkages may continue to sprout but they will remain sparse, as technology, brand names and marketing ability are more serious entry barriers than in other subsectors.

21. Textiles, and the two resource based industries are likely to be hamstrung by slowly growing world demand, and complications introducedby trade restrictions(textiles) and low profitability (rubber tires). The machinery subsectors are far better placed as regards both market trends and assimilatingtechnology. But all five subsectorswill need much help to loosen a number of constraints.

22. Technical, engineering and design skills are scarce throughoutthe manufacturing sector and their effects are felt in the mastering of technology, innovation,quality of product, the ability to fully utilize equipment, and repair and rebuild machinery. Smaller firms that have limited collateral frequently cannot raise sufficientcredit and are forced to make do with old machines, which further detracts from the standards of quality and finish. Companies that are without foreign partners show scant understanding of marketing techniques that are as important as innovativeness,design, quality and price competitivenessin achieving export success. Finally, Malaysia still has to build the network of channels that will provide manufacturers the volume of detailed information necessary to detect a market opening and design a product that will fit the market's specifications.

23. Industrial policy must act upon many facets of industrial life. It must create the right atmosphere so that entrepreneurswill be stimulated to act; tariff, taxes and subsidies must be fashioned to effectively support firms populating the sector; it must ensure that education and training policies generate an adequate supply of skills; R&D activities must be catered for. In addition, industrialpolicy must alleviate some of the micro-problems that the average firm encounters on a daily basis, problems associated with credit sapply, the use of facilities, obtaining raw materials and intermediate goods, and gaining access to market information.

24. The report identifies four areas where active government support will be required:

(a) industrialcredit, possibly through existing development banks or by way of commercial institutions;

(b) centers for design and research where higher-level skills could be imparted;

(c) vocational training, possibly supplementedby subsidized apprenticeship programs to meet the needs of modern industry; and

(d) a system for gathering market intelligencefrom overseas. - is -

The AgricultureSector

25. In the simplestterms the futureof Malaysianagriculture will be decidedby internationalmarket conditionsand rural laborsupply. Four sub- sectorsare coveredin the Report: rubber,oil palm, cocoaand rice. They all sharecertain features: in each thereis an efficientwing where yields are among the highestin the world and the latesttechnologies are in use, as well as a backwardsegment where the smallholdersderive low returnsfrom the use of laborand land. All agriculturalactivities are threatenedto varying degreesby the withdrawalof labor,but theirfate is likelyto be one of gradualdecline rather than a suddenprecipitous drop in output. 26. Rubberproduction is the one area where the large-scaleswitch to oil palm plannedby the estatescould have far-reachingeffects on production in the mediumrun. Rubberhas fallenfrom grace becauseat prevailingand anticipatedprices its profitabilitydoes not comparefavorably with that of palm oil and cocoa. Sincethe estatescannot readily increase their total area, they are cuttingrubber trees so as to make room for oil palm. Mean- while,the governmentis attemptingto enlargethe size and productivityof the smallholderhectarage by providingreplanting subsidies, extension servicesand assistancein establishingmini estates. The conclusionof the Reportis that with the pricesof commoditiessubject to wide oscillations, and demandbeing somewhatdifficult to predict,it is advisableto maintain efficientand diversifiedcoummodity production. If the estatescontinue movingout of rubber,output will diminishand technologicalchange slackenas estatestake the lead in plantingnew clones. Foreignproducers will see this as evidenceof a retreatby the world'sleading supplier and move to expand theirown area. Once the rubber industryis left to the smallholders,it will be of minor significance,and Malaysia'sagricultural commodity basket will be reducedto one major export,palm oil and two minor ones,rubber and cocoa. 27. Palm oil'strade prospects are superiorto thoseof rubber,competition from other suppliersis weakerand even at the depressedprices prevailing in 1986,it giveshigher returns. Malaysia'sstrategy should encourage estatesnot to reducetheir rubber acreage below 1984 levelsand urge small- holderscurrently growing rubber to plant oil palm instead. Efficientrubber productionwould be retained. Some of the povertystricken rubber small- holderswould be able to raise theirearnings by shiftingto a new tree crop. Palm oil outputwould expandand since the differentialbetween smallholders and estateyields is less for palm oil than that for rubber,the final production outcomewould not departtoo far from the scenariowhere the estates convert70Z of their land to oil palm.

28. The collapseof palm oil prices from about US$730per ton in 1984 to US$290per ton in the firstquarter of 1986 shouldbe warningenough as to the risks of increasingsupplies at a rate which the market cannotdigest and the hazardsof specializingin a singlecomuodity. The Rice Economy

29. After attempting for several years to meet over 80Z of its needs from the domestic production of rice, Malaysia is prepared to settle for a much lower target. The decision was motivated by low internationalrice prices that are projected well into the future and the failure of costly price support and subsidy programs to reverse the stagnationin output. Irrigated areas in four major schemes that are the source of 60Z of the rice produced are productive enough and will flourish so long as no major changes are introduced in the incentive system. The problems are in the rainfed areas where smallholdersachieve low yields and cannot earn enough from rice farming to rise above the poverty line. Many farmers in these regions have sought supp- lementary off-farm occupations,and others have given up trying to make ends meet and migrated to the cities.

30. Policymakershave three options: the high domestic resource costs of rice production can be used as a justification for scaling down incentives, a move that would swell the numbers seeking urban jobs; over the medium term the Government could hold the line on incentivesand accept the slow attrition of the farm economy; or it could pour funds into developing irrigation facilities and infrastructurein the rainfed areas in an attempt to bolster yields, the returns from rice cultivationand the total productionof rice in the country. Concerns arising from food security and uncertainty about the availability of enough employment in the urban sector limit the palatabilityof the first option. Past experience with small-scale irrigationand the high opportunity cost of capital, suggest that such an approach will not stem migration and could tie up resources in projects with low returns. On these grounds, the second option seems most appropriate for the balance of the eighties. It will probably result in stagnant or slowly falling levels of production but will minimize dislocation in the rice economy and argue against any costly new expendituresfor developing rice land.

ProjectingGrowth

31. Malaysia possesses the resources to join the ranks of the NICs, but it will require a steadfast industrial strategy and the benefit of fair international trading weather. The process will take time because new industries require a minimum number of years to mature into seasoned exporters. If the Fifth Plan is successfulat quickening the tempo of manufacturingactivity, the transition from primary producer to an emerging industrial nation would be well advanced by the beginning of the nineties. The slump in oil and commodity prices by depressing public revenues and foreign exchange earnings will, in the short-term,magnify the adjustment problem. To minimize net brorowing some growth may need to be sacrificedin order that the balance of payments difficultiescan be resolved more quickly. Our base scenario assumes therefore that the economy will gather momentum gradually, with growth remaining in the 1.52 - 2.5Z range during 1986-87 but picking up in the later years (4.0Z - 4.5Z) as the economy moves towards a resource equilibrium by way of fiscal measures that restore government savings and the strong check on public expenditures proposed in the Fifth Plan. Over this entire period, agriculture and mineral production will contributevery moderately to the expansion of the national product. The manufacturing sector and the continuingdevelopment of - xi - social overhead capital will be supplying most of the push, and manufactured exports will determine whether or not trading goals are met. Should progress in the manufacturing sphere falter, it will be very hard to do justice either to the growth objective or that of adjustment. CHAPTER I: TRENDS AND PROSPECTS

A Changed Environment

1.01 Small open economies lead a vulnerable existence on the international stage. Where larger countries can find a degree of seclusion from the bustle of the world market to pursue their own domestic designs, an economy the size of Malaysia cannot afford to neglect the activities beyond its shores. The entire effort of development must be cued to signals arriving from its major trading partners. Ever since the second round of oil price adjustments in 1979, the tempo of economic activity worldwide has been weaker, in part because of technological,institutional and demand-relateddevelop- ments in the industrial nations; partly also as a result of strains bred by the rise of many new aspirants to the status of industrial maturity, who have profoundly affected the pattern of trade and capital flows.

1.02 The meager productivitygains emanating from the electronics revolu- tion suggest that the time may have passed when the advanced economies could expect substantial annual bonuses from the increased efficiency of resource use. Aa aging population and institutionscanted towards distributive justice and generous welfare benefits are likely to limit the scale of capital accumulation as well as the market directed flexibility in the pricing and the real- locating of resources. Finally, for many basic consumer goods and durables, saturatedwants might dislodge the growth in demand from past trends. All of these presage a smaller appetite in the markets of the industrial countries for the goods produced in the developing world. Internationaltrade, the force behind the widespread surge in postwar living standards, could increase more fitfully under the weight of restrictions sparked by political concerns and the fears of deindustrialization. With trade and growth slowing, capital flows that have been so consequential in putting the surplus savings of the advanced economies behind the industrial ambitions of the LDCs, would also begin to falter, especially if debt crises continue to fan the apprehensions of bankers.

1.03 From the standpoint of the developing market economies, such as Malaysia, the earlier industrial strategy which assumed relatively unimpeded access to growing markets in the affluent West, might have to be refashioned in importantways. The path revealed by comparative advantage and export opportunitiesexploited in the past may have to be reconsideredto allow for the political limits to the expansion of trade in products favored by new developers,the likely persistence of internationalcapital scarcities, and the spreading influence of multinational companies (MNCs) in the spheres of investment,trade, technology transfer and product development. Increasing intracompanytrade and market sharing by major international industries are some of the more significant features of the current economic environment. So far, at least, policymakerssearching for a way around the multiplying com- plexitieshave leaned upon the themes of trade liberalization,comparative advantage and distortion minimizing, policy and price reforms. The challenge is ensuring the fruition of industrial initiatives begun in the recent past and devising policies that will deliver economic results in the face of much greater odds. - 2-

Malaysia's Economy: Recent Developments

1.04 Five yeers ago it became clear that Malaysia would have to concentrate on building an industrial system using the resources transferred ou of the plantation sector and revenues earned through petroleum imports. With the vitality ebbing from mining and parts of the plantation economy because of rising costs and weak demand, concentratinginvestible resources on manufacturing development using the example of the East Asian NICs, was the most attractive route. But export led growth must now be managed in a far harsher environment and while it might still be the strategy promising the largest rewards, the risks have increased and small countries with limited bargaining power are very much at the mercy of major trading partners and large multinational producers. Over the course of the Fifth Plan period (1986-90) a number of decisions will have to be taken which will determine the long-run sectoral composition and potentialitiesof the Malaysian economy. It is important that these be fully informed not just by the experience of the NICs in the seventies and early eighties, but also by the knowledge of how internationaleconomic relations are likely to be shaped.

1.05 The speed and direction of Malaysian economic progress in the eighties reflects the interplay of certain policy decisions with international market developments. Rising commodity prices in 1975-77 and the tripling of oil prices in 1979-80 provided an infusion of rental earnings which enriched the economy and elevated the country's credit standing. Its attractivenessas a base for assembly-typetextile and electronics industries, stimulateda substantial volume of foreign investment. MNCs looking for a blend of political stability, cheap labor, adequate infrastructure,unfilled export quotas and fiscal incentives, flocked to Malaysia. The factories they helped to establish within and outside Free Trade Zones (FTZs), allowed Malaysia to capital- ize on the enormous growth in the market for semiconductorsduring 1980-84 as well as the steady expansion in the demand for cheaper Asian-made garments in the USA and to a lesser extent the EEC. Intertwinedwith these was the Gov- ernment's decision to move at all possible speed towards modernizing infrastructure and creating the base for future industrial advance through investments in automobiles,machinery, petrochemicals,ferrous metals and cement. A second key decision, motivated by Malaysia's comfortable debt service ratio, the expectation of low or negative real interest rates on foreign loans (as was the case after the first oil shock) and the desire to cushion the economy against externally transmitted recession, was the willingness to borrow heavily to finance domestic, primarily public, investment. A third move related to the public sector's development push, was the parceling of responsibilities to nonfinancialpublic enterprises (NFPEs) created during 1976-81 without at the same time erecting a monitoring and control apparatus equal to the task of supervisingthe activities of many agencies and keeping track of the total financial implicationsof dispersed investment decisions.

1.06 The effects of these are visible in the macro indicators tracking the economy's movements in the first half of the eighties (see Table 1.1). First, growth, though lower than the average for the seventies (7.7%) was fairly stable because of the strong impetus from capital spending. Second, investment outlays rose far above the country's substantialgross national savings, resulting in very large current account deficits that had then to be - 3 -

financed through commercial borrowing. External debt registered a threefold increase between 1980 and 1984. Following a pattern observed in several of the Latin American NICs but also in Korea, the sudden disequilibrium in resource balances and the reliance on foreign savings which it entailed, arose squarely from the actions of the public sector. Spending by public agencies and especiallythe NFPEs, rose with alarming swiftnessas is shown by the behavior of public sector deficits.

Table 1.1: MALAYSIA: PRINCIPAL MACRO INDICATORS

1979 1980 1981 1982 1983 1984 1985

GNP growth (Z p.a.) /a 9.1 9.2 7.5 4.2 3.9 6.6 2.6 GDP growth (Z p.a.) 7T 9.3 7.9 6.9 5.6 6.3 7.6 2.8

GDI/GNP (Z) 30.3 31.9 36.5 39.2 38.7 35.9 32.0

GNS/GDP (Z) 33.3 29.6 25.5 24.0 24.8 28.8 26.8

Merchandise trade balance (M$ mln) 6,908 5,238 -243 -1,758 1,093 6,913 8,628

Current account balance (M$mlin) 2,033 -620 -5,633 -8,409 -8,026 -3,743 -2,230 as Z of GNP 4.7 -1.2 -10.4 -14.4 -12.1 -5.8 -3.1

Public sector overall balance /b (M$ mln) -1,890 -6,150 -9,464 -10,711 -8,510 -7,491 -4,930 as Z of GNP -4.3 -11.9 -17.0 -17.9 -13.0 -10.1 -6.8

Total debt/GYP (Z) /c 24.3 25.5 35.5 47.6 58.9 56.9 65.7

Debt service ratio /d 5.9 4.3 8.0 10.2 10.8 12.5 15.3 la At constant prices. T7 1979 data refer to Federal Government, 13 State Governments, 4 Local Govern- ments and 10 Public Enterprises. Since 1980, 26 additional public enterprises have been included. /c Total debt = Public and publicly guaranteed, nonguaranteed private, and short term debt. /d Ratio of total debt service to exports of goods and services.

Source: StatisticalAppendix Tables 2.1, 3.1, 4.1 and text Table 5.1.

1.07 Finally, the fruits of building capacity in electronics and textiles, but also the benefits of enlarging the dimensions of the palm oil industry, are apparent in the export statistics, especially for 1983/84, when Malaysia's growth and balance of payments were buoyed by a real increase of - 4 -

14X in exports of goods and nonfactor services. But the economic gains that so heartened policymakers in 1984 also stemmed from the Government regaining its grip over the spending of independentagencies, which served to narrow the public deficit. To ensure that spending by the NFPEs remains harnessed to the objective of reducing the public sector's deficit, monitoring committees have been established in both the Treasury and the Economic Planning Unit (EPU). Backing them up with more detailed surveillanceof planned expenditures and accounts is a newly created monitoring and control unit (CICU).

1.08 The economy entered 1985 in a spirit of considerableoptimism but events during the course of the year belied the earlier expectations. Growth in the US slipped to little over 2% and as this was not counterbalancedby stronger performance in other large industrialnations, world trade quickly felt the chill and increased by only 3% as compared to the 9% rate registered in 1984. This was damaging for Malaysia's manufactured exports and sales of both textiles and electronics, the two principal items declined. It may also have brought added pressure to bear on the markets for petroleum, palm oil and tin, three of Malaysia's largest commodity exports, that were already feeling the effects of oversupply. Petroleum prices began to retreat in mid-1985, followed shortly thereafter by palm oil and the market for tin collapsed in late October. In 1984, Malaysia exported 343,800 bpd of crude at an average price per barrel of US$29.87. Sales rose in 1985 to about 354,500 bpd but the weighted price was US$27.50 per barrel. Palm oil did substantiallyworse. Export earnings from palm oil and products (stearin, olein, kernel oil and cake) dropped by 1lZ from M$5.71 billion in 1984 to M$5.09 billion in 1985. Since tin accounts for less than 3Z of Malaysia's merchandise exports, the suspension of trading on the London Metal Exchange on October 24 and the collapse of the price barely dented overall export earnings but the ripple effects of mine closures and loss of employmentwere damaging on a regional scale, the economy of Perak being especially hard hit.

1.09 Overall the deteriorationin the terms of trade during 1985 amounted to 5.6%. Combined with the reduction in certain commodity and manufactured exports as well as the decline in private investment, this resulted in the worst economic performance in a decade. Higher production of petroleum, palm oil and timber helped raise the real GDP by 2.8%, but in nominal terms the domestic product was 2.1Z less than in 1984. As the economy generated fewer jobs, the unemployment rate climbed to 7.6%. But a slowing economy and falling commodity prices had certain beneficial consequencesas well: inflation was a negligible 0.3% (CPI); and a larger merchandise surplus served to narrow the current account deficit to 3.3% of GDP. Hence, medium- and long-term (MLT) debt grew 6.9Z to US$16,583 million as against US$15,513 million in 1984.

1.10 Starting in 1986, Malaysia will be charting an economic course that will be defined in the Fifth Five Year Plan. For sound political and economic reasons, the Government would like to set its sights as high as possible. During the Second and Third Plan periods, growth rates of GNP averaged 7.1% and 8.6%, respectively. In the first half of the 1980s, growth slowed to 5% p.a. and it appears from the trends projected in the markets for Malaysia's commodity exports that traditional sectors will need to be strongly abetted by others sources of growth if the country is to sustain an acceptable pace of economic advance. -5-

1.11 Lessons learned over the course of the Fourth Plan period have been chastening. External demand is undependable and traditional exports of commodities as well as light manufacturesare having to struggle in buyers' markets or scale ever higher nontariff barriers. At the same time, an aggressive attempt at generating growth through public investmentin both infjastructure and industry may have been a costly way of propelling the economy.- Average investment levels exceeding 36X (1981-83) of CUP added little more than 5% p.a. to the national product but saddled the country with a sizeable debt.

1.12 If growth is to move hand in hand with external adjustment, a smaller quantum of investment must be made to yield larger returns and more of the domestic value-addedmust find its way into exports. What this implies, first of all, is greater factor productivity. Second, Malaysia must enlarge the value-added in important export categories,for example, light manufactures, machinery, metal and wood products. Many other changes will also be required, calling for a very different constellationof policies and a tilting of initiatives away from the public and towards the private sector. Perhaps the most effective way of tracing the feasible economic perimeter is to assess the economy's supply potential from the macro plane and again at the subsectoral level. Then to juxtapose this with the demand possibilities that we see germinating internationallyin the world of the late eighties.

Sources of Growth: Demand Factors

1.13 An economy's sinews are moved by demand. How rapidly it advances ultimately rests on the strength of demand from expenditureson consumption, investment and exports. Except in certain stages of growth, it is consumption that leads the way with capital spending some way behind and trade often a distant third. In Malaysia, the pull of consumptionrose significantly from the first half of the seventies to the second, because of a major surge in private outlays (see Table 1.2). As foreign purchases of import intensive consumption and developmentexpenditures outpaced the growth of exports, the external account turned from being a small net contributor to growth to a significant drag on the economy's expansion. In addition, Malaysia's manufactured exports that began rising in the late seventies, were based on the processing of imported intermediategoods. The weight of both private and public investment was greater in the second period when Malaysia, benefiting from the primary commodity boom and heightened world business activity, was racing ahead of the Third Plan's growth targets. A decisive shift in sectoral con- tributions is evident after 1980, with changed external circumstances and development policies. Most significantwas the reduced pull by private consumption. Larger public consumption spending, some of it on administration, the rest on welfare and subsidies, compensated only marginally for the halving of the private sector's contribution to GDP growth. What sustained growth was the vast increase in public investment and to a lesser extent private capital outlay. As the net demand impetus from trade remained negative and at about the same level as in the late seventies, GDP grew more slowly but it certainly

1/ See Malaysia: DevelopmentStrategies and Their Financing, World Bank, Report No. 5560-MA, September 1985. -6- appears that the infrastructure-buildingactivities of the public sector and its entry into basic and transport industries were a considerablecountercyc- lical force during these years. Another change is apparent in 1984, a testi- mony to the government's success in trimming its capital budget, but also providing disturbing evidence of private business uncertainty. Investment demand declined, public as well as private. That the economy was able to notch up a GDP growth of 7.3% was the consequence,by and large, of unusually brisk export performance,low import demand and the highest annual increase in private consumption expenditurerecorded in the eighties -- 5.5% as against an average 2.7% over the previous 4 years.

Table 1.2: MALAYSIA: DEMAND DECOMPOSITION,SOURCES OF GROWTH

1970-75 1975-80 1980-83

GDP Growth (Purchaser's value) - 5 year total 41.10 51.05 19.80 Average annual growth rate 7.13 8.60 6.22

Percentage of GDP

Consumption 69.6 87.2 55.7 Public 23.7 22.7 27.3 Private 45.9 64.5 28.4

Investment 22.0 38.7 67.4 Public 9.1 14.5 35.1 Private 12.9 24.2 32.3

Trade 8.4 -25.9 -23.1 Export 35.3 47.1 46.3 Import -26.9 73.0 -69.4

Source: F. Desmond McCarthy and Nadeem A. Burney, Malaysia: Endowment, Growth and Development,Country Policy Department,The World Bank, July 1985, unpublishedmimeo.

1.14 If the Government's intention of containing public investment and pursuing a frugal line on administrativeexpenditures is combined with the indifferentoutlook for commodity exports over the next 18 months, economic expansionmust be powered by private investment and consumption. Private investment continued its worrisome decline in 1985 and the fraught economic climate brought down private consumptionas well, leaving public investment and the increased exports of petroleum to pull the economy along. The decision to peg oil production at 510,000 bpd will be an important source of economic momentum but with the Government seeking a lower developmental pro- file so as to achieve a smaller public deficit, additional support must come - 7 - from a revival of private investment. The Government has introduced a number of measures, which are discussed later in the report, to spur business activity. Entrepreneurialresponse to these recent moves will determine not just the scale of economic gains over the short run but also the longer-term prospects of the economy that rest very much on the extent and efficiency of diversificationinto tradable manufacturingand tertiary activities. Even if internationalbusiness activity recovers under the influence of reduced oil prices and inflation rates, the next 12 to 18 months are freighted with much uncertainty for the Malaysian economy. There has been a significant narrowing of the bases for growth, the reflationarypotential of the public sector is severely constrained,and it is private investment initiativesin what are admittedly difficult times that will spell the difference between stagnation and a growth rate of 2.5-3.5% which is consonant with continued adjustment.

Sources of Growth: Sectoral Contribution

1.15 In the first half of the seventies, a little over one fifth of the increase in GDP came from agriculture, nearly 30Z from manufacturing,government services accounted for 17% and constructionand commerce for another 15% (see Table 1.3). Both the major productive sectors, agriculture and industry have sunk in importance in the course of this decade. Agriculture's share now hovers around 12% while industry is close to 16%. The sectors that have gained in stature are construction, commerce, transport and government services. This reflects the resilience of services and the lure of real estate when other business activity is slow, it also indicates that Malaysia is adjusting towards an economic structure on par with its income level. The advance of services and constructionattests, moreover, to the permeation of the economy by the public sector, the great increase in public employment, the proliferationof agencies offering diverse services and the large injection of public funds into various types of constructionactivity.

1.16 The expansion of services and of the government sector is a normal and perhaps inevitable process, and multicountry research suggests that in th early stages, government size has a positive effect on economic performance.2 Beyond a point, it can divert resources from the directly productive activities and tilt the economic balance too far in the direction of nontradables, generating cost pressures and export supply constraints deleterious to the long term development of a highly open economy. There are few signs that the diminishing sectoral contribution of agriculturewill be reversed. The brief spurt by industry in 1984 was not repeated in 1985, but unless industry can reestablish itself as the principal sectoral player, Malaysia's development program will lack a dynamic center and without industry providing the "spread effects" which serve as the underpinningfor the prosperity of other sectors, the economy could quickly run out of momentum. Rents from primary exports would continue to underwrite some of the bills, but the battle to escape from middle income status into more comfortable circumstanceswould have been lost.

2/ R. Ram, "'GovernmentSize and Economic Growth: A New Framework and Some Evidence from Cross-Section and Time Series Data," American Economic Review, Vol. 76, No. 1, March 1986. -8-

Table 1.3: MALAYSIA: SECTORAL DECOMPOSITION,SOURCES OF GROWTH (as S of GDP) /a

1970-75 1975-80 1980-83

Agriculture 22.1 16.4 12.8 Agriculture & livestock 12.2 10.5 7.2 Forestry 9.8 3.4 6.2 Fishing 0.1 2.5 -0.6 Mining 2.2 4.3 4.4 Manufacturing 29.6 22.8 15.1 Electricity,gas & water 2.2 2.7 3.5 Construction 3.4 6.3 9.2 Commerce 10.9 14.8 14.0 Wholesale & retail trade 11.0 13.6 11.8 Restaurants & hotels 0.1 1.2 2.2 Transportation& communication 6.3 8.2 12.4 Finance & real estate 7.7 6.5 9.0 Finance & insurance 5.2 5.0 7.5 Real estate 2.4 1.5 1.5 Government service 16.7 11.2 19.8 Household, social & community services 2.3 2.7 1.8

Residual (Import duty, etc.) 3.4 4.1 -2.0

Total 100.0 100.0 100.0

/a Average contributionover the correspondingsubperiod.

Source: F. Desmond McCarthy and Nadeem A. Burney, Malaysia: Endowment, Growth and Development,op cit.

Decompositionof Growth

1.17 Another angle from which to view the recent economic performance of Malaysia is to explain the movements in GDP through the changes in the use of capital and labor plus the intangible contributionsfrom education, technology, scale economies and better resource allocation, what economists amalga- mate into a category labeled as the residual. Studies of the US and the Euro- pean countries covering the period 1950 to 1962 and Japan from 1953 to 1961 indicate that factor inputs were responsible for about a third of the expansion in Western Europe and Japan and closer to 60Z in the US. The balance came from the residual, which is to say that improved skills, knowledge and resource utilization provided no less than a third, and in the case of Europe almost two thirds of the growth. One interpretationis that the efficiency and dynamism of a system are measured by the size of the residual and that the -9- maturity of an industrial economy rspresented by its technological orienta- tion, its reserves of human capital and its sophisticatedmarket mechanism should be captured by increases in the residual.

1.18 To apply the procedure devised by Denison 31 in its refined form, is impossible because detailed statistics on investment, education, plant sizes and a host of other variables, are not routinely gathered in Malaysia. A simpler procedure which crystallizes usable approximationsbut does not separate the residual into its component parts, suggests that factor inputs have loomed very large in the growth equation (see Table 1.4). For the past one and half decades, 12-14X of the growth has arisen from the increase in the labor force. But it is capital that has been the driving force, its share swelling from 58% to 1081 between 1970-75 and 1980-83. As the influence of capital has burgeoned, the residual has fallen away from 28% in the first half of the seventies to a negative 21Z in the early eighties.

Table 1.4: MALAYSIA: FACTOR DECOMPOSITION,SOURCES OF GROWTH (as X of GDP growth) /a

1970-75 1975-80 1980-83

Factor input 72.0 86.3 121.1 Labor 13.6 11.7 13.4 Capital 58.4 74.6 107.7 Public 24.4 36.6 50.4 Private 34.0 38.0 57.3

Residual 28.0 13.7 -21.1

Total 100.0 100.0 100.0

/a Average contributionsove- the corresponding subperiods.

Source: F. Desmond McCarthy and Nadeem A. Burney, Malaysia: Endowment, Growth and Development, op cit.

While these estimates must be treated with all due caution, they are not implausibleand tally very broadly with the story that is told by other economic indicators. For over eight years, the annual dose of investment has been very large. It was 242 of GNP in 1975 and nearly 37% in 1983. This has strained the economy's absorptive capacity and outstripped its ability to find the supporting technical and managerial skills or for that matter, markets, to

3/ E.F. Denison, Why Growth Rates Differ, Brookings Institution, Washington, D.C., 1967; and E.F. Denison and W.K. Chung, How Japan's Economy Grew, Brookings Institution, 1976. - 10 - do justice to the services and goods for which production capacity exists. So rapidly has the capital base been expanded that new industries have been slow to move up their learning curves and few have made a start at serious applied research or process innovationdirectly affecting the residual. One implica- tion is that the residual could contribute importantly to future growth, especially since significantadditions to the stock of skilled manpower can be expected in the next few years. A smaller increase in the stock of capital would not, therefore, dampen GDP growth, on the contrary it might provide for sorely needed rationalization. A second and less reassuring message can also be drawn. If a sizeable proportion of the capital accumulated is in the form of capital intensive projects with very long payback periods or has gone into manufacturingoperations which will have to battle long and hard to find markets for their products, efficiency and learning related gains will accrue very 1,owly. In this connection, the experience of Singapore may be instruc- tive.- Although the growth of manufacturing industries between 1970 and 1979 was very rapid, it can be asc:ibed almost entirely to the increase in inputs -- total factor productivitycontributed less than than 10Z to the change in production. Three reasons have been advanced to explain this phenomenon which differs markedly from total factor productivitytrends in Korea and other East Asian NICs: because Singapore's industry is dominated by foreign firms, little effort has gone into adapting imported technology to the local environment and there has been less room for the learning which is responsible for minor innovations;until recently the emphasis was on labor-intensiveassembly operations and as Singaporewages were fairly stable in the latter half of the seventies, incentives for raising labor productivitywere diluted; and Singapore's financial and commercial expertisedoes not find an echo in the industrial sector. As a result, the entrepreneurialefforts at enhancing productivityhave been weak or nonexistent. Each of these causative factors straddles the Malaysian experience and should be taken note of in the framing of industrial policies.

1.19 Each of these glances into the past is suggestive i;.its own way. All of them reveal an economy that showed great promise in the seventies, weathered the early eighties with far fewer scars than most others and throughout this period, has been near the forefront in its propensity to invest. However, unlike the East Asian NICs who have derived rich export and growth dividends from accumulated capital, Malaysia has attained the status of a middle income country but fallen well short of becoming an industrial nation. It is worth noting why this has transpired,and the reasons for the surprisinglyevanescent nature of the recovery in 1984, as they are the step- ping stones towards an understanding of Malaysia's strategic options.

4/ Y. Tsao, "Growth Without Productivity, Singapore Manufacturing in the 1970s," Journal of Development E:onomics,Vol. 18, 1985, pp. 25-38. - 11 -

Approach to Industrialization

1.20 Lacking natural resources, tbe investment and energies of the East Asian NICs were directed more forcefully and single-mindedlytowards industrial advancement. Malaysia put much money into petroleum, palm oil, rubber, tin, timber and cocoa, which has paid handsomely but detracted from the difficult task of laying a secure industrial foundation. Second, from the very start the public sector has been active in providing infrastructureand services. As it had access to the earnings from primary production channeled through the Government, an increasing amount of investment has found its way into office construction,housing, transport facilities and overhead capital for agriculture. Because the attention of planners and indigenousbusinessmen alike was drawn towards the unfolding opportunitiesin the primary product sector and construction,certain critical aspects of manufacturingdevelop- ment, relating to technology transfer, securing backward and forward linkages, conscious efforts at grooming import substitutingindustries for eventual entry into the export market, were given insufficientattention. Export industries were left largely in foreign hands instead of becoming a preserve of Malaysian entrepreneursand the focal center of the economy. In Korea, Hong Kong, and elsewhere in East Asia, the entry of MNCs was followed, after a spell, by competing local investments and the aggressive expansion of input suppliers. In Malaysia, the foreign owned assembly operations have long been seen as providers of employment, some training and a small suite of linkages.

1.21 The narrow dimensions of industrial development were very evident in 1984, the best year enjoyed by the economy in the eighties, but one from which the economy derived scant long term gains. Manufactured exports, especially textiles and electronics which constitute two thirds of the total, rose by 27% pushing the sector's growth to 11%, more than twice the average for the preceding 3 years. Palm oil production climbed 23X over 1983 and overseas sales of crude and processed palm oil were 50Z higher than the year before. But it was housing, real estate and constructionthat continued to occupy the center of the economic stage. Over 35Z of all bank and finance company credit and 44% of total loans were channeled into these subsectors, a continuation of a trend visible for several years (see Table 1.5). This was significant for a number of reasons. First, the inclinationsof the banking community, lower constructionprices, housing programs and the preoccupation of the NFPEs with suitable office facilities,all continued to draw funds into these activities even thoulh signs of an impending glut are widespread. In Kuala Lumpur 836,000 m of office space lie unused, rents have dropped precipitouslyand worse will follow as 65 buildings under constructionwill add 1.1 million m2 to the rental market by 1987. - 12 -

Table 1.5: MALAYSIA: ALLOCATION OF CREDIT BY SECTOR /a

Share of total credit Share of GDP (Z) (Z) 1975 1980 1983 1984 1975 1980 1984

Agriculture 8.2 8.3 6.8 4.6 27.7 23.8 21.1 Mining and quarrying 1.7 1.1 1.6 1.1 4.6 4.5 5.0 Manufacturing 17.8 19.8 17.8 16.1 16.4 18.6 18.6 Building and construction 7.7 7.1 7.0 7.5 3.8 4.6 5.4 Utilities /b 0.0 1.1 0.2 0.1 2.1 2.3 2.6/c General commerce /d 24.0 19.7 17.3 16.7 12.8 13.5 13.5 Real estate - 5.0 8.8 13.3 15.1 n.a. n.a. n.a. Transport, storage and commuunica- tions 1.8 2.5 2.5 2.3 6.2 6.9 7.9 Finance, insurance and business services 5.9 5.7 9.9 10.8 8.5 7.8 8.0/e Housing 8.7 11.6 12.4 12.7 n.a. n.a. n.a. Miscellaneous /f 19.2 14.2 11.2 13." 18.1 18.1 17.9/& Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Memo: 1. Total housing, real estate and construction sectors 21.4 27.5 32.7 35.3 n.a. n.a. n.a. 2. Finance, insurance, business services, real estate housing 19.6 26.1 35.6 38.6 8.5 7.8 8.0 3. (1) and (2) plus Construction 27.3 33.2 42.6 46.1 12.3 12.4 13.4

/a Includes only credit from commercial banks and finance companies. 71 Electricity. 7E Electricityand water. 7T Data up to December 1979 include bills discounted or purchased and bills receivable for foreign trade. Since December 1980 such bills have been classified according to borrowers and included in the data for the appropriate group. /e Includes real estate and ownership of dwellings as well as finance, insurance and business services. /f Includes restaurants,hotels and boarding houses, purchase of stocks and shares, consumption credit, and other unidentified credit. Data in this group up to December 1979 includes loans to the Federal and State Governments. Since December 1980, such loans have been classified according to borrowers. /g Government and other services. 7h Wholesale and retail trade. Source: Statistical Appendix Tables 2.2 and 5.2. - 13 -

1.22 Construction has three negative strikes against it. It has further swollen the country's large investment budget at a time when adjustment motivated austerities are desirable. It has tightened the financial market for industrial entrepreneurs,with some deterrent effects on investment in primary and secondary sectors. But most importantly from the perspective of mediumterm investment, the support volunteered by the banks for real estate development has saddled financial institutionswith a large portfolio of doubtful asbets, some of which are currently nonperforming and many others threatened by the after-effectsof a continuing slump in the market. Such a portfolio will eat into bank profits, will sharpen their aversion to risks and will weaken their willingness to support an investment drive by the productive sectors.

1.23 Two other developmentswith a bearing on industrializationmust also be considered. One is the persistent unresponsivenessof the stock market both to the strong economic performance of 1984 and the financial inducements provided by the Government in the first half of 1985, which included the opening of credit lines for banks lending to investors, lengthening scrip delivery times, a halt on new listings and the proposal to establish a M$1 billion fund for industrial entrepreneurs. The state of the stock market places another hurdle in the way of businesses seeking equity financing, but beyond that, it also points towards an undertow of doubt regarding Malaysia's economic future that is seemingly impervious to the good economic tidings of 1984 and the Government'sattempts at sweetening industrial incentives in 1985.

1.24 The foreign share in export industries and equity holdings in the plantation sector offers another clue to the absence of momentum trom the business upswing in 1983/84. The exporting subsectors are among the most profitable in the economy but their investment policies are hitched to the global concerns of the parent companies and bear little relation to their annual earnings. Hence, instead of nourishing Malaysian industry and serving as a springboardfor an expansion of local manufacturing capacity, these funds flow out of the country in the form of repatriated dividends and profits.

1.25 These are a few of the recent economic events that will have a bearing on development in the coming years but, overlying these, will be the Government'sfiscal, sectoral, and exchange rate policies together with trends in domestic labor markets and in export demand. In order to apprehend the macroeconomicconstraints and scope for economic maneuver in the spheres of adjustment and growth, the following chapters will explicate the situation as regards resource balances in public and private sectors; the implicationsof recent trends in the supply and cost of labor for future industrializationand exchange rate policies; growth in the OECD countries and its likely effects on capital flow as well as the volume and pattern of exports from East Asian countries. The report will then review industrial and agricultural strategies calculated to advance Malaysia's development goals. In the closing chapter a number of scenarios depict the macroeconomic consequencesof an interplay between policy actions and internationaleconomic conditions. - 14 -

Chapter II: RESOURCE BALANCES AND THE PUBLIC SECTOR

2.01 Malaysia's current account deficit rose from 1.2X of GNP in 1980 to a peak of 14.4% in 1982 before dropping to 3.1X in 1985 (see Table 1.1). Over these years Malaysia added US$13 billion to the external debt carried over from the previous decade, and the debt service ratio (DSR) went from 4.3 in 1980 to 15.3 in a matter of 5 years. Although the current account narrowed in 1985 because of falling imports, the adjustment problem bedeviling the country is far from being resolved. Exports earnings are projected to decline in 1986 and this will push the DSR higher. The servicing of debt will become easier as the decade progresses, in part because the government took advantage of lower interest rates in 1985 to retire expensive debt acquired in the early eighties and replace it with floating rate notes of 20-30 year maturity. Of equal importance, however, will be measures that serve to restore foreign exchange earnings and minimize the demand for additional borrowing.

2.02 The arithmetic underlying the adjustment difficulties is very plain. Investment climbed very steeply during the Fourth Plan while gross domestic (and national) savings have, on average, been at lower levels than the ones attained over the Third Plan. Domestic savings dropped from about 34% of GNP in 1980 to 30% in 1982, national savings from 31% of GNP to 25.0% (see Table 2.1). A stronger economic performance,an increase in petroleum production and favorable terms of trade helped nudge the savings rates upwards in 1983 and 1984. But national savings receded once again in 1935 and given the commodity prices and growth rates being projected for 1986/87, a further decline can be expected, led by public savings. The Government's response to the balance of payments disequilibriumhas been to try and curtail public investment and the completion of several major infrastructureand manufacturing projects has abetted adjustment policies but the balancing of domestic resource availabilityagainst needs faces three problems. First, discretion- ary private savings have been shrinking and fiscal as well as monetary initiatives by the authorities to strengthen savings propensities have had limited effect: so long as the economy continues to be battered by recessionary pressures, a revival of private savings performance is unlikely. Second, while private investment and consumption remain weak the Go:ernment is almost compelled to move into the breach partially to salvage its growth objectives and the size of the public sector sharpens the temptation to act while bol- stering the effectivenessof such actions. In spite of the stringent measures in effect to check capital spending, public investment increased by 8% in 1985. Third, the Federal Government has chipped away at its development and operating expendituresfor the past three years, substantially reducing the public sector's resource imbalance, but in the future, public deficits could be far more recalcitrantbecause of emerging trends in revenues and expenditures. As this is an issue of major importance,a closer analysis is required.

Deficits and Their Financing

2.03 The dimension of the public sector can be readily adduced from Table 2.2. A picture of resource balances and an idea of the suddenness with which the budgetary crisis evolved can also be obtained (Tables 2.1 and 2.2). - 15 -

From an overall deficit of nearly 12% of GNP in 1980 the public sector moved, under the weight of extraordinary investment expenditures, to an overall deficit of 18Z of GNP by 1982 with public capital spending running ahead of savings by almost 10% of GNP. During 1983-85, the trajectory has been downward, because the federal government has pared its expenses, which has served to bring government development outlays to 11% of GNP (from 20%) and the developmentexpendit-ares of public enterprises to under 10Z of GNP.

Table 2.1: THE EVOLUTION OF RESOURCE BALANCES IN THE ECONOMY (Z of GNP)

1980 1981 1982 1983 1984 1985

Gross domestic investment 31.9 36.5 39.2 38.7 35.9 32.0 Foreign savings /a 1.2 10.1 14.1 12.3 5.0 3.1 Gross national savings 30.7 26.4 25.2 26.5 30.8 28.9 Public 10.1 10.5 9.7 12.3 12.7 14.0 Private /b 20.5 15.9 15.5 14.2 18.1 15.0 Total savings 31.9 36.5 39.3 38.8 35.8 32.0

Memo: Gross domestic savings 34.3 29.8 29.8 32.9 38.0 36.9 Net factor income -3.5 -3.3 -4.5 -6.4 -7.0 -7.8 Net current transfers -0.1 -0.1 -0.1 0.0 -0.1 -0.2

/a Equivalent to the current account balance. Tb Estimated as residual. Tc Gross domestic savings = Gross national savings - Net current transfers - Net factor incomes.

Source: StatisticalAnnex, Tables 2.1, 3.1 and 4.1. - 16 -

Table 2.2: PUBLIC SECTOR RESOURCEBALANCE (Z of GNP)

Average annual nominal growth rate, 1980 1981 1982 1983 1984 1985 1980-85

General government Revenue and grants 32.0 32.8 32.8 33.1 32.4 34.1 8.5 Operating expenditures 22.9 27.4 28.9 27.5 26.4 28.4 11.8 Savings 9.2 5.4 4.0 5.7 6.0 5.8 -2.3

Public enterprise savings 1.0 5.1 5.7 6.6 6.7 8.2 20.5 Ia

Public savings 10.1 10.5 9.7 12.3 12.7 14.0 14.2

Development expenditure and net lending 22.0 27.4 27.6 25.2 22.8 20.8 5.8 General government 15.5 22.7 20.9 15.9 12.4 10.8 -0.3 Public enterprises 6.5 4.7 6.7 9.4 10.4 9.9 16.5

Public sector deficit -11.9 -17.0 -17.9 -13.0 -10.1 -6.8 General government -6.4 -17.3 -16.9 -10.2 -6.4 -5.0 Public enterprises -5.5 -0.3 -1.0 -2.8 -3.7 -1.7

/a 1981-85.

Source: Statistical Annex, Tables 2.1 and 3.1.

2.04 At first the financing of the deficit presented few problems and perhaps that is one of the reasons why an earlier and more drastic solution was not sought. Assets could be liquidated, there were ample domestic resources and Malaysia's excellent credit standing made it easy to raise funds on the international market, recently replenished by OPEC revenues derived from the second round of oil price changes. Only 281 of the deficit was funded externally in 1981 because Malaysia's cash-rich Employee and Teachers Savings Funds were statutorily required to absorb a substantial volume of government bonds and PETRONAS was called upon to purchase M$1.8 billion worth of securities. The balance was raised through the banking system. In absolute terms, there was a further increase in the borrowings from these sources in'1982, i.e., the banks, the Employee Provident Fund (EPF) and PETRONAS, but the vast expansion of the deficit made a greater recourse to the foreign market inevitable. This trend became more noticeable in 1983/1984 as financing from the EPF stabilized, since its rates and coverage could not be readily increased, and PETRONAS ceased to be a pillar of budgetary support (see Table 2.3). It is becoming obvious that the capacity to service public debt - 17 -

domesticallyis under much strain and further encroachmentby the public sector would worsen the apparent crowding out of the smaller private borrowers at a time when the government is anxious to see more by way of private business activity. External financing during 1985 was lower than in the previous three years and for the time being, foreign buyers are willing to lend to Malaysia at low margins, but Malaysia cannot ignore the ris- in its indebtedness.

Table 2.3: MALAYSIA: NONBANK SOURCES OF BUDGET FINANCE (M$ bln)

SMP THP 1971-75 1976-80 1981 1982 1983 1984 1985 /a

Employees Provi- dent Fund 1.9 4.6 1.7 2.2 1.9 2.3 2.5

PETRONAS /b - - 1.8 1.9 -0.2 -1.7 n.a.

National Savings Bank 0.3 0.3 -0.1 - -0.1 - -

Teacher's Provident Fund & Social Security Organization 0.1 0.3 0.1 0.1 0.1 0.1 0.2

Insurance companies 0.2 0.3 0.1 0.1 - - -

Other /c 0.4 1.1 -0.1 -0.3 -0.4 1.1 -0.1

Total 2.8 6.6 3.5 4.0 2.3 1.8 2.8

/a Projected. 7i Reflects PETRONAS purchase of government securities; excludes payment of dividends/royaltieswhich are included in nontax revenue receipts of Government. /c Includes finance companies, discount houses and cooperative societies.

Source: Ministry of Finance

2.05 An adjustment problem is the worrisome tip of a complex situation arising from the interplay between macroeconomic policies, development spending and behavioral responses of the private sector to the prevailing environment. As such, it cannot be resolved overnight, nor is it desirable for the Government to rush the fences, as any sudden cessation of spending could be highly destabilizing. Nevertheless, the problem cannot be allowed to fester and the appropriate course is for the Government to reduce the overall resource imbalance by trimming the public deficit further over the medium run. - 18 -

Raising tax revenues could help the cause of public saving and augment the volume of internal financing available to the Government, but the ripples spreading from tax escalation are deflationaryand can blunt business incentives. Cuts in operating expenditures,the favorite target of frugal-minded policymakers,also generate reverse multiplier effects and depress the quality and volume of public services. A reduction in development outlays, aside from its immediate consequences for aggregate demand, also compromisesthe aims of development. In short, the medicine cannot be made painless, but its palata- bility can be manipulated by suitably mixing the ingredients.

2.06 All the macroeconomic omens (see Chapters 1 and 4) warn of a weakening economy, which argues for a certain judiciousness in pruning public expenditures in the short term, although, once the private sector has found its stride, it would be well to move towards a less extensive public presence in the economy as is the Government's intention. Over the next five years, the concerns of adjustment might be more nearly squared with the objectives of growth and modernization if steps are taken to increase revenues and in conjunction, the government controls operating expenses and avoids being drawn into major new capital projects involving large commitments over an extended time scale.

2.07 Such a three-pronged approach would compress the public deficit and have a positive influence on savings. The latter calls for closer government attention as the savings performance of the Federal Government and the public enterprises has deteriorated significantlyover the recent past. Government savings as a percentage of CNP slumped from 9.2Z in 1980 to 5.8% in 1985 (see Table 2.2) and may be headed down, caught between the blades of rising salaries for public emp'loyeesapproved in 1985, following a five year interval in which no structural changes were made, and revenue forecasts clouded by the lower anticipated returns from commodity and income taxes. The resource balances of public enterprises add to the gloom. Surpluses on current balances have risen in absolute terms from M$2.2 in 1981 to M$7.2 billion in 1984, but almost the entire saving from this source (84%) is attributable to PETRONAS (see Table 2.5). Operating losses are forecast for 15 of 36 enterprises in 1985 (an increase from 9 in 1981) and with three fourths reporting overall deficits equal to 11.5% of GNP, funds for capital spending must be supplied by the Federal Government, borrowed overseas or drawn from the commercial banks. As the outlook for petroleum prices is scarcely encouraging and demand liable to remain soft, PETRONAS may not be able to offset the financial erosion so apparent in the accounts of public enterprises. - 19 -

Table 2.4: SAVINCS PERFORMANCE OF THE FEDERAL GOVERNMENT (M$ bln)

1981 1982 1983 1984 1985

Revenue 15.8 16.7 18.6 20.8 21.9 Operating expenditure /a 13.7 15.9 16.1 17.5 18.4 Savings 2.1 0.8 2.5 3.3 3.5

Memo: Transfer to Development Fund 2.0 0.8 2.3 2.3 3.0 Savings as Z of GNP 3.8 1.3 3.8 4.4 4.8

/a Excludes transfer to Development Fund.

Source: Ministry of Finance

Table 2.5: PUBLIC ENTERPRISE STATISTICS /a

Current Number with Development balance -s operating expenditure as Z of total losses X of total /b 1981 1985 1981 1985 1981 1985

Ports 4.1 -0.8 1 2 3.5 2.4 Energy & utilities 84.8 92.8 1 2 23.8 25.5 of which: PETRONAS 82.6 83.8 2.5 6.7 Transport & communications 12.6 7.0 2 3 38.4 30.3 Cememt 0.1 0.4 1 4 0.3 5.2 Other -1.6 0.6 4 4 34.0 36.6 of which: HICOM 0.1 -0.2 0.9 4.2

Total 100.0 100.0 9 15 100.0 100.0

Memo: (?!$bln) 2.2 7.2 4.1 10.1

/a Figures for 1985 are projected; figures refer to 36 nonfinancial public enterpises and off-budget agencies. /b Includes off-budget expenditures.

Source: Ministry of Finance. - 20 -

Revenue Generation through the Tax System

2.08 Increasing revenue mobilization through the tax system to enhance the savings of the Federal Government is one of the few alternatives that is available, but the climate of opinion in business circles as well as in the government will have to change before it can be exploited. Kalaysia's tax effort ratio - 33Z of GNP in 1983 - puts most other developing countries to shame and handily exceeds the level of other East Asian countries such as Korea (23%), Thailand (18Z) and Indonesia (24Z). Tax collections,in relation to potential taxable capacity, are also high, with Malaysia comfortably ensconced in the uppermost decile of LDCs sampled. Two features of the system explain much of its efficiency at mobilizing resources. First, revenue growth has been aided by the 40% share (1984) of relatively buoyant direct taxes in total Federal collections (see Table 2.6). A second feature is the scale of tax returns from petroleum production and export. Corporate taxes paid by oil producers rose to 4.6Z of the GN? in 1985. In other words, more than a fifth of the federal tax collections a:e drawn from one sector of the economy and throughout the eighties have provided a dependable base to the tax edifice.

Table 2.6: STRUCTURE OF PUBLIC SECTOR REVENUES (Z of GNP)

1971 1980 1985

Direct taxes 5.7 11.0 13.4 Income taxes 5.5 10.2 12.4 Individuals 1.4 1.9 2.5 Companies 4.1 4.9 5.3 Petroleum - 3.4 4.6 Other 0.2 0.2 0.3 Petroleum royalties - 0.7 0.8 Taxes on goods and services 3.9 4.0 4.7 Taxes on international trade 6.5 9.0 6.7 Export duties 1.9 5.0 2.4 Petroleum - 1.3 2.1 Import duties and surtax 4.6 4.0 4.2 Other tax revenue 0.3 0.8 0.9 Nontax revenue 2.7 2.2 3.9 Petroleumdividends - - 1.3

Total Federal Government revenue 19.1 27.0 30.0 State government revenue 4.2 4.9 4.1 NFPE revenue /a 4.5 10.8 34.1

/a Includes 10 nonfinancial public enterprises in 1971 and 40 in 1980 and 1985.

Source: Ministry of Finance - 21 -

2.09 But even as revenue requirementsbecome more urgent and the rising share of interest payments in total budgetary expenses strengthens the case for husbanding tax buoyancies, the system will be appreciably less prolific in the future. Lower oil prices and the tax concessions extended to foreign oil companies so as to maintain competitivenesswith terms offered elsewhere, all presage a reduction in revenues, from this source. Income from direct taxes is likely to suffer because of certain other developments. Pressure to lower income and corporate taxes has been around for some time, but the persistent weakness of the private sector in recent years and the revival of faith in the power of fiscal stimuli for business initiative, has prompted the government to be more liberal with exemptions and deductions that lower the effective corporate tax rate and, in 1984, to reduce income taxes especially in the higher income brackets. As can be seen from Table 2.7, the buoyancy of individual income taxes has fallen to the level of the 1960s and that of levies on petroleum companies has been halved.

Table 2.7: TAX REVENUE BUOYANCIES, 1960-85 /a

1960-71 /b 1971-78 1978-85

Total Tax Revenues 1.29 1.15 1.30 Direct Taxes Income tax 1.39 1.54 1.76 - Corporate 1.43 1.10 1.43 - Individual 1.30 1.55 1.23 - Petroleumcompanies - 6.16 2.99 Indirect Taxes 1.14 0.88 Sales tax 1.30 1.65 Excise taxes 0.12-1.52 0.86 0.60 Road tax 0.54 '.92 Export Duties - Wrt. CDP 1.91 0.24 - Wrt. merchandise exports - 1.51 0.21

Import Duties - Wrt. GDP 0.38-0.88 0.77 0.83 - Wrt. merchandise imports 0.66 0.82 c.78

/a Estimated as log x = a + b log y, where x = tax revenue variable y = GDP

/b The estimates for income tax elasticitiesare taken from Nurun N. Choudhry, IMF Staff Papers, vol. 22, July 1975, pp. 494-509; the other estimates, with respect to national income rather than GDP, are taken from Sheetal K. Chand, IMF, DM/75/24 (unpublished),pp. 10-11, and Ministry of Finance. - 22 -

2.10 For a period, the state can finance some of its expenditures through the issue of debt instruments,but ultimately it is through tax revenues that the government must settle its bills and finance the growth in spending. Beyond that, ground will continue to be lost in the area of public savings unless the tax buoyancy is restored and revenues inciaased. If it is assumed that the buoyancy of petroleum revenues will be reduced by a third over the next five years, the buoyancy of the remaining levies must increase very substantially.

2.11 Although the dynamics of growth and industrializationwould argue for direct tax incentives and there is much political demand for this in Malaysia, the case, even at this stage needs a careful review. The evidence is scarcely unequivocal. Germany and Japan, both of which imposed very high effective tax rates on capital, have managed high rates of investment and growth. The UK, where capital taxes are low by the standards of industrial nations, has done poorly on both counts. Research on the US is equally suggestive; investment apparently does respond to tax incentives in the medium term, but because savings seem unaffected b reductions in direct taxes, no longer run gains are likely to be realized.>/ Casual empiricism fails to uncover a direct link between private investmentbehavior and effective rates of corporate tax action in Malaysia or even in neighboring Indonesia. Tax holidays, which have a tendency to stretch, contain hidden costs, and in fact, ingenious transfer pricing by foreign owned companies can result in negative tax obligations.

2.12 If the decision were taken to restore the buoyancy of the tax system and compensate for the fall in petroleum revenues, there are two kinds of options. Currently, income taxes are levied on just 10% of wage ea-ners and both individuals as well as corporations can exploit numerous loopholes to reduce their tax obligations. A wider coverage, fewer exemptions and improved record-keepingthrough an accelerated expansion of computer facilities would be one way of enlarging revenues from direct taxes without detracting from private capital spending. A second option, frequently discussed but yet to be implemented, is the broadening of the indirect tax base and steepening of rates. One round of sales tax changes was introduced in 1982/83 when rates were increased to an average of 10% from 52 in 1980/81. Selective e.sciseson motor vehicles, alcohol and tobacco were also raised. But to bring about a significant upward shift of the indirect tax schedule would require displacing the sales tax currently levied at the manufacturing stage with a broader expenditure-typetax which covered all but the essential items of consumption with rates on luxury items being substantiallyhigher than those on other products to combat regressivity. As inflationarypressures from other sources are likely to be minimal for the coming two to three years, introducing the. tax during this period would defuse one of the criticisms directed at indirect taxes with an extensive coverage and high rates. Other East Asian countries, e.g., Korea (in 1977) and Indonesia (in April 1985), have moved in this direction, which allows for partially substitutingdirect with broad-based ilidirect

5/ A. Ando, M. E. Blume and Irwin Friend, The Structure and Reform of the US Tax System, MIT Press, 1985, pp. 67-71. - 23 -

taxes. A tax system restructured along these lines may lend valuable support to the Government'sefforts in two other areas. The redistributionof income, one of the NEP's principal goals, would need to rely less on employment and equity restructuringpolicies, both of which dilute incentivesbehind productive investment. And by enlargini.the fiscal base, the government would have greater flexibility in using EPF funds to encourage private industry.

Spending Cuts

2.13 The tide may have run too far for revenue augmenting measures to be acceptable in the near future. Balancing of resources can then be achieved only by economizingon operating expenditures,which would enhance public savings, and slimming development budgets of government agencies and NFPEs so as to draw investment spending closer to domestic resource supplies. This exercise, which can be bureaucraticallyand politically arduous under the best of circumstances,is also rendered more treacherous by the possible repercus- sions which cuts in public sector spending may have on private decisions in a becalmed economy. In effect, the policymakersmust apply the scalpel with great care, trimming the lumpy capital intensive projects whose returns lie distant in time, without detracting from the task of providing suitable leading sectors and sufficient infrastructureto maintain economic dynamism. The government's intention to concentrate the bulk of its investible funds during the latter part of the eighties on projects carried over from the Fourth Plan years that justify completion deserves strong endorsement. It is the most efficient course to follow from the standpoint of both resource use and adjustment. - 24 -

Table 2.8: EC0I0NIC CLASSIFICATIONOF FD ERALOPERATINC EXPEnDITURES tS of total)

Average growth rate/a 1979 1980 1981 1982 1983 1984 1985 1979-84

Expenditureon Goods & Services 54.2 56.5 58.1 53.4 53.9 54.4 58.8 8.7 Wages and salaries 45.8 42.0 40.8 38.3 40.1 39.8 41.7 7.7 Other purchases of goods and services 8.4 14.5 17.3 15.1 13.8 14.6 17.1 11.9

InterestPayments 15.9 15.1 15.0 17.1 21.4 24.4 28.5 20.7

Subsidiesand Transfers 29.9 28.4 26.9 29.5 24.7 21.2 12.7 4.4 Transfersto other levels of government 2.1 3.5 3.0 3.5 2.9 3.3 3.0 20.0 Pensions 4.2 5.2 4.2 3.6 3.9 3.9 4.4 8.2 Other transfers /b 23.6 19.7 19.7 22.4 17.9 14.0 5.3 1.3

Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Memo: Federal Expenditures(X*illiLon) /c 7,890 10.217 13.686 15,921 16,124 17,506 18,353 10.7

/a Real growth rate estimated by using CPI as deflator. 7i Includescontributions to statutoryfunds and internationalorganizations, and petroleum (abolishedin 1984), paddy price and other subsidiesin operatingbudget. /c Excludestransfer to developmentfund.

Source: Ministryof Finance

2.14 Operatingexpenditures pose even greater problems. There is, to start with, the incompressiblenature of administrativecosts, debt servicing and certain welfare benefits. Defense is virtuallyuntouchable and many subsidies ringed around by powerful vested interests. Table 2.9 describes the compositionof federal current expenditures. Salaries,interest paymentsand pensions,which are the relativelynoncompressioLe items, constituted68Z of the total operating expenses in 1984 as against the 62Z in the previous five. This decline in flexibilityis the result of a dramatic increasein interest payments. A number of the NFPEs in the manufacturingsector are incurring substantiallosses and ecoomiescould be achievedhere. Savings are also possible in purchases of goods and servicesand transfers,with the latter presentinga softer target. For that very reason several of the more visible offenderssuch as the diesel subsidyhave been removed (see Table 2.9). The large subsidiesfor paddy are headed down as productionshrinks following the abandonmentof strict self-sufficiencytargets. Some large items, such as the one for agriculturalinputs, remain, but subsidieshad been reduced to 1Z of Table 2.9: FEDERAL SUBSIDY EXPENDITURES/a (M$ millions)

TMP 1976-80 1979 1980 1981 1982 1983 1984 1985

Operating Budget 1,027.8 165.9 713.9 944.4 981.0 1,360.3 437.7 289.6 Petroleum products 783.3 CPU2 575.5 721,3 750.0 1,090 9 172.0 9. Textbooks 120,3 36.7 14.2 22.4 30.0 34.4 26.8 41.5 National Electricity Board 13.6 - 13.6 19.5 21.0 52,6 60.2 68.9 Paddy price support 110.6 - 110,6 181.2 186.0 182.4 178.7 170.0

DevelopmentBudget 595.2 132.3 258.2 262.1 306.8 313.2 295.9 147.1 Rubber replanting 215.9 48.4 87.9 54.7 100,.9 95.3 74.9 33.6 Pineapple replanting 10.9 1.8 2,2 2.0 2.9 4.3 2.2 3.7 Agriculture/fisheries financial assistance 52,6 14.4 21.6 22.1 15.9 31.1 36.7 - Vegetable price support - - - - - 20,0 6.4 - Agriculturalinputs 126.7 26.8 99.9 118.2 97.0 90.0 75.8 74.8 1 Farm mechanization 15.2 5.3 3.6 4.9 27.2 20.0 16.0 - Coconut replanting 32.2 7.1 9.3 9.7 10.9 13.0 13.6 13.5 Crop diversification 71.6 18.4 17,9 13.7 15.6 17.0 0.8 - Animal husbandry 5.4 1.7 1.6 15.7 17.5 9.8 11.8 13.1 Other 64.7 8.4 14.2 21.1 18.9 12.7 57.7 -

Total /b 1,623.0 292.2 972.1 1,364.0 1,293.8 1,673.5 733.6 436.7

As X of GNP 0.9 0.7 1.9 2.5 2.2 2.6 1.0 0.6

/a Refers to identifiablesubsidy schemes; excludes a number of other schemes which appear in the development budget but are difficult to disaggregate. /b Excludes interest rate subsidies to state and local governments,public and quasi public entities and cooperatives.

Source: Ministry of Finance. - 26 -

GNP by 1984 from 2.6Z a year earlier and the activity of economizing may be moving very close to the bone though possibilitiesfor additional savings may not be entirely exhausted. Table 2.10 reveals the distribution of development spending but a further careful review of major items of expenditure is needed to advance specific suggestions on how economies might be achieved.

2.15 Three issues emerge from this brief review of resource balances and the public budget, which bear upon adjustment and growth. First, the downward slide in the savings of the Federal Government and public enterprises makes it necessary to sacrifice growth for the sake of BOP equilibrium. Second, a solution to the public deficit and the growing cost of debt servicing must be sought through a combination of revenue-raisingand expenditure-reducingmea- sures. Unless the tax buoyancy rate is restored, the budgetary situation will continue weakening and without tax reforms, government revenues will become even more dependent on a diminished flow of taxes and dividends from t'Leoil sector. Third, given the size of the annual investment budget and operating expenses, there is bound to be some further room for economizing should the need arise, but whether this option is exercised will have to be guided by macroeconomicexigencies, particularlymovements in private consumption and investment. - 27 -

Table 2.10: FEDERALGOVERNMENT DEVELOPMENT EXPENDITURES BY SECTOR/a (Z)

2MP 3MP 4MP (1981-85) 5MP original Actual Actual Original Estimated allocation (1971-75) (1976-80) allocation actual (1986-90)

Economic 66.9 64.0 57.9 60.5 76.1 Agriculture,rural & municipal development 24.2 22.1 21.3 16.3 17.1 .Commerce& industry 19.3 15.3 13.8 13.6 14.1 Transport 16.6 13.4 10.5 15.1 15.6 Communications 2.4 5.4 3.9 5.2 14.1 Energy & utilities 3.9 7.5 8.3 9.9 14.3 Feasibility studies /b 0.5 0.3 0.1 0.4 0.7 Social 17.5 17.1 16.3 21.5 13.1 Education r; Health & population 2.5 1.5 1.5 1.6 0.1 Information & broadcating 1.2 0.3 0.4 0.2 0.1 Housing & sewerage 2.4 6.4 4.2 8.7 2.9 Culture, welfare and community development 0.9 1.3 2.0 0.6 1.0 Purchase of land 1.1 0.3 0.6 0.2 - Security 13.8 16.7 23.9 16.9 6.8 Administration 2.0 2.2 2.0 1.8 4.0 Total /a 100.0 100.0 100.0 100.0 100.0 M$ millions 7,415 21,202 39,330 46,320 69,000

/a Columns may not sum due to rounding. /b Includes resea.ch and development. Source: Fourth Malaysia Plan, (1981), and Mid-Term Review of the Fourth Malaysia Plan, (1983), Fifth Malaysia Plan, 1986 and Ministry of Finance. - 28 -

CHAPTER III: THE ROLE OF LABOR AND EXCHANGE RATES IN EXPORT-ORIENTEDDEVELOPMENT

Labor Markets in East Asia

3.01 East Asian NICs have added new legends to the record of economic development by following the route of high capital accumulationand managing to avoid the shoals of debt crises through unrelenting pressure on domestic savings rates. But in examining the experience of Japan, Korea and the rest, economists are having to recognize the pivotal role played by labor markets and how they have been instrumentalin enabling these countries to outdistance their competitors. In drawing lessons from the past experience of the NICs in Latin America and East Asia, the course taken by wages and labor supplies, the flexibilitywith which labor was deployed and trained, require the attention that has long been obligatory for capital and technology. Poorly endowed with natural resources, the East Asian NICs depended on an elastic supply of 'Labor to fuel their drive to modernity and developed institutionswhich seem marvel- ously attuned to the exacting needs of an export-oriented,manufacturing system. Having passed one threshold of industrializationand moving to a future with high-technologyproducts, they are again looking to the newly acquired technical and scientific skills to complement their -apital resources in devising products that will preserve their trading edge. By the same token, many Latin American countries appear to be losing the race, in spite of initial resource advantages, partly because of rigidities introduced by labor market institutionsthat have contributed to inflationarypressures and a slow growth in productivity.

3.02 As the dependence on primary products has lessened,Malaysia is also confronted with the necessity of exploiting its labor force more fully, equip- ing workers with the skills that will go towards building industrial strength and creating market institutionswhich will guarantee stability, together with allocative flexibility. A number of concerns can be isolated. For the purposes of growth, what matters is the supply of labor, the spread of industrial skills, trends in wages and productivityand the size of local markets. But the rate of economic expansion will also have a decisive bearing on concerns regarding employment.

Population and Industrial Progress

3.03 Since the problem of market size is linked to labor supply but also more generally to macroeconomic issues, it can serve as a point of departure. Malaysia has a population of 15.6 million, growing in recent years at 2.4Z p.a. In terms of market size and rate of increase it compares favorably with the East Asian NICs, except Korea. But just as these economies have found that domestic sales are inadequate to support rapid growth based on manufacturing plants of efficient size and have turned overseas in quest of buyers, Malaysia is also forced to adopt an export-orientedstance. What this means is that Malaysian firms must progress very quickly along their learning curves and attain a degree of competitivenessthat will permit them to draw benefits from the internationaleconomy. The risks are high, for not only must companies incur the cost of building facilities of sufficient scale but - 2!r- have to take the plunge knowing that a sheltered domestic market can only absorb a part of their output. Other NICs have found an answer to the problem by exploring pathways to greater efficiency in factor markets, production and marketing, because the alternative of increasingthe domestic market through faster population growth, poses numerous difficulties.

3.04 Research has shown that gains from scale economies,made pgmsible by a larger population are certainly possible though they may be small.- What cannot be sidesteppedare the costs associatedwith a faster growing population. Costs related to a higher dependency ratio that can reduce household savings even as they enlarge the society's carrying costs in the form of education and health expenditures. Further, if per capita incomes are to be prevented from declining, which would defeat the entire purpose of raising the population size, additional saving is necessary on the part of current earners to provide enough capital to productivelyemploy new workers joining the labor force. The expense of raising more children and the savings effort would be an immediate drag on the economy. Any conjectural gains from larger market size would lie a generation into the future. Domestic markets might be smaller than industrialistswould desire but labor supply, which over the next five years will be growing at 3.1Z p.a., is unlikely to constrain growth of industry.

Sectoral Labor Supplies

3.05 In certain respects, Malaysia's labor market is unique and its special characteristics,if assiduously managed, could remain an important positive factor in the country's development. Historical, racial and political forces have seeded the labor market with "noncompetinggroups" occupying different sectoral niches. For instance, workers of Tamil extraction, the majority over the age of 45, are heavily represented in rubber production and they, together with smaller number of Malay and Chinese laborers in similar age brackets, comprise a relatively immobile group assuring the continuance and competitivenessof the rubber industry over the next decade. But this reprieve might only take rubber production to the end of this century as few members of the younger generation are disposed to work in rubber plantations and smallholdings. In fact, a substantialexodus of people from the agricultural sector is in progress, the rate of migration having risen from 96 per 1,000 in 1970 to 143 per 1,000 ten years later. According to the last census, internal migrants nearly doubled from 1 million to 1.9 million between 1970 and 1980. Migrants were preponderantlymale though the margin has been shrinking. Most are drawn from the 15-35 year age bracket and their educa- tional attainmentsare generally above the average for the rural populace. A high percentage are single. Women also come from younger age groups but are close to the rural average in terms of schooling. In the early seventies, single female migrants were a small minority and Malay women rarely migrated independentlyof their families. With changing mores and the growing accept- ability of dormitory living and urban factory work, single Malay women are now as predisposed to seek jobs in the cities as females from other racial groups.

6/ C. McNicoll, "Consequencesof Rapid Population Growth: Ar Overview," World Bank Staff Working Paper No. 691, 1984, pp. 36-37. - 30 -

3.06 For the agriculturalsector, the cityward movement of workers spells the beginning of a major change. Rubber tapping, a skilled occupation that has resisted effective mechanization is under the severest longer term threat because rubber's lower profitabilitymakes it difficult to offer younger workers pecuniary inducementsthat might persuade them to stay. Yet the peculiar age and skilL composi.ion of the labor force staves off any sudden drop in the supply of tappers. Other agriculturalactivities are feeling the pinch as well. Oil palm harvesters come from the most migracion prone age brackets and theirs is an unusually demanding occupation. Rising wages can slow but never arrest a secular decline in labor supply, which has begun to interfere with the harvesting of the existing palm acreage. Progress has been made at mechanizing the cutting of fruit and its transport but the effort of able-bodied men cannot yet be substantiallyreduced. Rice growing, the principal occupation of some 150,000 subsistence farmers is being affected by the pull of cities as is apparent from land abandonmentand declining production. The future of the rice economy is also colored by low absolute returns from small farms which the generous subsidies for grain and fertilizers cannot reverse. Hence those who cannot grow enough rice to earn a decent return are turning to off-farm occupations for supplementalincome or emigrating in search of urban jobs. Rice self-sufficiencyhad fallen to 70Z in 1984 from 90% in the early seventies and the trend foreshadowsat best stagnation or, more probably, a gradual decline.

Wages

3.07 The agriculture sector's loss is to the advantage of secondary and tertiary activities. For the next five years and perhaps well into the nineties the industry and services sectors will benefit from an elastic labor supply; the combined result of intersectoralmigration, rising participation rates of women in the 30-50 year age bracket and the natural increase of the urban population. This will be one factor dampening wage pressures, but for some time, labor costs will also be influenced by other market characteristics that over a ten year period have averted a drift towards a wage-price spiral. Table 3.1 shows the course taken by wages during 1977-83. Growth was moderate in the seventies, accelerated in the early eighties but the tendency for wages to increase appears to be subsiding in 1983/84. What is striking is the great variability in wage movements across subsectors and also the presence of wage asymmetries between different categories of workers. The remunerationof clerical and lower grade office employees rose much more quickly in 1980-82 and unskilled employees in certain branches of industry such as textiles and electronics gained. When we consider sectoral changes in productivitymea- sured by the increase in value-added per unit of labor (see Table 3.2) growth for the whole economy averaged 4.2% p.a. between 1975-84 with considerable variation among sectoral rates; manufacturinggrew at 12.5% p.a., while construction, government services, and finance and commerce grew only about 2% p.a. In some cases, productivityappears to have risen more slowly in the eighties than in the earlier period with agriculture,a few service subsectors and transport being the activitiesaffected, but manufacturing,construction and government services did appreciably better. Over the entire stretch, real wages seem to have grown only slightly in excess of productivity,but in recent years, particularly 1980-83, manufacturingwages were increasing far more than value-added while agriculturalearnings remained more or less in - 31 - Table 3.1: MALAYSIA: REAL AVERAGEMONTHLY EARNINGS IN THE MANUFACTURING SECTOR /a

Growth rates (x) 1977 1980 1983 1977-80 1980-83

Lare Rce Mills Istrial efficiency engineer n.-. n.a. U.S. n.a. n.a. Skilled /b 281 255 287 -9.2 12.7 semiskilrl-d/c 278 n.a. 220 n.a. U.a. Unskilled 1d 179 240 311 34.3 29.8 Office cle-W (A) 340 360 731 5.9 103.0 Typist (F) n.a. U.S. n.a. n.a. n.s. Textiles Industrial efficiency engineer 1.827 1,962 1,443 7.4 -26.5 Skilled (F)lb 182 204 235 12.0 15.2 SemiskilledCtF/c 159 195 232 22.7 18.8 Unskilled (A)/d7 145 163 220 12.4 35.0 Office clerk IX) 289 343 485 18.7 41.4 Typist (F) 258 244 262 -5.3 7.2

Rubber Products Industrial efficiency engineer n.a. 2,217 2,741 n.a. 23.6 Skilled /b 568 653 678 14.9 3.8 SemiskillSed /c 331 456 425 37.9 -6.7 Unskilled (AMJd 194 277 238 43.0 -14.2 Office clerk I) 343 353 341 2.8 -3.5 Typist (F) 364 376 401 3.2 6.7

Chemical Products Industrial efficiency engineer 3,014 2,157 2,159 -28.4 0.1 Skilled lb 408 550 317 34.7 -42.3 semiskilred (A)/c 183 413 354 125.3 -14.3 Unskilled (A)/d 328 349 416 6.3 19.2 Office clerk TX) 530 539 597 1.7 10.8 Typist (F) 405 319 467 -21.2 46.3 Industrial Machinery and Parts Industrialefficiency engineer 1,574 1,621 1,970 3.0 21.5 Stilled /b 363 463 489 27.5 5.7 Semiskilied /c 347 419 416 20.8 -0.7 Unskilled (AVid 160 286 282 78.6 -1.6 Office clerk -M 391 407 416 4.1 2.2 Typist (F) 304 354 351 16.5 -0.8

Electronics mdustrial efficiency engineer 1,574 1,421 1,640 -9.7 15.4 Stilled (F)/b 254 281 466 10.6 65.8 Seniskilled-lF/c 189 222 429 17.4 93.4 Unskilled (F)/C 213 736 342 10.6 45.0 Office clerk II) 342 374 624 9.3 66.8 Typist (F) 407 371 463 -8.9 24.9

All Industries /e Industrial efficiency engineer 1,737 1,628 1,595 -6.3 -2.0 Unskilled (A)/d 341 232 304 -32.0 31.0 Office clerk Tn 390 410 556 5.2 35.7 Typist (F) 334 325 627 -2.7 92.9

/a Deflated by CPI (1980 - 100). 7W Skilled jobs are: rice miller, cloth weaver, tire builder - case maker, mixing machine operator, metal products fitter assembler, material handler, and technician, respectively. /c Semiskilled jobs are: stationery engine operator, sewing machine operator, rubber molding press operator, nther production and related workers, metalworking machine setter-operator, and production operator, respectively. /d Unskilled refers to laborers. 7-e Other industries covered by the survey are: rubber latex processing, tobacco products, plywood and particle board, printing and publishing, motor vehicles, dairy products, cement and concrete, furniture, Iron foundries, fish processing, planing, mills and joinery, shipbuilding and repair, and plastics.

Note: (F) refers to female earnings, (A) to weighted average of male and female earnings. Unless otherwise indicated, earnings refer to male earnings.

Source: Ministry of Labor, Occupational Wages Survey Peninsular Malaysia, 1984. - 32 -

step with productivity. The impression that congeals from this information and earlier research, is of a very segmented labor market with slowly climbing unit labor costs overall but with the pressures being more acute in certain manufacturing subsectors than in the rest of the economy.

Table 3.2: MALAYSIA: EMPLOYMENT AND PRODUCTIVITYBY SECTOR Employment ('000)

Fin & Total Agr Kin Mfg Const Gov't comm Trans Others/a

1970 3,340 1,776 87 301 91 398 411 133 143 1975 4,020 1,915 88 448 160 520 521 181 192 1980 4,817 1,911 81 751 268 693 644 199 271 1983 5,244 1,941 65 800 346 837 713 242 301 1984 5,407 1,961 64 833 369 868 743 256 313

Value-Added per Worker (M$ 1970 prices)

Fin & Total Agr Min Mfg Const Gov't comm Trans Others/a

1970 3,138 1,932 7,022 4,342 5,825 1,995 6,589 4,496 3,846 1975 4,208 2,508 9,051 6,362 4,088 4,250 7,077 5,917 4,391 1980 5,276 3,273 14,493 6,490 4,511 4,621 8,651 9,060 4,889 1983 5,857 3,566 21,541 7,074 4,870 5,056 9,499 10,112 5,306 1984 6,098 3,636 26,219 7,547 4,946 5,070 9,766 10,418 5,521

Memo Items Annual average growth rates of Value-added per worker

1975-80 4.6 5.5 9.9 0.4 2.0 1.7 4.1 8.9 2.2 1980-84 3.7 2.7 15.9 3.8 2.3 2.3 3.1 2.8 3.1 1975-84 4.2 4.2 12.5 1.9 2.1 2.0 3.6 6.5 2.6

/a Includes electricity and water; community, social and personal services; and domestic services of households.

Source: F. Desmond McCarthy and Nadeem A. Burney, Malaysia: Endowment, Growth and Development, op. cit.

3.08 Malaysia's wage dynamic is a creature of peculiar institutionaland demand circumstancesas well as the supply trends described earlier. Although the divisions are becoming blurred, the labor market remains balkanized. Chinese have traditionally sought jobs in services and, to a lesser extent, industry; those of Tamil descent are concentrated in the plantation sector but have begun moving into manufacturing and government services. Malays, who at one time were entrenched in subsistenceagriculture, are now well represen.ed - 33 -

in the plantation and the manufacturing labor force but they have, in addition, become the backbone of the work force in the public sector. Only a fifth of the working populace is unionized (383 unions in 1982), much of it in the public and plantation sectors, and fears dating back to the Emergency, have kept alive sentimentspreventing the spread of unionization and contained the political voice as well as bargaining power of organized labor (26 strikes were reported in 1983). The closing of ranks amongst workers and the narrowing of the many fissures in the labor-marketis also hindered by the multi- racial mix of the population,and deep-seated conflicts of interest originat- ing from the remaining skewness in the distributionof skills and assets. Thus, Malaysian labor does not possess either the organization or the political voice which have made unions in some of the Latin American economies so effective in pursuing wage demands.

3.09 The push for higher incomes that might have resulted from competing wage demands by the various labor blocs, especially the efforts by Malay workers to draw economicallyabreast of the others, has been adroitly defused by the welfare and hiring policies of the Government. Through the farsighted program launched by the NEP, the government has been able to elevate the incomes, living standards and access to services enjoyed by the poorer segments of the society. Beyond that, by promoting economic mobility among the Malay population, the Government managed, until recently, to satisfy the aspi- rations of the majority group without affecting too drastically the opportunities available to the others. This balancing out could become difficult under weaker economic conditions,but so far, it has headed off a wage spiral arising from labor market rivalries. Of course, generally conservative fiscal and monetary policies that have kept the increase in prices to single-digit levels for a decade and a half, have given the macroeconomic reinforcement to other labor market-related policies and averted the nucleation of inflationary expectationsthat have wreaked such havoc elsewhere.

3.10 This is not to suggest that wage pressures have been absent or that labor costs in some sectors of the Malaysian economy have not risen faster than is desirable given the competitive internationalenvironment. The very large expansion of public sector employment in the late seventies and early eighties, shifted upwards the demand curve especially for labor with clerical, professionaland technical skills. Although the data tend to be scanty, Tables 3.3 and 3.4 give an indication of changing magnitudes, with the jump in clerical workers from 3.5Z of the labor force in 1962 to 8.6% in 1980 being very noticeable. During the phase of high growth, the public sector, profiting from the surge in revenues associated with higher commodity prices, acted as a wage leader, particularlyin the low skill categories. Growth in public employment led to a tighteningof the labor market, while the handsome salaries earned by public sector employees probably induced an upward drift in wages paid in parts of the urban, formal sector subject to a demonstration effect. Wages and salaries in manufacturingalso received a powerful nudge from foreign companies producing electronics and textiles, which were expanding their operationsand bidding aggressively for unskilled workers as well as technical staff. - 34 -

Table 3.3: TREND IN EMPLOYMENT BY MAJC,2OCCUPATIONAL GROUPS, PENINSULAR MALAYSIA 1962-79

Urban Rural OccupationalGroups 1962 1970 1975 1980 1979 1979

Administrative& Managerial 1.8 1.1 1.3 1.9 2.7 0.7 Professionaland Technical 4.4 4.6 5.5 6.8 9.4 4.3 Clerical 3.5 4.7 7.1 8.6 14.9 4.9 Sales Workers 11.6 11.3 10.4 10.5 15.9 7.7 Service workers 6.8 8.1 8.2 9.3 13.9 6.6 Productionworkers, transport equipment operators, miners and general laborers 19.1 21.3 25.7 30.6 38.7 25.7 Agricultural,livestock, forestry workers and fishermen 52.8 48.8 41.9 32.2 4.4 50.0 Total 100.0 100.0 100.0 100.0 100.0 100.0

Note: The definition of occupationalcategories has changed slightly for 1970 onwards. Government executive officials previously classified as "administrative and managerial" workers were included in "clerical" workers instead since 1970, as were some categories of communication and transport workers. These changes thus slightly inflate the share of clerical workers in later years, but the effect is small. The category "aLdministrativeand managerial" excludes managers of commerce, catering, lodging and agriculture. Source:WongPoh Kam, Economic Development and Labor Market Changes in Peninsular Malaysia, Universiti Sains Malaysia, unpublished mimeo, December 1983, Table 3.4.

Table 3.4: OCCUPATIONALSTRUCTURE OF PUBLIC SECTOR EMPLOYMENT AND ALL URBAN EMPLOYMENT IN PENINSULAR MALAYSIA

Urban Peninsular Public sector Malaysia (1973) (1982) k1975) k1919)

Administrativeand managerial 1.7 1.4 2.5 2.7 Professionaland Technical 32.9 36.4 9.0 9.4 Clerical 15.4 23.8 13.4 14.9 Subtotal 50.0 61.6 24.9 27.0 Sales - 0.1 17.9 15.9 Services 9.5 10.3 13.9 13.9 Production and General laborers 39.5 25.1 36.2 38.7 Agriculture 1.0 2.9 7.0 4.4 All 100.0 100.0 100.0 100.0

Source: Wong Poh Ram, Economic Development and Labor Market Changes in Peninsular Malaysia, op. Clt., Table .,). - 35 -

Wage Competitiveness

3.11 Market segmentationmeant that eddies from the public sector and export-orientedmanufactures were weakly felt by wages in the plantation sector, for instance, and increments in earnings were quite moderate even in other segments of industry and services. But the period 1979-83 certainly witnessed an increase in unit labor costs, a shift in relative prices favoring nontradables, many of them a preserve of the public sector, and an erosion of Malaysia's competitivenessas a producer of light manufactures and electronic parts. Comparisons with other East Asian economies are exceedingly treacherous because differences in the quality of statistics and methods of collection are one source of distortion, while problems of standardizationcan further compound any errors that creep in. Nevertheless,with all due caveats, Table 3.5 shows how Malaysian earnings moved in relation to the income of industrial workers in Korea, Singapore and Hong Kong. If these samples are representative,the earnings of Malaysian industrial labor rose very strongly during 1980-83 well ahead of those in the neighboring countries. Table 3.6 reveals how Malaysia's productivity increase has compared with that of its neighbors which offers a rough guide to the evolving cost pressures and profitability and a harbinger of future trends in relative competitiveness amongst the East Asian trading economies. In terms of overall growth in productivity in the eighties, Korea is the leader followed by Singapore and then Malaysia. Korea's performance in manufacturing has also been superior, with Malaysia occupying second place in the group.

3.12 Piecing together the rather fragmentary information on the labor market (see also Chapter 8 for information on tree crop sector wages), it seems that the future sectoral distributionof the labor force, unless offset by migration from Indonesia and Thailand, will constrain the growth of agricultural products, with the effects becoming very noticeable in the nineties. Earnings in the public sector and export oriented manufacturing rose well ahead of productivity in the late seventies and early eighties and there are some grounds for believing that wage levels in the modern manufacturing sector are close to those in the East Asian NICs. On the more positive side, Malaysia's institutionalcircumstances, a history of low inflation, the State's successful attempt at warding off wage demands and the public sector's determination to restrict its absorption of labor, all suggest that real wages should not rise much more than productivityduring the balance of the eighties. After a five-year interregnum in which government pay scales remained static, public employees were allowed an interim 3.5Z increase in 1985, a step that could set the tone for wage bargains elsewhere in the economy and reinforce the effects of a relatively elastic labor supply. However, the factors influencing labor costs and the pattern of market segmentation definitely requires further research. - 36 -

Table 3.5: NOMINAL AVERAGE MONThI.YEARNINCS IN MANUFACTURING /a (1980 - 100)

1977 1980 1983

Males Malaysia 75.7 100 172.4 Singapore /b n.a. 100 139.6 Korea /c 61.1 100 118.1 Hong kong /d 73.9 100 116.2

Females Malaysia n.a. 100 198.3 Singapore /b n.a. 100 144.6 Korea /c 60.6 100 121.2 Hong Kong /d 73.9 100 116.2

/a Data in national currencies converted to nominal US$ and then indexed. 7T Calculated from earnings/hourdata on the basis of 44 hours per week, 4 weeks per month. /c Includes family allowances and the value of payments in kind. Td Rates per month.

Source: ILO, Yearbook of Labor Statistics, 1984; Ministry of Labor, Mala7sia, Wages Survey of Peninsular Malaysia, 1984; Ministry of Finance, Malaysia, Economic Report, (Various issues); I5F Interna- tional Financial Statistics. - 37 -

Table 3.6: VALUE-ADDED PER WORKER (Average annual growth rate, Z p.a.)

Cons- Cov't Fin & Total Agr Min Mfg truction service comm Trans Other

Malaysia 1975-80 4.6 5.5 9.9 0.4 2.0 1.7 4.1 8.9 2.2 1980-83 3.5 2.9 14.1 2.9 2.6 3.0 3.2 3.7 2.8 1975-83 4.2 4.8 11.4 1.3 2.2 2.2 3.7 6.9 2.4

Korea 1975-80 3.9 -0.2 -13.3 7.1 1.2 n.a. n.a. n.a. 1.1 1980-83 5.3 14.2 11.9 3.9 12.3 n.a. n.a. n.a. -0.2 1975-83 4.4 5.0 -4.6 5.9 5.2 n.a. n.a. n.a. 0.6

Singapore 1975-80 3.3 -0.7 26.3 2.9 -8.5 n.a. 2.8 - 4.4 1980-83 5.1 11.2 -2.5 2.2 -23.6 n.a. 6.8 -7.1 -3.7 1975-83 4.0 6.4 14.6 2.6 2.5 n.a. 8.9 -2.7 -2.7

Thailand 1975-80 3.0 -0.5 7.8 4.5 -1.7 n.a. 0.8 3.2 4.4 1980-83 0.2 0.6 -27.4 -0.5 -12.6 n.a. -2.9 2.5 -3.7 1975-83 2.2 -0.2 3.7 3.1 -4.9 n.a. -0.3 3.0 2.0

Source: Ministry of Finance, Malaysia, Economic Report 1984/85; Department of Sta- tistics, Korea, Korea Statistical Yearbook, 1984; Department of Statis- tics, Singapore. Singapore Yearbook of Statistics, 1982/83 & 1983/84; National Statistical Office, Thailand, Thailand Statistical Yearbook, _976-80 and 1981-84.

3.13 If Malaysian manufacturingwages are approaching those of the East Asian NICs even though the country lags behind in terms of industrial maturity, catching up by way of export led industrializationwill be considerably more difficult. This has implicationsfor industrialand exchange rate policy as well as the urgency of stimulatingproductivity. Should industrialization flag, unemployment (7.6Z in 1985) affecting primarily school leavers and the unskilled, will emerge as a serious economic and social problem. Many of the institutionalfeatures and constraints on geographical,sectoral and inter- industry mobility responsible for the large wage differentials and the sluggish adjustment of earnings to changes in market demands will wither over time, exposing sectors now sheltered from rising costs, but labor supplies will be a countervailingforce. Asido from the natural increase, there remains a pool of workers in the agriculture sector, and young people from rural areas will continue to seek urban jobs. Higher rates of participation by married women could also stabilize wages in service and assembly industries in which women are already welL represented. Just as public sector employment - 38 - was an incentive to intersectoralmigration by Malays, so too the jobs offered by the Government appear to have facilitated,in Malaysia, as in other countries, the entry of women into the labor market and their gradual diffusion laterally across sector and longitudinallyover the job hierarchy (see Table 3.7).

3.14 The labor demands generated by a number of feasible industrial strategies will 1.c discussed later in the report. In the following section we will pursue the exchange rate related ramificationsof the Malaysian wage structure.

Table 3.7: MALAYSIA: FEMALE PARTICIPATIONIN EMPLOYMENT BY SECTORS, 1957-1979 (Z)

1957 1970 1975 1979

Agriculture 32.2 37.2 40.9 42.5 Padi, livestock, forestry and fishing 27.9 34.2 39.4 36.4 Rubber, oil palm, coconut 35.2 39.7 42.1 45.8 Mining and quarrying 16.2 12.8 12.3 14.6 Manufacturing 16.7 29.0 39.3 38.8 Construction 7.9 7.1 6.4 6.4 Utilities 3.4 5.2 3.2 6.6 Transport, Communication and storage 2.0 4.2 6.3 8.0 Commerce 9.5 17.9 26.9 28.5 Services 19.1 29.7 37.9 41.8

Total 24.6 31.8 34.5 35.4

Source: Wong Poh Kam, Economic Development and Labor Market Changes in Peninsular Malaysia, op. cit., Table 3.6.

Exchange Rate Policy

3.15 After the Sterling Area was dismantled in June 1972, the Malaysian ringgit was linked to the dollar, the effective rate varying from M$2.75 to M$2.88. In mid-1975, the currency entered into a controlled float against the dollar and in September of that year this conditionwas associated with a basket of unspecifiod currencies. Unofficially,the ringgit has maintained a tie with the Singapore dollar with its roots in the long standing economic and financial links between the two countries. An extended spell of stability against the US and Singapore dollars was finally broken in late 1984, when the Bank Negara adopted a more flexible posture towards exchange rate management. - 39 -

3.16 There are two sets of reasons why exchange rate policy might be a critical tool for advancing Malaysia's industrialambitions. Manipulating the exchange rate can serve as an alternative to taz and tariff policies designed to hasten industrialization. Being more neutral, this approach will result in fewer distortionary side affects and unlike direct controls, it is less susceptibleto pressure from interest groups which leaves more discretion in the hands of the central government. By maintaining a suitably competitive exchange rate, a country can create a system of relative prices that sets in motion resource transfers favoring ezport and import substitutingactivities. The transfers are from buyers of imports, or to put it more generally, from labor to producers. In effect, a flexible exchange rate policy can reduce domestic labor costs and enhance the returns to tradable goods production, or when some of the advantages of lower wages are passed on to final purchasers, increase the competitivenessof exports.

3.17 Maintaining an undervalued rate can be a costly exercise which merely transfers resources to foreign buyers, hence the return to an equilibrium rate must be the eventual goal. Moreover, the generalized protection offered by undervalued exchange rates has a cost and is justified if much of the resource reallocationthat occurs is efficient, taking into account long- term gains in the form of learning, productivityand managerial improvements. The test of allocative efficiency is the once protected industry's ability to thrive and achieve an above average economic return (to offset the extra costs incurred during the years of protection) after the exchange rate has returned to equilibrium. If only a fraction of the industries that might emerge are likely to graduate to efficient and self-sustainingmaturity once relative price equilibrium is restored, there is the beginning of a case for more selective intervention. No policymaker can know whether the results a decade or more later will justify the long-term use of exchange rate policy for industrial ends. Hence, the risk minimizing strategy has to be properly timed, that is, exchange rate and other related macroeconomicmeasures are introduced when the supply of factors, organizational,information-related and entrepreneurialinputs is assured.

3.18 In this regard, Malaysia has certainly passed the requisite threshold. Supplies of semiskilled labor are more than adequate, and in the medium term, technical engineeringand industrial skills will become more plentiful. The financial and administrativeinfrastructure is quite well developed and over a twenty year period, the economy has garnered a substantialfund of industrial experience. Where uncertainty still lingers is regarding the managerial and marketing capacities of Malaysia's indigenousindustrial firms, most of whom are still small by the standardsof other East Asian NICs, have led a sheltered existence and have yet to build the informationand sales network which is the key to successful exporting.

3.19 The exchange rate can be an important ingredientof long-run industrial policy when a certain target real rate is adhered to for a long period. Resource rich primary product-exportingcountries, like Malaysia, encounter the problem of appreciatingreal effective exchange rates through the following route: During spells of strong world demand and rising commodity prices, export earnings increase and the nominal exchange rate tends to be fairly firm. Because a disproportionateshare of development expenditure is absorbed - 40 -

by construction,services and other domestic nontradables, the relative prices of these items rise and this propensity is particularlymarked when spending accelerates in boom years. The twisting of relative prices in favor of nontradables pulls resources towards nontradables,exerts pressure on wage rates and results in a real exchange rate appreciation.

3.20 As delineated earlier, Malaysia has pursued a very aggressive development strategy since the late seventieswith high levels of spending on infrastructureand services. Relative prices followed the classic pattern, with the real estate sector taking the lead in terms of price increases. Wages, because of the factors described above, were slow to respond, but rose quickly in 1981-83. Since the nominal exchange rate was unchanged, the real effective rate appreciated (see Table 3.8). Public sector investible funds continued to flow into the manufacturingsector but private capital increasingly sought the high and safe returns from construction, real estate and services. Since the fourth quarter of 1984, the authorities have allowed the ringgit to depreciate against the referencebasket of currencies. This, along with the check imposed on public spending has served to gradually bring down the real effective exchange rate. The sharp fall in palm oil prices in the latter part of 1985 and of petroleum in the first half of 1986 brought renewed pressure on the exchange rate. Estimatesof the REER and the NEER using the ratio of the domestic CPI to the correspondingtrade partner CPI and 1975 as the base year are shown in Table 3.8. The REER appreciates steadily from the fourth quarter of 1981 to the third quarter of 1984. It then sinks for two quarters to the level reached in early 1983. The remaining three quarters of 1985 witnessed a downward drift until, in line with the sudden fall in oil prices and the depreciationof the dollar, the REER dropped to a point which in April 1986 approached levels not seen since the early eighties.

3.21 Whether the REER is now close to an "appropriate" level from both a short- aa well as a longer-term perspectiveis conjectural. There is little reason to treat the real effective rate of 1981 as a target for the future if domestic and internationaleconomic conditionsare departing from the situation in the early 1980s. The precipitousdecline in Malaysia's terms of trade and the resulting adjustment problem, as well as the needs of longer-term industrialand tree-crop developmentand export growth, would tend to require a lower real exchange rate for the future. At the sAme time, there is evidence that the growth in wages has been reduced compared to the early eighties; real estate investmenthas been slowing down, industrialproduc- tivity wouLd tend to improve as the high investment of recent years bear fruit, and the effects of continued conservativefiscal and monetary policies lead to domestic inflation rates below internationalrates. These latter factors would help improve Malaysia'scompetitiveness. - 41 -

Table 3.8: MALAYSIA NOMINAL AND REAL EFFECTIVE EXCHANGE RATES /a (1975 Ql - 100)

Nominal Real /b Nominal Real /b

1975 1 100.00 100.00 1981 1 91.48 81.18 2 100.13 96.51 2 92.37 82.06 3 97.09 92.85 3 94.51 83.88 4 93.97 88.23 4 95.71 84.20

1976 1 93.75 87.93 1982 1 96.57 86.33 2 95.02 87.65 2 97.63 87.43 3 96.15 88.79 3 99.23 89.30 4 96.10 87.35 4 99.98 89.83

1977 1 96.01 86.96 1983 1 100.05 90.21 2 95.65 84.80 2 100.88 90.07 3 95.03 b.4.0. 3 101.32 90.94 4 94.56 84.81 4 100.95 90.38

1978 1 93.11 83.57 1984 1 100.35 91.59 2 90.91 80.91 2 101.36 91.54 3 89.41 80.20 3 103.62 93.84 4 92.29 82.61 4 102.76 91.76

1979 1 92.58 83.21 1985 1 103.99 90.85 2 94.18 83.70 2 104.64 90.84 3 95.43 84.33 3 101.64 88.96 4 96.76 84.87 4 97.55 84.01

1980 1 96.67 85.34 1986 Jan 95.83 82.51 /c 2 95.17 82.10 Feb 92.96 80.04 7T 3 95.62 83.25 4 94.13 82.20

/a Increase = appreciation. 7T The real effective exchange rate is calculated by comparing Malaysia's nominal exchange rate deflated by its CPI with the weighted average of the exchange rates of its trading partners deflated by their CPIs. /c Estimate.

3.22 The desirable level of the real effective exchange rate will come into focus only after a measure of stability returns in the markets for Malaysia's major exports, especially oil. Much will also depend on the changing relative competitivenessof Malaysia's neighbors, several of whom are committed to aggressive export strategies; trends in Malaysian wages and labor productivity;and the approach taken towards reforming industrial incentives. MALAYSIA: NOMINALAND REAL EFFECTIVEEXCHANGE RATES (197S 01 100) 1s6-

NEER

1 10 - - - REERCCPX/CPX)

185_

906

4% /~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~4

805

75-

70- 75 78 77 78 79 80 81 82 83 84 86 V4*' - 43 - CHAPTERIV: THE FUTUREOF EXPORTS

4.01 Every economymust first look to its own factorresources when drawingup a developmentprogram. The managementof factor suppliesand the manner in which they are augmented through improvements in quality and tech- nologyis a necessarystep towardstranslating ambition into achievement. But economiclinks betweenthe nationalplayers in the world'smarket place have been multiplying and the percentage of the traded national product has expandedremarkably in even the largesteconomies. For small countrieswhich have reliedupon externaldemand to supportgrowth, the dependenceis much more acute. The ratio of exportsto GNP is 53X in Malaysia,38Z in Korea, and 124% in Singapore. Since the importintensity of investment,and less directlyconsumption, is also quite high, such economiescannot expand without addingto their ezternaldebt unlessexports can be made to grow at a certain rate. The precariousnessof the small open economieswas clearlyrevealed in the early eighties, when the attempt to maintain growth momentum in the face of slowly increasing world trade combined with higher interest rates to drag many of the NICs into severe debt crises. If anythingthe pointwas driven home twice over in 1984 and 1985. First, the strength of business recovery in the U.S. in conjunction with the overvaluation of the dollar was a bonanza for exporters the world over. Totalworld trade expanded9% in 1984, that of manufacturesby 12Z. A third of the overallincrease was traceableto demand in the U.S. and, as can be seen from Table 4.1, sales to the U.S. were responsible,in many cases for half or more of the exportgrowth from countrieson the Pacificrim. In the aggregate,the US accountedfor close to 96% of the growthin manufacturedexports of the East Asia regionduring 1980-84. When, as has been the case over past cycles,the U.S. economyslackened in 1985, the effectswere immediateand by virtueof their suddenness,a sourceof conster- nationthroughout East Asia. The Latin AmericanNICs, who appearedto be gaininga grip on their debt problems,once again found themselveson a knife edge. - 44 -

Table 4.1: CROWTH OF EXPORTS TO THE US

Growth in goods exports to US US US ($ value) share of share of 1984 1983-84 1982-84 1983 exports export growth ___ _. ______(z) - ______

United Kingdom 8.3 5.3 13.8 41.0 Japan 38.3 64.0 29.5 79.4 Hong Kong 34.3 56.3 32.2 40.2 Korea 24.5 63.6 33.8 79.7 Singapore 22.2 85.1 18.1 36.4 China 60.7 56.0 7.8 41.2 Malaysia 22.7 63.4 13.2 25.8 Philippines 15.7 30.6 36.3 90.2 Thailand 35.9 47.1 15.0 55.3 Argentina 20.9 -8.3 9.9 19.4 Brazil 46.8 79.8 23.2 54.1 Chile -15.9 13.8 28.1 - Mexico 22.9 35.9 58.1 86.9

Source: Data Resources Inc.

4.02 About 26% of Malaysia's export growth in 1984 was the result of sales to the U.S., but that country accounted for much of the gains in critical items like garments and semiconductors. Demand from other industrial economies was responsible for perhaps two thirds of the remainder, so that, in total most of the surge in manufactures and commodities other than palm oil cAme from the advanced countries. Since exports will have to rise faster than CUP in the coming years, if Malaysia is to stabilize the debt obligations, its economic scores will be decisively affected by how successfullythe OECD countries can solve the afflictions that have lowered the growth averages from 3.4% in the 1970s to 1.5% in the 1980s. Concerning the medium term the OECD countries look as if they are headed toward a 3% growth rate in 1986. As the full effects of lower petroleum and commodity prices filter through the system, this might rise to 3.5-4% p.a. in 1987-88 helped perhaps by the approach of elections in the U.S. and the need to find a solution to high rates of unemploymentin Western Europe.

Export Prospects: Commodity Markets

4.03 Commodity prices fell by 10% in real terms over the course of the fifties and this rate of decline continued through the sixties. A strongly expanding world economy in the early seventies served to reverse the gradual descent and together with other events made this a turbulent and exciting dncade for producers. Crop failures in 1973-74, fluctuating exchange rates, inflation, and the aggressive behavior of speculators produced cycles of - 45 - unusualamplitude. Commodityprices rose to a historicalpeak in 1971-3and climbedagain during1975-77 before commencing a long slow slide which returnedthem by 1985 to real levelsseen in the early fifties. Comparedto the price movementsthat accompaniedcycles in the seventies,commodity indicasresponded with less alacrityto the 1983-84business upwelling and also subsidedmore quicklyin 1985.

4.04 Many parametersappear to be changingand they indicatea returnto trendspushed out of mind by the brisk price movementsof the seventies. Commoditysupplies--agricultural as well as mineral-lookhealthier than they have for a long time, a synergisticoutcome of governmentpromotion, technological advancesand the normalresponse of output to high prices. Further, many countriesare beingdriven by the thirst for foreignexchange into enlargingtheir salesat a time when marketsare softening.On the side of demand,the computerizationof stockholding,combined with higher interest rates,has resultedin a lower inventorydemand and a reductionof certain stockpiles,most significantbeing the large metal holdingsof the US government. Relativeprice stabilityon a worldwidescale has taken the wind out of speculativedemand and the shift in consumerpreferences towards services referredto above,has pared the coefficientslinking commodity consumption with GNP growth. Manufacturershave learnedto economizecn raw materialsand numericallycontrolled tools have cut waste. Lastlythe hand of substitution has been at work, ceaselessly.Natural rubber's share of the total world marketfor elastomerswas 33Z in 1983, comparedwith 66Z in 1950; while the use of substitutessuch as aluminumand successat loweringmetal contentand increasingrecovery has nearlyhalved the co4gumptionof tin per unit of GNP in the OECD countriesbetween 1970 and 1983."

4.05 With the shareof tin down to 3.2Z of Malaysia'sexports in 1984 and the slowlyincreasing world demandovershadowed by large stocksand significant excesscapacity not just in Malaysiabut also in Thailand,Indonesia and Brazil,the commodityseems destinedto continuesinking in the export horizon. But over the foreseeablefuture, rubber, that contributed9.5X of

7/ See P.F. Drucker,The ChangingWorld Economy,Foreign Affairs, Spring 1986, for an interestingdiscussion of the globalimplications, and E.D. Larson,M.H. Ross and R.H. Williams,Beyond the Era of Materials, ScientificAmericar, June, 1986 for an analysisof the factorsbehind the fallingdemand for certainmetals. - 46 - MALAYSIA COMPOSITIONOF MERCHANDISEEXPORTS

1975- M$ 9,230.9 MILUON MAJOR PRIMARY COMMODITIES TIN 60.8% PALMOIL 13.1%

LOGS/TIMBER RUBBER 21.9% , OTHEREXPORTS 9.9% PETROLEUMM PETROLEUM 7.9% MANUF.GOODS MANUFACTURES& 7,9% 21.4% OTHERS 31.3%

1984- M$ 38,653.8 MILUON RUBBER PALMOIL B5BR 11.7% MAJORPRIMARY COMMODITIES TIN ~ 33.9% PETROLEUM 3.0% 22.6% PETPOLEUM 3...... ELOGS/TIMBER 9.7%

X r /OTHER EXPORTS 12.4%

MANUFACTURES& MANUF.GOODS + 43O5% 31.1%435 - 47 - exports in t,3S4and palm oil, the source of another 12%, will remain important,8

4.06 Malaysia has been and remains the dominant producer and exporter of rubber in the world. In spite of gains by new challengers such as Thailand and Indonesia, exports grew 2.7% p.a. between 1965 and 1984 and at the end of this period Malaysia held 36% of the market as against 38% two decades earlier. Although natural rubber, in the company of other commodities, enjoyed more favorable terms during the seventies, the industry has been buffetted by falling real prices ever since the close of the Korean war. In constant terms, prices declined by two thirds from 1950 to 1984 but even this did not stem the march of synthetic rubber whose share of total elastomer consumption doubled, to 66%, in the mid-eighties. Rubber production flour- ished in the face of falling prices because yields rose 2Z p.a., but as productivity growth realized from cloning techniques seems to be diminishing, the higher cost producers among the top five, and especially Malaysia, look to the future with some trepidation. After a respite in the seventies, prices began to slip once again after 1980 and how they behave henceforth will depend very much on what happens to the cost of petroleum and to automotive demand. A prolonged slump in oil prices, by cheapening synthetic rubber, would have grave consequences for the natural rubber industry, but most analysts are assuming that oil prices should begin recovering in the nineties, with the result that natural rubber prices, after some further weakening during the second half of the eighties, could recover in the next decade.

4.07 Of greater concern perhaps is the slow 1.2% p.a. growth in the demand for automobiles in advanced countries. As the automotive sector is responsible for 75% of the natural rubber consumed this will weigh heavily on the industry. Sellers of natural rubber stand to gain from the progressive radializationof tires r.ince,although these have twice the life span of the cross-ply variety, they have a higher natural rubber content, and reduced pump prices of gasoline may encourage motorists to drive more, thereby boosting tire demand. Estimates of gasoline price elasticitiesin the U.S. for the

81 Tin traded at E 8,145 per ton on the London MetaL Exchange on October 24th 1985 when trading was suspended. Resumed trading through informal channels and through markets in Kuala Lumpur and Thsiland has been at prices ranging from E 3,500-E 4,200. In 1985, Malaysia produced 36,300 tons, but as a result of the fall in prices just 199 gravel mines were operating in early 1986 as against 360 in 1981. The number of dredges was down to 28 from 60 five years ago. Approximately 22,000 people were employed by the tin mines, but closures have cut their numbers to less than 12,000. Since it costs M$25-26 to produce 1 kg of tin using gravel pumps and M$14-20 per kg by means of dredging, the M$14.20 per kg price at which tin sold in the Kuala Lumpur market during the second quarter of 1986, inflicted considerablehardship. The size of worldwide stocks makes it unlikely that prices will soon recover and hence Malaysia's production might drop below 20,000 tons in 1986. Since some gravel mines are susceptible to flooding if they are not worked, a portion of the country's mining capacity will be irretrievablylost. - 48 -

1960-80 period suggest that short-term elasticitieslie in the -0.2 t -0. 4 range while longer-run elasticitiesrange from -0.7 to as much as -1._/ But countering these positive shifts will be the downsizing of tires, advances in retreading and technologicalgains that promote tire lonigevity. Forecasts of how much rubber production could be absorbed by 2000 vary widely (see Table 4.2). A figure of 6 million tons is not implausible,implying an 2.3% p.a. increase from the 4.2 million ton base in 1984. In this tightening market, Malaysia will have to struggle hard to maintain her market share against other lower cost producers (especiallyIndonesia) with more elastic supply potential. Rubber can remain, until at least the end of the century, an important export but it is a comodity well past its prime in Malaysia's primary product stable.

9/ C. Kouris, Energy Demand Elasticities in IndustrializedCountries: A Survey, The Energy Journal, Vol. 4, No. 3, 1983. - 49 -

Table 4.2: WORLDNATURAL RUBBER DEMAND, 1982-2000 ('000 tons)

Average annual 1982 1985 increase actual estimated 1990 2000 1982-2000

WORLDBANK /a NR demand 3,436 3,942 4,800 n.a. 4.3/f

TASK FOGCE lb NR demand 3,700 n.a. 5,000 6,000 2.7

FAOIWORLDBANK /c NR demand /d n.a. 3,476 4,689 5,342 2.9/g

SMIT STUDY /e NR demand 3,583 4,004 4,476 5,416 2.3

/a The demand projections are from, Price Prospects for Major Primary Commodities:Volume III - Agricultural Raw Materials, Report No. 8141/84, September 1984, pp. 40-58; The price projections are from the latest World Bank projections, dated July 1985. /b The Kalaysian Natural Rubber Industry 1983-2000: Rev irt of the Task Force of Experts. Malaysian Rubber Research and Dckelopment Board, October 1983, p.l. /c Indonesia: The Major Tree Crops - A Sector Review, Projects Department, East Asia and Pacific Regional Office, Report No. 5318-IND, April 15, 1985, pp. 23-27 and a companion study by the FAO, FAO Report 101/83 TA.INS 41. /d This is demand for category 1 rubber only, demand which, on technical grounds, can be met only by isoprenic rubber, i.e. natural rubber or a relatively costly synthetic with technical qualities very similar to natural rubber. This category accounts for only 75Z of natural rubber consumption. The demand figures, therefore, are underestimates. /e The World Rubber Economy to the Year 2000, Hidde P. ;mit, Free University of Amsterdam, 1982, p.368. These data are obtained from the 'tstandard demand scenario", which assumes moderate world growth and moderate world prices. If For the period 1982-1990. 7j For the period 1985-2000. - 50 -

Table 4.3: WORLD PRODUCTION OF MAJOR OILS AND FATS ('000 tons)

1958-62 1968-72 1978-82 average average average 1984 Total Z Total Z Total X Total Z

World Production /a 29,088 39,613 56,170 62,703

Soybean oil 3,282 11.3 5,915 14.9 12,588 22.4 13,452 21.5 Cottonseed oil 2,290 7.9 2,620 6.6 3,046 5.4 3,400 5.4 Groundnut oil 2,445 8.4 2,798 7.1 2,606 4.6 2,873 4.6 Sunflower oil 1,902 6.5 3,555 9.0 4,910 8.7 5,798 9.2 Rapeseed oil 1,178 4.0 1,961 5.0 3,796 6.8 5,354 8.5 Coconut oil 1,849 6.4 2,196 5.5 2,774 4.9 2,094 3.3 Palm oil 1,302 4.5 1,776 4.5 4,540 8.1 6,290 10.0 Palm kernel oil 425 1.5 413 1.0 611 1.1 825 1.3

/a Includes some lesser oils and fats not individually listed below.

Source: 1958-1982: OILWORLD: The Past 25 Years and The Prospects for the Next 25 in the Markets for Oilseeds, Oils, Fats and Meals. 1984: OILWORLD: May 17, 1985

4.08 With rubber entering its twilight years, Malaysia is fortunate in having found another plantation product to lead the agriculture economy. Palm oil is a perennial entrant in a vegetable oils market where annuals such as soya bean, groundnut and cottonseed oil, bulk large (see Table 4.3). Though the cultivation of tree crops tends to be riskier because of gestation lags, production of palm oil has rizen at 6.2Z p.a., slightly higher than soya bean oil (6.1Z), which currently has the largest market share (21.5Z in 1984). Palm oil owes its success to a number of factors. High demand, initially from the industrial countries and during the past decade from developing economies, has been the main spur but the very large yields and superior profitability of palm oil have allowed it to outdistance competitors and annex 11 of world production. A geographical shift in production from the African countries, with 80Z of the palm oil exports in the mid-sixties, to far more dynamic supply centers in South East Asia, has also contributed. Lastly, the Asian producers who now account for four-fifths of palm oil traded have been successful in diversifying the uses of their product and widening its market appeal through better refining.

4.09 Having observed the meteoric gains made by palm oil in the last few years, forecastersare painting an optimistic export future with a growth rate of 4.92 p.a. leading up to a 11 mi'lion ton traded volume in 1995, at which time soya and palm oil could represent close to half of the world market for fats and oils (462 in 1982). A few clouds do remain. Per capita consumption of oils and fats throughout the world has been growing at 1.42 p.a. for - 51 -

25 years and was 13 kg in 1982. But in the industrial countries, excepting Japan, per capita intake was 30 kg which is close to saturation. If anything, for health related reasons, the trend may be downwards and towards soft vegetable oils, which palm oil is not. Hence export hopes rest not on further penetration into protected EEC markets but in finding buyers from among the developing nations, where the per capita consumption is a modest 8.1 kg.

4.10 Because there is such a vast unsatisfied demand particularly in the Asian economies for cooking oil, forecasts call for a 2% p.a. increase in per capita use, a not excessive figure in terms of wants but one that might be difficult to translate into effective demand. The great surge in Asian and Mid-Eastern oil consumption during 1975-82 was assisted by the foreign exchange and income gains arising from changes in petroleum Prices. Arab markets are also approaching satiety and the economic difficultiesconfronting OPEC are bound to reduce the flow of remittances to countries such as Pakistan, India and Sri Lanka. Tne first cwo are among the biggest importers of refined vegetable oils and it is the well-being of their economies that will be decisive for the growth of palm oil trade. At this stage it is impossible to determine how tightly constrained the Asian nations will be by foreign exchange availability. They might manage to find the resources needed to raise the volume of their consumption by 4.52 annually, though this will depend on the strength and duration of future business cycles, on the future course of palm oil prices and trends in domestic production. Hard times for the industry and the accumulation of nearly 900,000 tons in unsold inventories by the end of 1985, stemmed from a reduction in demand from India and a shift by traditional South Asian buyers towards more attractively priced Indonesian palm oil. Most recent projections assume that Malaysian production will reach 6.5 million tons by 1995. Indonesia's output will be 2.3 million tons and West Africa will continue to stagnate. Based on average OECD growth rates of 3.0-3.5% which set the pace for expansion elsewhere, the projected traded volume will be absorbed only if prices are significantly lower (in constant 1983 dollars) during the 1985-95 period. Lesser growth in the world economy, greater competition from producers of soya oil, a weaker dollar that restores the U.S. standing in the vegetable oil market, all of which are on the cards, could limit the increase in palm oil exports, or, alternatively, force prices lower. These factors have already begun to influence prices which had dropped to US$243 per ton by March 1986 from an average of US$729 in 1984.

Export Prospects: Petroleum

4.11 Malaysia produced 446,832 b.p.d. of oil in 1984 and exported 343,508 b.p.d. at an average price of $29.87 per barrel, about 30% of it through sales on the spot market. The average daily production in 1985 was 446,100 b.p.d. with exports running at 354,500 b.p.d. but at a price, th-t for the year as whole, averaged $27.50 per barrel. About 40% of the oil was sold on the spot market. Petroleum is the country's single largest traded item, encompassing slightly less than a quarter of all the earnings from merchandise sales overseas. How it fares during the second half of the eighties will have far-reaching consequencesfor the current balance, the health of the federal budget and the development program to be launched under the auspices of the Fifth Plan. - 52 -

4.12 There is no shortage of speculationconcerning the trajectory oil prices and production. Out of all the analysis a number of threads can be glimpsed which make it possible to very roughly chart the terrain ahead. The oil market has been transformed in a number of ways. OPEC's share of oil produced during 1984 was just 33% as against 56% in 1973. Oil's share in total primary energy consumed has tumbled to 432. Higher real interest rates, expectationsof further price erosion and a supply situation made easier by the desperate financial straits of some producers and the large (100 million barrels) floating stocks held by Saudi Arabia and Kuwait, have persuaded oil companies to reduce inventories. In two of the largest consuming nations, the U.S. and Japan, the coefficientsof total energy use in g.d.p. have dropped substantially,with oil having taken an especially sharp plunge. There are many reasons: cars, airplanes and industrialboilers are more fuel efficient, energy intensive basic industries are growing slowly, houses are better insulated, coal and nuclear energy are being used more extensively to generate electricity and after the price of oil rose above $20 per barrel, a host of industries,cement, bricks, distillation, metallurgy switched to alternative fuels. A 40% decline in real prices since 1981 may have taken a little of the edge from oil conservation,but the trend is likely to continue, reinforced by changes in consumptionpatterns and sustained by the long lives of structures and capital equipment being put into place.

4.13 So much for longer term demand; the disarray within OPEC, a persisting excess supply of nearly 1.5 million b.p.d. and uncertainty about future real interest rates have clouded the short-term outlook. The OECD countries seem headed towards an expansionary phase which should strengthen demandt But the sophisticationof their buying and refining practices has strengthened their hand vis-a-vis the producers. Japan, for instance, now purchases 50-60% of its oil on the spot market as against 20Z a few years earlier and Japanese trading houses are aggressive in hunting down bargains. An enlarged catalytic cracking capacity means that a consumer is less tied to a particular oil pro- eucer and can instead refine other types of crude that are more cheaply available.

4.14 Oil producers have placed themselves at a tactical disadvantageby becoming mired in costly development programs that must be paid for through sales of oil in a glutted market. As long as Saudi Arabia was able to produce at less than its OPEC allotment (25Z or 4 million b.p.d.) other members could pump more without depressing prices. But Saudi Arabia needs to pump between 2.5-3.0 million b.p.d. to produce the associated gas needed for its petro- chemical, metal and distillationplants (output was in the region of 4.5 million b.p.d. in mid-1986). Having incurred current account deficits of $20 billion and $25 billion in 1984 and 1985 respectively,the country is also approaching,though more slowly, the budgetary bind many other producers are now in.

4.15 Beyond 1990 the chances of an upturn in prices are fairly strong for three supply linked reasons. Lower returns and the increasing disassociation of the major oil companies from production activities, have since about 1981- 82 made exploration unappealing. This is beginning to be felt in the reserve production ratios (R/P). The average R/P ratio was 35:1 in 1983 but it varied from 100:1 in the Gulf areas down to 20:1 elsewhere. New reserves amounting - 53 - to five billion barrels per year have been added mostly in remote areas where productionis costly. Currently about half of world production is from areas where R/P ratios are 20:1. Until producers arrive at an understanding that will help to erase the oversupply and real interest rates decrease, petroleum prices will remain weak although the economics of production in the North Sea and the U.S. should prevent a prolonged spell in the $10-$12 range. Even if the trend in reserve findings were to continue, while world demand grows 2Z p.a., the R/P ratio will be 15:1 by 1992. Proven worldwide reserves rose from 680 billion barrels in 1983 to 707 billion barrels in 1984, but almost the entire increase was in the Gulf region. If exploration continues to wane, non-OPEC reserves and supply conditions would once again permit the cartel to push up prices in the early nineties.

4.16 This is conjecture, but it is informed conjecture being voiced by experiencedmarket observers, who are taking note of the Soviet Union's struggle to maintain its output and sales, now that the large, more easily accessible fields are past their prime, the share of U.S. production originat- ing in high cost secondary recovery from depleted fields; and the approaching productionpeaks in Mexico, Algeria and the North Sea.

4.17 Malaysia cannot expect to recoup the revenue lost as a result of falling oil prices by raising production to 510,000 b.p.d., the target for 1986, and exports to 395,700 b.p.d. Total earnings from petroleum exports were US$3.55 billion in 1985. If the price per barrel in 1986 averages US$15 per barrel - during April 1986 the various grades of Malaysian crude fetched between US$12.45 (Bintulu) and US$13.50 (Tapis) - export proceeds will be about US$2.2 billion. In the nineties, however, Malaysia, with current proven reserves of $3.5 billion barrels, enough for 22 years production can look forward to higher economic returns.

4.18 The above suggests that four commodities-rubber, palm oil, tin and petroleum-which provided 472 of Malaysia's exports in 1985, may be hemmed in by constraintsarising from declining prices and slowly rising demand in the latter part of the eighties. Resource balancing will be much trickier during the Fifth Plan than it was in the Fourth and its search for manufactured exports will have to be pursued more vigorously than ever.

Export Prospects: Manufactures

4.19 The past behaviour of world trade in manufactured goods is an indifferentguide to market possibilities in the years ahead but it remains the only solid empirical bridge that we have to the future. World trade in manufacturesincreased by nearly 10% p.a. during 1966-73 and at half that rate from 1974 to 1980. However, the manufactured exports of the LDCs performed much better in the second half of the seventies growing by 10% p.a. (see Table 4.4) although their share of LDCs' total exports (about 20% from 1966 to 1980) changed little (see Table 4.5). - 54 -

Table 4.4: ANNUAL GROWTH RATES/a OF LDCJ' MANUFACTUREDEXPORTS

Quantity /b 1966-73 1974-80 1966-80

Trade 8.4 4.7 9.8 Non-Marzfacturing 6.8 7.4 11.4 Manufacturing 12.8 10.0 11.3 Chemicals 16.6 7.7 12.9 Machinery & Transport Equipment 25.5 13.5 20.2 Passenger and Road Vehicle 31.2 20.5 27.7 Other Manufactures 11.7 9.4 9.9 Textile Yarns and Fabrics 13.7 16.5 14.9 Iron & Steel 17.9 21.7 16.7 Non-Ferrous Metal 4.5 10.5 6.4 Other Manufactured Metal Products 17.9 24.5 18.9 Clothing 26.6 20.7 23.6

/a Least squares growth rates. lb The underlying quantity indexes are obtained from a division of a time series in current value by a corresponding price index.

Source: C. Leechor et. al., Structural Change in World Industry, op. cit. Table 8.

Table 4.5: SHARE OF MANUFACTURED(z) EXPORTS IN TOTAL EXPORTS

LDC DC World

1966 18.4 71.6 60.0 1970 23.9 75.4 64.8 1975 17.2 75.2 59.5 1978 23.0 77.0 62.5 1980 20.0 74.6 57.3

Source: C. Leechor, et al., Structural Changes in World Industry, op. cit., - 55 -

Over time, the contribution of labor intensive products declined from 86X of LDC exports to 66Z. In fact, closer examination shows that machinery and transport equipment accounted for 42Z of the growth and their share rose from 202 in the late sixties to 29Z during 1974-80. Other important items were chemicals whose contribution in the seventies equalled 121, clothing which registered a 212 p.a. increase and iron and steel products that grew 22Z p.a. Another interestingdevelopment over the 1966-80 period was the faster expansion of intra-LDC trade in manufacturesas compared to the trade between the industrial economies and the LDCs, as a consequence of which the former took 70X of LDCs' manufactured exports in the mid sixties and 601 in 1980 (see Table 4.6). There was a pause in export growth in the early eighties, followed by a spurt during 1983-84. In 1983 alone, industrial countries' exports rose 71 by volume after growing just 1.51 in 1982.

Table 4.6: SHARE OF DEVELOPED MARKET ECONOMIES (DME) IN MANUFACTUREDEXPORTS OF LDCs (US$ million)

To To Share of exports Year DC World to DC (Z)

1966 4,825 6,916 69.8 968 6,330 8,873 71.3 1970 8,993 13,143 68.4 1972 11,590 17,536 66.1 1974 24,989 38,158 65.5 1976 31,364 47,747 65.7 1978 45,154 69,606 64.9 1980 66,556 111,564 59.7

Source: C. Leechor, et al., Structural Changes in World Industry, op. cit. Table 13.

4.20 Judging by these trends, the expansion of manufactured exports from LDCs has been high and relatively stable for two decades in spite of the cyclical ups and downs in the OECD economies, because competitive, relatively labor intensive products from lower income nations have been effective in penetratingwestern moarketsin good times as well as bad. Although developing countries have been slow to wean themselves away from the industrialized world, their trade with each other is no longer derisory and has come to serve as a launching ground for the more capital and skill intensive exports. In short, the message for prospective exporters that we can dredge from the past is a reassuring one: entrepreneurialenergy can yield a high pay-off if channeled into SITC categories 5 through 8. - 56 -

Table 4.7: LARGEST MANUFACTURED /a EXPORTS FROM SELECTED ASIAN COUNTRIES TO MAJOR OECD ECONOMIES /b (US$ million, ranked by 1983 value)

SITC Commodity 1975 1978 1980 1981 1982 1983

KOREA

841 Clothing 895.7 2,173.4 2,447.8 2,995.0 2,979.0 2,951.6 851 Footwear 177.1 644.1 804.2 864.4 1,038.0 1,156.7 724 Telecommunications equipment 124.7 506.0 677.2 747.2 735.0 1,044.0 729 Electrical machinery, NES 206.0 430.3 511.8 494.0 580.6 824.4 735 Ships and boats 0.2 1.6 27.0 11.0 35.5 596.5

HONG KONG

841 Clothing 1,625.5 2,860.3 3,832.2 3,921.8 3,861.2 3,972.5 894 Toys, sporting goods etc. 240.4 588.3 886.6 943.0 1,104.4 903.7 724 Telecommunications equipment 208.2 368.4 529.7 572.5 566.9 760.0 864 Watches and clocks 63.5 379.5 784.2 710.7 547.1 650.9 714 Office machines 84.0 214.3 324.3 327.5 304.3 647.8

SINGAPORE

729 Electrical machines, NES 230.4 376.2 870.4 889.8 968.3 893.5 714 Office machines 56.1 61.6 96.4 134.0 288.7 834.1 724 Telecommunications equipment 124.2 203.3 729.4 768.2 690.8 728.1 841 Clothing 81.4 153.8 305.4 308.0 308.2 312.0 722 Electrical power machinery 29.2 60.0 127.1 142.3 145.7 162.0

/a Manufactured exports are defined as SITC 5, 6, 7 and 8 minus 68. 7i Major OECD economies are USA, Japan, and EEC.

Source: World Bank Trade Data Base System.

4.21 Greater specificity as regards manufactured exports with the most promise, can be obtained by narrowing the compass of the search through past trade data so as to identify the export successes of East Asian NICs. Table 4.7 shows the five largest exports (by value) from Korea, Hong Kong and - 57 -

Singapore to the major OECD economies and Table 4.8 gives the fiy81 exports from these countries that had the highest growth during 1978-83.-

Table 4.8: FASTEST GROWING MANUFACTURED /a EXPORTSFROM SELECTED ASIAN COUNTRIES TO MAJOROECD ECONOMIES/b (US$ million, ranked by 1978-83 growth rate)

Annual annual growth SITC Commodity 1978 1980 1983 rate 1978-83

KOREA

735 Ships and boats 1.6 27.0 596.5 226.7 672 Iron & steel, primary forms 13.5 161.9 223.4 75.5 725 Domestic electric equipment 11.3 22.2 125.7 61.8 521 Coal, petroleum, etc: chemicals 11.9 42.1 93.2 50.7 673 Iron and steel shapes 13.5 38.7 61.8 35.5

HONG KONG

719 Machines, non-elec. NES 24.1 114.7 225.2 56.3 722 Electrical power machinery 69.9 132.9 281.4 32.1 714 Office machines 214.3 324.3 647.8 24.8 891 Sound recorders, producers 71.0 115.4 172.6 19.4 725 Domestic electric equipment 100.3 206.6 240.0 19.1

SINGAPORE

512 Organic chemicals 1.1 4.4 84.7 138.9 714 Office machines 60.6 96.4 834.1 69.0 891 Sound recorders, producers 22.5 59.3 116.8 39.1 725 Domestic electric equipment 29.5 68.8 106.1 29.2 821 Furniture 16.0 38.7 53.3 27.2

Note: This table includes only exports with 1983 value greater thar. $50 million.

/a Manufacturedexports are defined as SITC 5, 6, 7, 8 minus 68. 7i Major OECD economies are USA, Japan, and EEC.

Source: World Bank Trade Data Base System.

10/ Garments and textiles contributed 43% of the overall increase in the exports of all the developing countries in the East Asia region during 1980-84. China and Korea benefitted most. China, which accounted for only 2Z of world exports in 1978 had raised its share to 8% in 1984 and became after Korea, the second largest exporter of garments. - 58 -

Interestinglyenough there is considerableoverlap among the top exports. Telecommunicationsequipment and clothing are common to all three countries. Office machines are shared by Hong Kong and Singapore; electrical machinery by Singapore and Korea. Then there are items such as ships, toys, footwear, and electric power machinery which figure prominently in the exports of a single country. Traditional light manufactures such as textiles, clothing and toys are conspicuouslyabsent from the faster growing commodities. Instead, electronic equipment, electrical and nonelectricalmachinery, transport equipment and metal products are the items that have turned in the best growth performance. In a few of the East Asian NICs, electrical and electronic goods taken together, were the largest exports in 1984, finally outdistancing such die- hards as yarn and clothing. None of these economies has been able to uphold the potential shown by the chemicals industry in earlier years. Both in terms of manufacturing value added and exports, chemicals vied with machinery and metal products for first place. Although it remains a technologicallydynamic industry the comparative advantage in producing bulk chemicals such as ethy- lene and polypropoleneis moving into the hands of the major oil producers, while the large multinational companies seem to have consolidated,even more, their monopoly over technologicaladvances.

4.22 Thus, a second and more particularisticframe of past trade patterns indicates that chemicals, one of the recent industrial stars, has because of rising stock prices, worldwide overcapacity in bulk chemicals, protectionist moves by the European countries and the lead taken by U.S. and German firms in the sphere of new product and process technologies, lost its eminence in the trading field. It is likely to become a preserve of oil rich nations and advanced industrial economies. Numerically controlled machine tools, computer directed machining facilities and manufacturing systems and industrial robots, where the trading possibilities remain very large, seem to be securely in the hands of a small number of Japanese and American companies. Entry barriers related to the high research, marketing and capital costs of an efficient sized operation and the necessity of establishingan effective service network have prevented the European machinery producers from moving into this market. For the NICs the problems of entry look even more insurmountable. Hence, they may encounter difficultiesin tapping the fastest growing segment of trade in machinery in the coming years. Korea is now an acknowledged force in the shipbuildingindustry and several Korean car manufactures are positioning themselves for a limited entry into the major western markets either indepen- dently or through the avenues opened by joint production arrangementswith American and Japanese manufacturers. But the world shipping glut threatens existing producers with many years of lean profits and thin order books and will certainly deter any aspirants from attempting to carve a place for themselves. The motor car industry has its own eccentric features. Entry barriers for all the usual reasons having to do with research costs, scale and marketing are extraordinarilyhigh. But in addition, this industry is ruled by impregnable oligopolies; trade with the industrial countries is subject to controls; and, automation may, in time, halve the labor costs of production, currently about 202, which are the source of potential competitiveness for the developing economies.

4.23 Among the rapidly growing manufactured exports of the seventies and early eighties, those that seem capable of holding their pace are items like - 59 - electricalmachinery, the simplermachine tools, electronic subassemblies, electronicparts, sportinggoods and possibly,office machines. But there can be no doubt that in each of these productlines, old NICs and the proto NICs will be ezposedto sharpercompetition from new producersand assemblersof machineryand electronicgoods among the other LDCs and uncertaintiesposed by technologicaland market linkedchanges in the industrialeconomies. Table 4.9: MALAYSIA: MERCHANDISEEXPORTS (K$ million,f.o.b)

Averageannual growthrate 1975 1980 1984 1975-80 1980-84

All exports 9,231 28,171 38,654 25.0 8.2 Manufactured 1,978 6,231 12,208 25.8 18.3 Petroleum& Tin 1,933 9,214 9,899 36.7 1.8 Agricultural/a 4,406 10,928 11,770 19.9 1.9 Other /b 914 1,798 4,777 14.5 27.7

Shareof Total Ezports All exports 100.0 100.0 100.0 Manufactured 21.4 22.1 31.6 Petroleum& tin 20.9 32.7 25.6 Agricultural/a 47.7 38.8 30.4 Others/b 9.9 6.4 12.4

/a Agriculturalexports include rubber, timber and logs, and palm oil. 7T Obtainedas residual.

Source: Ministryof Finance,Economic Report 1984-85.

Malaysia'sExport Trade

4.24 What can Malaysia'spast exportrecord reveal about the country's preparednessfor a largerrole in the market for manufacturedexports? It is clear from Table 4.9 that manufacturedexports have performedvery creditably in the eighties,albeit from a very low base, after growingat the average rate for total exportsduring 1975-80. Their sharehas also climbedfrom 22% in 1980 to almost32Z in 1984. The largestmarket for Malaysia'sexports is Singapore(see Table 4.10) which takes a sizeablepercentage of her petroleum, tin and palm oil exportsfor furtherprocessing, but absorbslittle by way of manufactures. Between them, the industrial countries are the destination for about half of all exportsand the bulk of manufactures.Of the five largest manufacturedexports to Japan, the EEC and the U.S., four were items that also rank high in the trade of the East Asian NICs, viz. electrical machinery, telecommunicationsequipment, clothing and office machines (see Table 4.11). Only veneers and plywood, an offshoot of Malaysia's timber production, differ- enatiateher from the other four. The same story is true if one looks at growth rates. Office machines leads the way, followed by the others. - 60 -

Table 4.10: MALAYSIA'S EXPORTS BY DESTINATION

Value (US$ mil) Share (Z) Importer 1980 1981 1982 1983 1980 1981 1982 1983

Singapore 2,480 2,683 3,005 3,226 19.1 22.8 25.0 22.8 USA 2,119 1,538 1,399 1,845 16.4 13.1 11.6 13.1 Japan 2,958 2,489 2,449 2,737 22.8 21.1 20.3 19.4 EEC 2,193 1,792 1,791 2,012 16.9 15.2 14.9 14.2 Rest of world 3,210 3,271 3,400 4,315 24.8 27.8 28.2 30.5

World total 12,960 11,773 12,044 14,135 100.0 100.0 100.0 100.0

Memo: Industrial countries 7,712 6,239 6,055 7,034 59.5 53.0 50.3 49.8

Source: IMF, Direction of Trade Statistics.

Table 4.11: MALAYSIA: LARGEST MANUFACTURED /a EXPORTS TO MAJOR OECD ECONOMIES /b (USS million, ranked by 1983 value)

Average annual growth SITC Commodity 1975 1978 1980 1983 rate 1978-83

729 Electrical machinery, NES 201.7 583.8 1,081.8 1,513.4 21.0

724 Telecommunications equipment 16.2 47.8 111.4 217.0 35.3

841 Clothing 28.7 84.6 136.3 183.9 16.8

631 Veneers and plywood 63.1 96.3 94.4 83.1 -2.9

714 Office machines 32.9 1.9 2.8 39.0 82.8

/a Manufacturedexports are defined as SITC 5, 6, 7 and 8 minus 68. 7i Major OECD economies are USA, Japan and EEC.

Source: World Bank Trade Data Base System. - 61 -

4.25 The most visible difference between Malaysia and the NICs is in the proportion of manufactured exports in the total. On probing further, certain other points of difference can be detected. First, and most obvious is that in shared export categories, Malaysia exports smaller volumes of telecommunications equipment, clothing and office machines, than her newly industrialized neighbours. Second, and although this is a difficult distinction to make, more of Malaysia's manufactured exports are produced either by subsidiariesof MNCs or by firms in which there is foreign involvement. Third, less evidence can be found that the assembly of clothing, electricalequipment and electronic parts has spilled over into local manufacture of inputs. That is to say, the deepening of the industrial system has progressed farther and, in two cases, much further in the NICs. Fourth, a related point, indigenous entrepreneurial activity is on a smaller scale and less attracted to manufacturing. Finally, while it is apparent that small producers in the NICs, especially in Hong Kong, devote little to R&D, Malaysian companies are conspicuous in their reticence to spend on research.

4.26 Compared to the East Asian DICs, Malaysia's exports of not just manufactures, but also primary products are less narrowly directed to a few countries. This could have affected export growth in the very recent past, but as a longer term strategy it provides the diversificationwhich may become an important asset in a fractionatedworld trading environment. The shares of Malaysia's various trading partners are shown in Table 4.12; it gives a sense of the country's dispersed trading contacts and the low concentration ratios for three of the six items.

4.27 Just by looking at the mix of exports, there is little ground for believing that Malaysia is specializing in products shunned by the successful NICs. On the contrary the country seems to be very much in the thick of things. But doubts remain as to Malaysia's capacity to fully exploit the developmental gains from its current industrial fold and therefore, the indigenous industrial sector's ability to foresee and react autonomously to future export possibilities,which has been the basis for self-sustainedgrowth in the NICs (see Chapter 1).

InternationalTrading Environment

4.28 One story is narrated by past statistics, another can be guessed from the intense trade negotiations in progress, within and between industrial economies. Urless these two can be stitched together the future of manufactured exports -&nnot be confidently read out of historical time series and must remain at the level of vague conjecture. It is a commonplace in the literature on internationaltrade that the complex web of trade we have today was catalysed into existence by a series of trade negotiations - Dillon, Kennedy, Tokyo - that levelled the trade barriers which had risen in earlier, economically troubled decades. After the Tokyo round, as can be seen from Table 4.13, the average tariff rates in the advanced countries were lowered by between 15 and 30Z to an average of about 4.0Z. In terms of import weighted tariff averages on manufactures, the cuts were quite drastic (Table 4.14) and remained significant only on textiles and clothing and finished items in the leather, footwear, rubber and travel goods category. - 62 -

Table 4.12: MALAYSIA: DIRECTION OF MAJOR EXPORTS (X share)

1980 1982 1984

Petroleum /a Singapore 21.3 46.8 33.6 Japan 42.7 27.7 29.6 Thailand 3.2 11.1 8.8 USA 27.6 3.6 0.6 Share of top three importers 91.6 85.6 72.0 Palm Oil /b India 19.3 15.4 21.3 Singapore 28.3 20.1 26.0 Netherlands 7.1 6.8 5.6 Japan 6.7 5.9 6.0 USA 5.0 3.5 3.5 Share of top three importers 54.7 42.3 53.3 Rubber Ingapore 25.9 21.4 13.6 USA 7.6 10.9 10.1 USSR 6.8 6.1 5.8 China 5.9 5.0 6.9 Share of top three importers 40.3 38.4 30.6 Tin lNetherlands 32.5 53.8 30.1 Japan 26.2 26.5 49.2 USA 15.2 1.5 0.1 Share of top three importers 73.9 81.8 79.4 -ssanLogss Japan 67.3 62.9 64.6 Korea 11.6 17.2 14.4 Other East Asian economies 13.4 13.0 14.9 Share of top three importers 92.3 93.1 93.9 Sawn Timber Netherlands 23.9 23.3 23.3 Singapore 20.6 20.6 18.6 Belgium 4.5 5.9 6.8 Thailand 3.1 5.3 5.2 West Germany 5.7 5.0 4.1 Australia 5.0 4.3 6.9 Share of top three importers 50.2 49.8 48.8

/a Crude petroleum. 75 Crude and processed palm oil. Source: Ministry of Finance, Economic Report, 1985/86, Table 3.3. - 63 -

Table 4.13: AVERAGE PRE- AND POST-TOKYO ROUND NOMINAL TARIFF PROTECTION IN TEN DEVELOPED MARKETS

Average tariff rate on all imports (Z) Pre- Post- Importers Tokyo Tokyo Reduction

EEC 3.0 2.4 20.0 USA 4.3 2.9 32.6 Sweden 4.8 3.8 20.8 Norway 5.6 4.4 21.4 Finland 6.0 5.1 15.0 Austria 12.7 10.1 20.5 Japan 7.0 5.8 17.1 Canada 5.5 4.0 27.3 Switzerland 3.9 3.3 15.4 New Zealand 14.3 13.0 9.1

Total 4.6 3.6 21.7

Note: Pre- and Post-Tokyo Round tariff rates computed from data recorded on UNCTAD-CATT computerizedtrade and tariff tapes. The averages shown in this table are based on tariff rates actually facing the individual exporting countries (i.e. most-favored nation, generalized system of preference, or general tariff).

Source: A. Olechowski and A.J. Yeats, Implicationsof the Tokyo Round for East-West Trade Relations, UNCTAD Reprint series No. 27, 1982, Table 1. - 64 -

Table 4.14: PRE- AND POST-TOKYO ROUND SECTORAL TARIFF AVERAGES FOR THE DEVELOPED COUNTRIES

Import-veighted averages Simple averages Pre- Post- x Change Pre- Post- Z Change Tokyo Tokyo Tokyo Tokyo

Textiles and clothing Raw materials 1.1 0.8 25 3.7 2.9 21 Semi-manufactures 14.7 11.5 22 13.7 9.6 30 Finished manufactures 20.6 16.7 19 17.6 11.8 33

Leather, footwear, rubber and travel goods Raw materials 0.2 0.0 80 2.0 1.0 50 Semi-manufactures 6.8 4.4 35 6.9 4.5 35 Finished manufactures 11.5 10.2 11 14.4 10.2 29

Wood, pulp, paper and furniture Raw materials 0.4 0.2 54 1.3 0.7 46 Semi-manufactures 3.1 1.9 38 6.3 3.7 41 Finished manufactures 7.1 4.2 41 8.6 5.1 41

Base metals Raw materials 0.3 0.0 82 0.5 0.2 61 Semi-manufactures 4.3 3.2 26 7.0 4.6 34 Finished manufactures 9.4 5.9 37 10.2 6.1 40

Chemicals Semi-manufactures 7.8 5.0 36 10.2 6.2 39 Finished manufactures 10.5 6.0 43 11.1 6.2 44

Non-electrical machinery Finished manufactures 7.7 4.1 47 8.1 4.4 46

Electrical machinery Finished manufactures 9.2 6.1 34 13.2 5.0 42

Transport equipment Finished manufactures 7.8 5.0 36 10.0 6.5 35

Source: Bela Balassa and Carol Balassa, Industrial Protection in the Developed Countries, The World Economy, Vol. 7, No. 2, June 1984.

4.29 Most of the changes agreed at that time have been implemented. Now the developed countries and particularly tne U.S. have realized the scarcity of new industrial opportunities and to safeguard mature industries they are beginning to multiply nontariff trade restrictions (NTBs) thereby introducing - 65 - a new note into internationaltrade relations. So far, US sanctionsand penaltieshave been largelycircumvented by foreignsuppliers and have rather perversely,added to the quasi rents ezportersearn in the US market (an examplebeing cars). This explainshow the US was the destinationof nearly half the sanufacturedgoods sold abroadby LDCs in spite of all that has been said and done in terms of regulatingUS importsover the last decade. What Malaysia'sexporters have to contendwith as regardstariff and nontariff barriersis shown in Tables4.15 and 4.16. Apart from footwear,textiles and clothing,the levieson other items are light or nonezistentand not significant impediments.The list of exportsthat feel the edge of NTBs, is longer and in particularinstances these can bite deeper. An exampleis the limitationon the exportof cannedpineapples to Japan.

4.30 The latestmoves by the industrialcountries, following more than two years of at times acrimoniousdiscussion, seem to be of a differentorder and in the wingr is legislationthat may forcea taperingof futureexport growthfrom the developingcountries. Currently,27 categoriesof imports into Japan are subjectto quotas,23 to the US, and 4 to the UK. About 22Z of total importsby the OECD countriesare affectedby nontariffbarriers, but in the US the level is closerto 45% and it is 36Z for France. Japan,which takes just 8Z of LDCs' manufacturedexports also has a host of testing requirements,cultural barriers, inefficiencies in the distributionsystem and relationshipsbetween producers and sellers,ihst make it difficultfor foreign goods to penetratethe domesticeconomy. What is so ominousabout the protectionistmoves and countermovesis that even the Japanese,with a worldwide trade surplusof $122 billionin 1984 and substantialsurpluses with virtuallyeach v.ie of the East Asian countries,have been sufficiently disturbedby the growth in importsof yarn, fabrics,and knitwearfrom China, Pakistan,South Korea and other East Asian economies,to considerapplying the MFA for the first time and have exemptedsynthetic fibers and clothingfrom the Tokyo round related,tariff reductions in July 1985.

4.31 Thirtyyears of economicdiplomacy guided by the dictatesof free trade and comparativeadvantage has embeddedthe industrialcountries in trade and monetaryregimes that will not dissolveovernight. There are treatiesand obligationsto be observedand beyondthat, a real beliefon the part of economists,statesmen and consumersalike, as to the rightnessof the incremental changesthat have producedthe tradingenvironment we now have. But the advancedcountries are findingthat the industrialbase of their prosperirvis being erodedand no other s_.ctoroffers the combinationof employment,linkages, productivitygrowth and value added, to adequatelysubstitute for it. The world,therefore, appears headed towardsa long seasonof managedtrade. Treatiesentered into by the OECD countriesmight sustaina liberalcore to world trade;however, the NICs with their limitedpower to retaliate,will be more susceptibleto such management,both throughrestrictions on direct exportsand the large amount of intra-firmtrade. Already,close to 25-30%of OECD trade is "managed".another 10% could be includedif intra-firmmovements are accountedfor. This proportioncould grow, with a situationarising where

11/ See for instance,K. Ohmae, Triad Power,Free Press,1985, Chapter8. Table 4.15: ACTUAL LEVEL OF TARIFFS FACED BY MALAYSIAN IMPORTS /a

U.S.A. E.E.C. Japan Pre- Post- Reduc- Pre- Post- Reduc- Pre- Post- Reduc- SITC Commodity Tokyo Tokyo tion Tokyo Tokyo tion Tokyo Tokyo tion

851 Footwear 23.1 23.1 - - - - 10.0 10.0 - 653 Woven textiles noncotton 21.0 20.6 1.9 15.7 10.8 31.2 5.0 5.0 - 841 Clothing 19.7 9.8 50.3 1.8 1.3 27.8 8.9 7.R 12.4 651 Textile yarn and thread 16.3 12.0 26.4 10.8 8.8 1.5 6.9 5.7 17.4 652 Cotton fabrics, woven 11.0 7.9 28.2 0.1 O.l - 3.0 3.0 - 729 Electrical machinery, NES 5.8 4.0 31.0 n.4 0.4 - 4.5 1.6 64.4 621 Materials of rubber 4.6 - 100.0 ------051-055 Fresh nnd preserved fruits & vegetables 2.9 1.0 65.5 14.7 14.7 - 19.7 16.R 14.7 631 Veneers, plywood, etc. 2.7 2.6 3.7 12.4 9.6 22.6 0.6 n.6 - 722 Electric power machine, switch- gear O.R 0.8 - - - - 5.4 2.6 51.9 632 Wood manufactures 0.1 - 100.0 3.9 2.3 41.0 10.0 5.7 43.0 821 Furniture 0.1 0.1 - - - - 10.1 4.8 52.5 741 Office maclines - - - 13.7 11.7 14.6 - - - 241-243 Wood and Cork - - - 0.1 0.1 - 0.1 0.1 - 725 Domestic electric equipment - 0.1 +100.0 ------

/a The Post-Tokyo tariff levels reflect the situation which will prevail in 1987 when all the Tokyo Round reductions will have been implemented.

Source: IBRD. - 67 -

Table 4.16: MALAYSIA: NONTARIFFBARRIERS AFFECTING XPFORTS/a

Country Products affected Type of measure

EEC Cut flowers, flour and meal of sago and of Import licensing manioc, vegetable oils (wholly or partly hydrogenatedor solidified or hardened), footwear with outer soles of leather

Cocoa beans, sugar, timber, wood and timber Import licensingand tariff products (except of plywood), travel goods, quotas. footwear, transmissionapparatus, diodes and transistors,chairs and other furniture, umbrellas, rubber, rubber tires, tubes, tire flaps, electricalgoods including transformers, semiconductors, microcircuits, telecommunications equipment

Sugar, pineapple and other fruit and Sugar duty and agricultural vegetable juices containing added sugar duty

Plywood, footwear Quantitativerestrictions

Japan Fish Long administrativedelays and complex inspection procedures.

Pineapplesin cans or bottles containing nuantitativerestrictions added sugar

Other exports, excluding raw materials Tariff quotas, difficulties relating to announcement delays, and nonavailability of regulationsin languages other than Japanese.

United States Exports other than raw materials Tariff quotas, agricultural products subject to health and sanitary regulations

Source: S. J. Anjaria, et. al., Developmentsin InternationalTrade Policy, TMF Occasional Paper 16, November 1982, Table 7. - 68 - the increasein exportsfrom old and new NICs could come to dependon the politicaland economictolerability of importpenetration on a case by case basis. 4.32 Shouldideas on industrialstrategies patterned on the Japdnese model prevailin the West, side by side with managedtrade, they will negate the predictivepower of past trendsin exports. This is not to imply that export-ledgrowth will not be possible,but that such growthmight have to be achievedby orchestratingsmall advancesby a diffuseconglomeration of industriesrather than throughmassive gains achievedby a few "beachhead" sectors. - 69 - CHAPTERV: EXTERNALBORROWING AND CAPITALFLOWS

5.01 Exportsmust grow at a rate equal to the interestpayable on foreign borrowingsfor the debt serviceratio (DSR) to be held constant,assuming that the importelasticity with respectto GNP is unity,which is approximately what it is for Malaysia. Where the objectiveis to reducethe DSR, exports must run ahead of interestrates. Hence any possibilityof world trade slowing down is a matterof seriousconcern to countriesthat have acquiredlarge debts. Malaysia'sdebt profileis outlinedin Table 5.1. Total MLT debt in 1985 stoodat US$16.5billion, a 72 increaseover 1984. The shareof short term borrowingswhich is an index of vulnerabilitywas 142 in 1985, or below the averagefor developingcountries. Attractiverates on 20-30 year floating rate notes enabledMalaysia to retirea few expensiveloans contractedin the early eightiesand to improvethe maturitystructure of its externaldebt therebyavoiding a steep increasein amortizationpayments in the mid-eighties.However, the poor performanceof merchandiseexports pushed the DSR up by 3 pointsto 15.3. As foreignexchange earnings in 1986 will be reducedstill furtherbecause of unfavorablecommodity prices, the DSR will rise yet more, but it shouldstart to declinein the late eighties. With its exportand growth prospectsrather badly tarnished,the terms on which Malaysiaraises funds on internationalmarkets might be steeperthan in the recentpast, but much will depy2fon the market'sability to defusethe problemsof the major debtors -

12/ For furtherdiscussion and comparativeinformation on debt profiles,see Malaysia: DevelopmentStrategies and their Financing,World Bank, Report No. 5560-MA,September 1985, Chapter2. - 70 -

Table 5.1: STRUCTURE AND LEVEL OF TOTAL FOREIGN DEBT OUTSTANDING AND DISBURSED (US$ million)

1981 1982 1983 1984 1985

Total OutstandingDebt 8 478 12 184 16 633 18 044 19 268 Medium- and Long-Term 6,854 10 461 13,606 15,513 16,583 Public and publicly guaranteed 5,062 7,269 9,928 11,527 12,445 By lender Bilateral 854 808 983 1,803 1,737 Multilateral 873 982 1,091 1,150 1,144 Financial institutions 3,049 5,112 7,141 7,928 8,864 Suppliers' credits 58 82 359 356 582 IMF 227 285 354 290 118 By debtor Federal Government 3,692 5,668 7,582 8,597 8,899 Other /a 1,370 1,601 2,347 2,930 3,546 Private nonguaranteed 1,792 3,192 3,678 3,986 4,138 Short term /b 1,624 1,723 3,027 2,531 2,685 Total debt servicing 1,110 1,454 1,763 29394 29733 Publicly guaranteed 975 ****J*803130Z 1,7604 Amortization 17 1 383 524 Federal government 86 209 215 280 348 Other /a 92 101 85 103 176 Interest payments 356 493 675 919 1,080 Federal government 277 407 535 730 807 Other /a 79 86 140 189 273 Private nonguaranteed 457 523 607 888 904 Amortization TM 3YTTO 3aY 5 Interest payments 166 187 248 299 314 Short term 119 128 181 204 224 Ratio to GNP (Z) Total Outstanding Debt 35.5 47.6 58.9 56.9 65.7 Federal Government 147E E77U 2771ET 27587T Other publicly guaranteed /a 5.5 6.2 8.4 9.6 11.9 Private sector 7.2 12.4 13.1 13.0 13.9 Debt Service Ratio (Z) /b 8.0 10.2 10.8 12.5 15.3 Federal government 276 -CW3 4.6 -373 -s67 Other publicly guaranteed /a 1.2 1.3 1.4 1.5 2.5 Private sector 3.3 3.7 3.7 4.6 5.0 Memorandum item: Prepayments (in million of US dollars) - - - 173 2,206 Ratio to current account receipts - - - 0.9 5.0

/a Mainly non-financialpublic enterprises. 7b Ratio of debt service to exports of goods and services. Source: Data provided by the Malaysian authorities. - 71 -

InternationalFinancial Markets

5.02 Between 1983 and 1984 the outstanding debt of the developing countries rose 6X to $895 billion, but the average interest rate, at 8%, was below that paid in 1982 (9.21), as was the proportion of short-termdebt. Conditions for reschedulingswere easier in 1984, maturities and grace periods longer and the mark-up over Libor ranging between 1.5Z and 2% in 1983. In 1985, the average spread on syndicated loans fell to 60 basis points from a peak of 115 two years earlier. This easing of terms, aided no doubt, by the substantiallyimprcved trade balances of major debtors occurred in spite of the huge demands placed by the U.S. economy on internationalcredit. The 1983-84 recove.rycame none too soon. Adjustment measures were seen to yield immediate and significant results. Governments could show that the sacrifices imposed were paying off and the banks saw a reassuring drop in repudiation risks. Were it not for the collapse of oil prices in 1985-86, it would be possible to claim that the worst stage of the debt problem had been left behind. Unfortunately,oil exporters, some of whom also fill the ranks of major debtors, are faced with a squeeze at an awkward moment in their adjustment schedules. The misfortune of oil producers cheapens the import bill of the non-oil economies, developing or developed, but the developing ones stand to lose more from the falling exports to OECD countries than they will gain from the expected acceleration of business activity. Therefore, if prudence in debt management was the watchword for 1984-85 it is freighted with more urgency today. The world lacks the buffer provided by large savings surpluses and net transfers to the LDCs are becoming negative. It is possible that long before insolvency is reached, political events co-uldspark another spate of crises. But even if the banks, that are currently flush with cash, supported by western governments can once again paper over the problem, credit could become tif .-er and dearer, especially for a country whose share of traded GNP is far above the average and primary commodities comprise the bulk of exports.

Equity Purchases and Capital Flows

5.03 Malaysia's rising debt burden projected over the coming years is a cause for worry. Measures that would reduce resource imbalances are discussed in Chapter 2 and the scope for increasingexports is Analyzed in chapters 4 and 7. This does not quite exhaust the menu of short-run choices. From the national accounts it is apparent that between 18 and 20% of gross domestic savings leaves the country as a result of interest payments, dividends, fees, repatriatedprofits and unrecorded capital outflows. When interest payments are netted out, about 3.4% of GNP is accounted for by the rest. A reduction in these items would narrow the current account deficit and reduce financing requirements.

5.04 Since the mid-seventies,the government has, through PNB, PERNAS and other agencies purchased equity in foreign firms operating in Malaysia so as to raise the Bumiputra share of corporate wealth. It would appear that foreignerswho are induced to part with their assets do not reinvest the funds they receive in the country, and other businesses discouraged by the threat of equity restructuringprefer to hold foreign assets. As data that would permit a direct test of this hypothesis were unavailable, some indirect indicators - 72 -

must be used. From Table 5.2 it can be seen that the equity share of foreign residents fell sharply over the period 1980-83, a time when the trust agencies are known to have ben acquiring majority share holdings in foreign businesses operating in Malaysia. Table 6.1 indicates that this may have influenced the flow of remittances. Considering that great strides have been made over the past five years in transferring foreign equity into Bumiputra trusts, a modification of the restructuringpolicy would cempreas the payents deficit and bring down external borrowing requirements.

Table 5.2: OUNERSHIPOF CORPORATEASSETS IN MALAYSIA (Z)

Annual Average growth REP target rate 1971 1975 1980 1985 1990 /a 1975-80 1980-85

Malaysian Residents 38.3 46.7 57.1 74.5 70.0 21.3 25.1

Bumiputeraindividual and trust agencies 4.3 9.2 12.5 17.8 30.0 23.8 27.3 Bumiputeraindividuals 2.6 3.6 5.8 10.1 5.2 27.9 32.5 Trust agencies 1.7 5.6 6.7 7.7 24.8 20.8 22.0 Other Malaysian residents 34.0 37.5 44.6 56.7 40.0 20.6 24.5

Foreign Residents 61.7 53.3 42.9 25.5 30.0 11.6 6.9 Share in Malaysian Companies 32.9 31.3 24.0 14.8 19.5 10.5 7.6 Met assets of local branches 28.8 22.0 18.9 10.7 10.5 13.1 5.9

Total 100.0 100.0 100.0 100.0 100.0 16.5 18.6

/a As projected in Fourth Malaysia Plan (1981-85),p. 176.

Source: StatisticalAnnex, Table 9.2.

RegulatingCapital Movements

5.05 Analysisof the trade and external payments strategiesfollowed by Latin American and some East Asian NICs during tba seventies and eighties has put empiricalweight behind two propositionsthat are germane to this u:scus- sion. First, a policy of liberalizationcalculated to stimulate industrial developmentand exports should begin ,ichtraded goods and only later move to the financial sector. A prematureliberalization of capital flows as took place in Chile, for example, can lead to interestrate and credit conditions prejudicialto the growth of industry,aside from facilitatingcapital outflow. Second, the countries whose debt problems were greatly exacerbatedby capital flight, such as Argentina, Venezuela and Mexico, shared certain - 73 - features in coumon. All suffered from overvalued real effective exchange rates, a history of financial instabilityand fluctuating inflation, large public deficits, interest rates that diverged from those offered abroad and, most significantly,these countries did not impose controls on capital. Brazil and Korea, both of which had to cope with many of these problems managed to avert a serious drain of capital through measures that, in spite of many deficiencies, still exerted some check.

5.06 The phenomenon of unrecorded capital movements is a much debated issue in Malaysia. Well-founded statistics are unavailable but the large errors and omissions item in the balance of payments (see Table 5.3) is suggestive and supports the widespread belief that capital is moving out of the country. While a financial sector closely linked to overseas markets and, most significantly that of Singapore, is an important economic plus, there can be degrees of openess depending upon the costs from capital movements and the gains in financial sophisticationand credit flows arising from integration with other financial centers. If raising taxes is politically or administra- tively infeasible, national savings continue falling and deep cuts in government axpendituresare damaging for growth, then foreign borrowing might be most readily minimized by curtailing or even suspending the program of acquiring foreign assets in Malaysia, keeping a closer watch on trading in the joint Malaysian-Singaporestock market and at the very least, installing the machinery, that exists in most developing countries, for registering and monitoring capital movements in a systematic fashion. The point to be noted here is t:hat Malaysia, unlike Chile in the seventies, is not faced with the choice of liberalizing;it already has an open capital account. Whether it can live with the consequencesand conduct an effective industrial and macro-policy still has to be fully established.

Table 5.3: ERRORS AND OMISSIONS IN THE BALANCE OF PAYMENTS

1979 1980 1981 1982 1983 1984 1985

Net Errors & Omissions -1,704 -240 -845 -1,520 -976 -2,159 -300 Z of GNP 3.8 0.5 1.5 2.5 1.5 2.9 0.4

Source: Statistical Annex, Tables 2.1 and 4.1. - 74 -

CHAPTER VI: DIRECT FOREIGN INVESTMENTAND ECONOMIC MODERNIZATION

6.01 Accounts of modernization in the East Asian NICs that fasten on how the governments'support for trade oriented industries served to harness the societies' confucian ethics, high savings propensitiesanti entrepreneurial resourcefulnessto this transcendentpurpose, often miss the presence of a key player, the MNC. The ascending development curve followed by these economies cannot be understood until the MNC connection has been explicated. Barring Korea, each of the others has depended extensively upon foreign companies to serve as a conduit for capital and technology and as a vehicle for gaining foreign market access for their goods. Both sides have profited from this pact, but by accommodating themselves to MNC needs, these countries have imparted a certain cast to their development. In a sense, theirs has been a complementary form of industrialization,heavily concentratedin assembling garments, machinery, electronics, footwear, leather goods, consumer durables and toys. Such industries have permitted the NICs to optimally utilize a large force of disciplined and educated, but compared to the U.S., relatively low paid workers. Using machines and in many cases parts and components imported from industrial countries, the East Asian economies have made a success of producing goods with moderate to low value-added, that by virtue of a labor content ranging from 20 to 50%, are less profitable to manufacture in the West. The MNCs are either directly, or as trading middlemen, indirectly involved in a large part of these operations which have materially aided the development of East Asian industry, enabled Western firms to export machinery and intermediategoods, while consumers in the advanced economies have benefited from low priced imports. A certain equilibrium in which gains and losses were balanced is now in danger of being upset by the great success the NICs have had at exploiting backward linkages from export industries into plant machinery, metal products and many of the intermediateinputs needed by assembly operations. For example, some of the East Asian economies are now important exporters of textile machinery.

6.02 Japan continues to sell a large volume of capital goods in the area and still enjoys the induced benefits of export growth from East Asia, but the U.S. and the European countries now run adverse trade balances, and the political, if not the economic pressures, these have unleashed cannot be ignored by the MNCs, even though their interests are not necessarily congruent with those of governments and labor in western economies.

Direct Foreign Investment (DFI) in Malaysia

6.03 For over 15 years, between 9% and 15% of gross capital accumulation in Malaysia has come from foreign investors. The share of manufacturing investment is much bigger and overseas capital settling largely, but not exclusively, in the Free Trade Zones, has given rise to a major assembly industry for electronic products and significantlyaugmented the capacity of the textiles subsector; in 1984, these two industries accounted for over 60% of manufacturedexports. Foreign investmenthas also been attracted into mineral production as well as hotel and banking services, and foreigners still hold equity in rubber and oil palm plantations. More so than in any of the other South-east Asian economies, Malaysia has relied upon MNCs to supplement - 75 - its resources,to assistin the exploitationof naturalresources and to lead the way in manufacturingand certainservices. Hence,the evidenceof complementarydevelopment is more insistent. Unlikethe East Asian NICs, Malaysiaremains at the finalassembly stage, supplying labor to create finishedproducts using inputs and machinerybrought in by the MNCs from abroad.

6.04 During the FourthPlan period,some initialmoves were made by the publicsector and privateentrepreneurs to deepenthe industrialbase and meet more of the demandsgenerated by linkagesfrom the exportsector locally. This drive is to continueover the courseof the Fifth Plan, mainly through the initiativeof privatebusinessmen, but the governmentstill looksupon DFI as an essentialplank of its developmentstrategy. As in the past,DFI should suprortthe growthof manufacturedexports and in the processprovide employmentthat will be sorelyneeded. It is hoped that MNCs will becomemore activeat transferringtechnology and in satisfyingtheir material requirementsby using Malaysiansubcontractors. Foreign companies are also viewedas the answerto the problemsof marketingand access to overseas buyers,faced by developingcountries. Finally,injections of equitycapital are thoughtto be a relativelypainless and inexpensiveway of accommodating Malaysia'ssubstantial projected requirements of foreignresources.

6.05 Malaysia'scombination of duty free importprivileges, tax holidays and other incentivesis no less generousthan the packagebeing offered elsewherein East Asia, but to counterrecent moves by other countriesto enhAncetheir allureas investmentplatforms, the governmenthas raisedthe limitof 30% equityholding by foreigners,in non-FTZfirms, to 50X and more dependingon the type of investment.This and othermeasures being planned, to woo MNCs will, it is hoped,allow Malaysiato speed along the path taken by the NICs.

6.06 An analysisof the nature and importanceof DFI in Malaysiahas to contendwith a scantydata base,updated with a lag and the quirkinessarising from a samplebiased towards smaller firms. Nonethelessenough informationis at hand for a start to be made. Perhapsthe most importantfactor is the steadydecline in the growthof DFI betweenthe early 70s and the first half of this decade(see Table 6.1). Since 1982, in fact,DFI has declinedin each year. When the inflowsare rangedagainst profit and dividendsrepatriated, for most years the net flow is significantlynegative and the gap is growing largeras repatriatedearnings have remainedstable at close to 6.5% of CDP while investmenthas fluctuatedand in recentyears, followed a descending spiral. If corporateasset holdingsby foreigners(see Table 5.2) is used as a proxy for the stockof foreigncapital, then in 1983 the fixed charge representedby dividendsand profitscome to 18.1% (i.e. M$3.0 billionon M$16.7billion). This is well above the cost of borrowingthrough other avenuesand puts a very differentcomplexion on the attractivenessof DFT. 6.07 As was alludedto above, foreigninvestment in the manufacturing sectorhas caken severalforms. The majorityof firms in the country's 10 Free Trade Zonesare whollyowned subsidiaries.The LicensedManufacturing Warehouses(LMWs) 5 that have the privilegesaccorded to the FTZs but are geo- graphicallyscattered, also fall into this category. There is, however,a Table 6.1: AGGREGATED&RECT FOREIGN INVESTMENTSTATISTICS (H$ million)

Ratesof rovth 191- 190- I91l- 1971 1975 1979 1980 1981 1982 1983 1984 1985 P 75 80 8S

A. Profit and dividendpaymentm /s 543.0 890.0 2,485.4 2,589.6 2,529.4 2,627.3 3,014.9 3,306.8 3,604.0 10.4 15.6 7.3 B. Direct foreign investment/a 306.0 862.0 1,255.4 2,034.3 2,915.2 3,194.5 2,893.3 2,301.4 2,259.0 23.0 16.0 -5.0 C. Net flow -237.0 -28.0 -1,230.0 -555.3 385.8 567.2 -121.6 -1,005.4 -1,345.0 - - - Ratio.(Z) 4.2 4.0 5.5 5.0 4.5 4.3 4.4 4.3 4.4 - - -

B/Gross Current Account Receipts 5.5 8.1 4.6 6.3 9.1 9.5 7.6 5.2 5.0 - - -

B/Net Capital Account Receipts 57.5 63.5 - 125.4 54.7 41.0 37.5 56.8 37.2 - - -

B/Grois Investment 11.4 16.5 10.4 13.7 15.5 14.4 12.3 9.9 9.1 - - -

B/PrivateFixed Capital Formation 16.2 24.7 18.5 22.4 28.3 28.8 26.3 21.5 19.5 - - -

C/Gross Current Account -4.3 -0.3 -4.5 -1.7 1.2 1.7 -0.3 -2.3 -3.0 - - -

A/B 177.5 103.2 198.0 127.3 86.8 82.3 104.2 143.7 159.5 - - -

/a Includesreinvested earnings of foreign enterprises. Sources Blance of PaymentsTables provided by DOW, EPU, Bank Ne8ara Nblaysia. - 77 -

considerablevolume of DFI that is outside the enclave sectors and involves joint ventures with public and some private sector firms. Although the firms in the FTZs are wholly trade oriented, other joint ventures have less of an export bias than the average Malaysian firm. The reason for this can be traced to the objectivesof foreign investors. Unlike the situation in the East Asian NICs, the pattern of foreign participation in Malaysia is very unusual. Whereas investors from the OECD countries are preponderant elsewhere, 33Z of DFI in Malaysia has been by the NICs with Singapore in the lead (see Table 6.2). Small and medium sized firms from the NICs have invested in Malaysia to scale tariff barriers and gain a share of the local market; to obtain production cost advantages from Malaysian labor; and to make use of Malaysia's export quotas to the US and the EEC in items such as textiles, garments and footwear. Because the smaller investors are often short of funds they are liable to seek joint ventures with capital-richpublic enterprises.

6.08 Capital from the NICs does not bring much technology in its wake or for that matter an internationalbrand name and access to a worldwide marketing network. Much of it goes into the traditional, relatively labor intensive areas like food and beverages, clothing, paper and printing, metal products and leather goods. Relatively little finds its way into the principal export subsectors: electrical and electronic products and scientificand measuring instruments. In electronics,large MWCs from the US and Japan have 31% and 24Z of the fixed assets respectively. The NICs have 16% of the total, much of it in small scale consumer electronics. Japanese investors dominate the textile industry with over half of the fixed assets. Investors from the OECD countries are also prominent in food and beverage industries, tobacco, nonmetallic mineral and chemical sectors which sell -nainlyto the domestic market. Some of the chemicals, nonmetallic and rubber goods investments are a carryover from the pre-independenceperiod when tin, rubber and petroleLwn refining were a focus of foreign owned manufacturing activities. DFI in food and tobacco was motivated by the desire to scale tariffs, particularly afte; barriers were raised over the 30Z average in the mid 70s.

6.09 There are two other empirical developmentsof note: first, the capital intensity of foreign operations is higher than that of local firms; and second, the capital coefficientsare rising with the trend towards automation which has reduced the average level of employment in MIDA approved foreign ventures.

MNC Strategy and the Future of DFI

6.10 What bearing might DFI have on the industrializationof the economy in the eighties and beyond? The government projects a recovery of the capital inflow and this receives a measure of support from a study by IMF researchers which concludes that a 5Z p.a. real increase in DFI over the next five years is a realistic possibility. Whether or not a reversal of the downward trend is likely and the magnitude of the increase if it occurs, no amount of statistical legerdemaincan wring from past data. What can b- discussed are the changing strategies of the MWCs, how they affect SE Asian economies, and the net gains for Malaysia from soliciting the business of foreign companies, small and large. Table 6.2: NATIONALDISTRIR11TION OF DIRECT FOREIGNINVESTMENT /a (MN millionof fixed assets)

OECD countries/b East Asian newly Industrialized/c Other Total Japan UK US Total Singapore Hong Kong E.*A/d Other /e Total

Food manufacturing 241.3 54.6 134.2 9.2 277.1 2.7.2 49.7 0.2 159.4 677.8 Beverages and tobacco 204.7 - 161.0 29.2 153.2 152.9 0.3 - 0.1 358.0 Textilesand textileproducts 204.5 169.4 6.2 3.9 122.1 3R,2 82.9 1.0 14.0 U40.6 Leather and leather products 0.1 - 0.1 - 2,2 2,2 - - 14.8 17.1 Wood and wood products 56.6 25,7 3,2 10,7 44,7 33,0 10.3 1t4 0.6 101.9 Furniture and fixtures 5.0 2,1 - 0.5 4,6 4,6 - - - 9.6 Paper, printingand publishing 4.5 o.4 - 0.5 28.9 24,9 3.0 1.0 n.1 33.5 Chemicalsand chemicalproducts 189.4 21.4 91.3 45.9 90.9 34.5 56.3 0.1 2.1 282.4 Petroleum and coal 170.6 O.2 166.1 - 14.3 14.2 0.1 - 0.1 185.0 Rubber products 144.0 16.6 40.2 36.8 43.4 28,.5 12.4 - 6.8 194.2 Plasticproducts 21.1 18.4 1.5 0.2 11.7 9.2 1.6 0.9 1.3 34.1 Nonmetallicmineral products 200.6 68.5 81.0 1.4 145.2 142.2 1.6 1.4 82.4 42R.2 Basic metal products 76.7 37.8 0.1 0.1 86.6 77.2 0.5 8.9 4.3 167.6 Fabricatedmetal products 71.1 21.8 4.3 0.6 67.3 61.2 5.3 0.7 7.2 145.6 Machinerymanufacture 48.2 24.3 6,7 10,2 11.4 10.5 0.1 n.8 0.1 59.7 Electricaland electronic 678.3 214.9 4'.6 279.2 143.7 98.3 37.9 7.5 69.4 891.4 Transportequipment 91.1 48.0 7.7 18.8 33.3 24, 8.2 0,3 10.6 135.0 Scientificand measuringequipment 32.5 3,7 0.l 2.3 0.6 - 0,6 - - 33.1 Miscellaneous 46.1 14,6 3,2 21.3 1.1 0.9 0.l n.1 1.7 48.9 Hotel and touristcomplexes 30.9 24.2 0.8 - 119.2 85.1 34.1 - 2.6 152.7.

Total 2,517.3 766.6 755.2 473.0 1,401.5 1,069.6 305.0 24.3 377.6 4,296.4

(Z) (58.6)(17.8) (17.6)(11.0) (32.6) (24.9) (7.1) (0.5) (8.R) (100.0)

/a As of December31, 1983. 7TWAustralia, Austria, Belgium, Canada, Denmark, France, Holland, Italy, Japan, New Zealand,Norway, Sweden, Switzerland, UK, US, and the FederalRepublic of Oermany. /c Hong Kong, Singaporeand selectedother East Asian economies. 7Tr Other East Asia economics. 7i Bahamas,Brunei, India, Indonesia,Philippines, Sri Lanka,Thailand, some MiddleEastern countries and others. Source: MIDA. - 79 -

6.11 MNCs have thrivedbecause they have certain intangibleassets to offer,be they technology,brand names, managerial skills or marketingcapabi- lities,and there is an advantageto sellingthese througha multi-country organizational_y7icle as againstmaking the technologyor knowledgeavailable by othermeans.- Fallingtransport costs, the ever closerintegration of nationaleconomies, standardized manufacturing techniques and the perfection on the one hand of systemsfor coordinatingdispersed production, on the other of worldwidemarketing, has increasedthe potencyof the MNCs. Predictably, they have used these forcesto enlargetheir worldwidemarket sharesand lessenmarket uncertainty. But they have also securedtheir positionin other ways as we,i..Advertising on an internationalscale has shapedconsumer tastes,solidified a brand imageand createda stabledemand where, in the past therewas none. Entry barriersfor newcomershave been made stifferby systematicproduct differentiation whose object is to saturatethe market. A technologypolicy, partly dictated by the desireto remain -ompetitiveagainst other multinationalfirms, partly to push technologicalchange at a pace and in a directionthat would be sorelyexpensive for a new entrantto match, has consolidatedoligopolistic positions. Size has also meant that the MNCs have the financialdepth to surviveswings in the businesscycle and to counter price or productmoves by their adversaries.

6.12 Thus the appearanceof powerfuloligopolies, which between themselvesare carvingup the world marketfor a wide range of products,that are capital,technology and marketingintensive and benefitfrom high income elasticitiesof demand,is alteringthe trade environment. Items such as motorbikes,cameras, VCRs, compactdisc players,camcorders, mini and main- frame computers,industrial robots and automobiles,with their short product cyclesand close identificationto a handfulof producersare virtuallybeyond the reach of new aspirants. The channelsof trade may be wider and deeper than ever before,which in thecryis a positivedevelopment as far as new tradingnations are concerned,but some of the most desirablechannels to be in are protectivelycontrolled by MNCs. By one estimate,half of US imports representthe internaltransactions of large companies.

6.13 The manner in which the MNCs straddlethe bywaysof world trade makes industrializationbased on the large-scaleexports of manufacturesto OECD countries(the biggest,if not the fastestgrowing markets), an arduous task withoutthe connivanceof MNCs. Whetherit is the provisionof technology or capital,or marketaccess, or a brand name or even managerialknowhow, MNC participationmakes all the other exchangerate, industrialand labor marketpolicies yield results. The troubleis that many of the developing countriesneed the HNCs slightlymore than the corporationsneed their business or their labor. They are operatingin a buyers'market with a stringof

13/ Paras 6.11-6.17are basedon researchon MNC's discussedin R.E. Caves, MultinationalEnterprise and EconomicAnalysis, Cambridge University Press,1982; A.M. Rugman,ed. New Theoriesof the Multinational Enterprise,St. Martin'sPress, 1982; C.P. Kindelbergerand D.B. Andretsch,eds. The MultinationalCorporation in the 1980s,MIT Press, 1983, and C.P. Kindelberger,Multinational Excursions, MIT Press,1984. - 80 - options to choose from and the ability to arbitrage institutionalpossibi- lities and incentives in different countries.

6.14 For some years, MIC strategieshave been in a flux. Protectionism in the advanced countries and the labor saving bias of new technologieshave tilted the scales towards investment in the industrial economies. On the other hand, market growth, actual and potential, and financial attractiveness -a combination of fiscal incentives, opportunity for transfer pricing and lower operating costs-have all drawn them towards the NICs. There are many ways of interpretingcurrent events but the widely publicised moves by IBM, Toyota, Fujitsu, Komatsu and others, all suggest that the MNCs see their future lying more towards producing and selling in the industrial countries. DFI may continue to grow, but more of it might be channeled between OECD countries. The MNCs also recognize that if the exports of the NICs and the proto NICs have to surmount higher trade barriers their market growth, which was an important secondary attraction for MNCs, will be lessened.

6.15 There are limited alternativesfor a small country to develop export industries in subsectors such as consumer durables, electrical and electronic products, chemicals, transport equipment and even textiles without linking up with the MNCs, but Malaysia must also consider strategies that take into account the possibility of diminishing MNC support. There are several reasons aside from the above-mentionedshift in DFI. Malaysia's smallness makes it intrinsicallyless attractive as a future market and its wage structure is almost on par with that of the dynamic NICs. Where Thailand, Indonesia and Philippines can still lay claim to reserves of cheap labor, Malaysia has lost the edge. The advantages of political stability are partially vitiated by the policies which the government has used to restructure equity. The effect this has had on foreign investors is amply depicted in the negative capital flows shown in Table 8.1. Foreigrers' share in corporate equity has fallen from 622 in 1971 to 33Z in 1983.

6.16 Many MNCs set up operations in Halaysia when it introduced the FTZ in 1972, a novelty in those times. By the eighties most of the tariff scalers, the seekers after textile quotas, producers supplying the large domestic market for agricultural chemicals, and exporters in the electronics and garments subsectors,were already in and new capital was being funnelled into expansion of existing facilities. Jobs had been created - 70,000 in the FTZs alone - but the MNCs had not seen fit to pursue the long-term design, skill and technology transfer programs that gave rise to dense networks of subcontractorsin some of the NICs and Australia and helped these economies gain industrialmomentum. Domestic value added in Malaysia's FTZs has stagnated in the 12-15% range. This reflects the MNCs' assessment of Malaysia's potential as a market and an export platform. In addition it is evidence of their reluctance to part with technology that could impair future market control and the preference for importing parts from their home bases for reasons of quality and reliability but also because these transactions serve as a venue for transfer pricing.

6.17 In the mediumrterm, the appropriate policy for Malaysia would be to bid for all the DFI it can attract into assembly type industries by maintaining incentives that are competitive. But there would not seem to be much gain - 81 -

from adding to these incentives as they would be matched by neighbouring economies and in any case the response elasticity of DFI is probably small. Once the country has developed its own base of producer goods and parts manufacturers, more important than DFI will be the skill shown by local businessmen in using NBCcontacts to improve their access to western markets and obtain, through licenses or other means, the technologies developed and controlled by the foreign firus. As regards energy related DFI, the current and projected oil prices, by squeezing the exploration budgets of the oil majors will reduce the flow of foreign capital into the petroleum sector for some years irrespective of how the contract terms are modified. - 82 -

CHAPTERVII: INDUSTRIAL STRATEGYAND DEVELOPMENT

7.01 Economic tradition calls for developing countries to rigorously observe the dictates of comparativeadvantage and free trade. Within the intersticesof these rules lies the concept of infant industries, permitting the use of industrial policies which include not just tariff and taxes but also attempts to foster research9 labor skills, financial institutions and a mentality supporting the goals of modernization. How the rearing of infant manufacturing firms can be reconciled with the other two has never been satis- factorily explained. Policymakershave been urged to keep incentives as neutral as possible, to allow the market maximum play and to set limits on the period of infancy. These rules have been variously translated. In Malaysia's case, the country remained for long a producer of primary commodities, while much of the output was exported raw or in semi-processedforms, the initial forays into manufacturingwere in affiliated fields like rubber goods, vegetable oil refining and tin smelting. Subsequently--duringthe period dating from the late sixties through much of the seventies-the economy moved into a more intensive phase of industrialization. Behind newly raised tariff walls encouragementwas given to firms producing food and beverages as well as light consumer goods almost exclusively for the home market; basic materials for example, agriculturaland industrial chemicals, cement, metal products, paper and wood products; and to labor intensive assembly and processing industries that were primarily trade oriented.

7.02 Broadly speaking, economic policy did not deviate much from the conventionalinterpretation of comparative advantage. In fact, through the medium of DFI, Malaysia's export sector evolved on the pattern that would be expected of a labor rich economy where skill, technology and capital were relatively scarce. It played host to footloose industries and used MNC and other established chanzels for selling its output overseas. The first phase of tradable goods developmenthas come to a close. Malaysia has since been drifting without a coherent strategic direction towards a second phase. The manufacturing sector expanding around export as well as domestically oriented poles grew at 13X p.a. between 1973-78, but then slowed to 9.3% p.a. from 1978 to 1980'4/ The first half of the eighties has witnessed a further decelerationof the manufacturing sector to about 4.9% p.a. with the impetus coming mainly from the public sector and to a lesser extent DFI in the electronics industry, although the data do not permit a partitioning of the investment series which would allow the public sector's role to be conclu- sively demonstrated. Textiles attracted the most resources in the seventies and expanded at 16% p.a., its share of manufactured CDP trebling to 6% by the

14/ The World Bank has reviewed the performance and prospects of Malaysian industry in two reports issued in the early eighties: Malaysia's Manu- facturing Sector: Development Issues and Policy Options, Report No. 3187-MA, April 1981; and Malaysia: Development Issues and Prospects of Small Enterprises,World Bank Report No. 3851-MA, June 1982. Many of their findings in the area of credit availability,technology, skills and market access, support the main recommendationsof this report. - 83 -

end of the decade. Growth was slower in the eighties but still a respectable 8% p.a. Close behind textiles was electronicsand electrical products, but as a result of internationaldemand, the industry showed an improvement in performanceover the seventies; its annual rate of increase over the Fourth Plan period was over 132 p.a. Transport equipment, petro-chemicalsand metal products shared the limelight with textiles and electronics as the major industries and all contributed significantly to exports, but the lion's share - almost two thirds - belonged to the two leading subsectors.

7.03 In the earlier stages when capacity expansion was concentrated in sectors of low capital intensity, employment in manufacturing increased by 12% p.a. But after 1978, when industries such as petrochemicalsand non-ferrous metals moved to the forefront, jobs became less plentiful, growing by 4Z p.a. between 1978 and 1980 and by around 2Z in the first half of the eighties (1981-85),pointing roughly, towards an elasticity of 0.5 with respect to o-itput. As the labor force has been increasing at 3Z during the first half of the decade the manufacturing labor force has remained fairly constant at 17.5% of the total.

7.04 Besides the diminished rate of job creation, certain tendencies have become more visible. More than a fifth of the manufacturing output was exported in 1984, a 50% increase over 1975. Four sectors, electronics and electrical equipment, textiles, petrochemicalsand transport equipment dominate exporting activities and close to three fourths of the goods sold overseas originate in the FTZs and Licensed Manufacturing Warehouses (LMWs). Although value-added in petrochemicals is extremely high, the average for the FTZs is 232 of sales, less than half of which takes the form oi wages, the balance being mostly profits, 90% of them accruing to foreign companies. Imports of materials comprised 75Z of the value of sales from the FTZs, while the ratio of local materials to the total purchased was under 4% as recently as 1982. The situation was only marginally better for the LMWs. Value-added was 38Z, with wage payments and electricity accounting for 40Z and profits, more than two thirds claimed by foreign firms, taking up the remainder. LMWs obtained 10% of their materials domestically. - 84-

Table 7.1: INDUSTRIALSECTOR - BASIC DATA

A. Contribution to GDP Shares (Z) - Growth rates (Z) 1975 1980 1985 1975-80 1980-85

GDP 100.0 100.0 100.0 8.6 5.8 Industry 26.8 30.0 29.3 11.0 5.3 Manufacturiag 16.4 18.6 19.1 11.3 4.9 Agriculture 27.7 23.4 20.3 5.3 3.4 Others 42.7 46.6 50.4

B. Contribution to Foreign Trade

Shares (Z) Growth rates (Z) 1975 19 8 1984 1975-80 1980-84

Total Exports 100.0 100.0 100.0 25.0 8.2 Manufactured 21.4 22.1 31.6 25.3 18.3 Agricultural 47.7 38.8 30.4 19.9 1.9 Petroleumand tin 20.9 32.7 25.6 36.7 1.8 Others 9.9 6.4 12.4 14.5 27.7

C. Employent Shares Growth rates (Z) 1974 1980 1982 1974-80 1978-82

All Sectors 100.0 100.0 100.0 2.1 Agriculture Industry 21.7 26.6 27.5 5.1 Nanufacturing 14.6 18.3 17.6 3.1 Others

Manufacturing 100.0 100.0 100.0 Food (311) 11.8 Wood (331) 12.9 Electrical/Electronics(383) 17.5 Textiles (321/22) 13.7 Rubber (355) 7.2

Rates of Protection D. Structureof protection Nominal Effective 1979 1982 1979 1982 All Sectors 13 17 24 23 Exporting 9 10 5 12 Import competing 16 16 27 24

Subsectors Food, beverage & tobacco 32 16 15 9 Textiles, garments,leather 32 24 54 35 Wood, wood products 22 22 37 35 Paper & paper products 18 18 31 31 Chemicals, plastic,rubber 13 20 17 32 Machinery, equipment 16 15 21 17

F. Investment,Employment, K/L Ratios 1975 1980 1984

Investment(M$, million) 1,427 2,103 3,800 Employment (000) 44 45 57 K/L Ratio (Incremental,MSOOO) 33 46 66

Source: Various statisticalannex tables and Malaysian authorities. - 85 -

Table 7.2: MIDA - PROJECT APPROVALS, 1981-85 (No. of approved projects by subsector)

Cumulative 1981 1982 1983 1984 1985 1981-85 z

Industry Food manufacturing 59 34 41 50 57 241 8.2 Beverages and tobacco 8 10 8 8 5 39 1.3 Textiles and textile products 60 29 39 68 50 246 8.4 Leather and leather products 1 4 2 3 1 11 0.4 Wood and wood products 59 51 37 42 28 217 7.4 Furniture and fixtures 10 12 10 16 7 55 1.9 Paper, printing and publishing 18 20 15 46 35 134 4.6 Industrial chemicals and chemical products 56 45 23 47 39 210 7.2 Petroleum and coal 9 15 11 12 11 58 2.0 Rubber products 38 25 24 28 24 139 4.8 Plastic products 21 24 37 46 42 170 5.8 onmoetallicproducts 87 57 60 84 84 272 12.7 Basic metal industries 22 17 17 30 32 118 4.0 Fabricatedmetal products 49 32 33 70 53 237 8.1 Machinerymanufacturing 17 22 31 36 41 149 5.1 Electrical and electronics 45 46 53 72 62 278 9.5 Transport equipment 24 11 31 70 33 169 5.8 Scientificand measuring equipment 5 4 3 2 5 19 0.6 Miscellaneous 8 10 15 19 16 68 2.3

Total 596 468 490 749 625 2,930 100.0

Source: Fifth Malaysia Plan 1986-90, Table 11.2

7.05 Under the Industrial CoordinationAct (ICA) of 1975 which empowers the government to regulate industrial capacity and provides a vehicle for pursuing the NEP goals all industrial projects valued in excess of M$250,000 were licensed by the Malaysian Industrial Development Authority (MIDA). In December 1985 the exemption limit was raised to M$l million. The number of approvals each year is a very crude index of investment activity past, present and future. Tables 7.2 and 7.3 give information on the number of projects licensed and the amounts approved. Between 1975 and 1980, approvals averaged 439 projects each year rising to 589 during the period 1980-84. If it is assumed that approximately 90Z of proposed investments were vetted by NIDA and on an average, four fifths were implemented, then manufacturing investment, - 86 -

TUble 7.3: MIr - PROJECT APPOVALS, 1981-85 (Amounts, M$ millionY

Cumlative 1981 1982 1983 1984 1985 1981-85 S

Industry Food manufacturing 323.9 184.4 61.0 258.1 578.7 1,406.1 6.5 Bev-ragesand tobacco 47.0 142.7 13.8 15.8 28.6 247.8 1.1 Teztiles and textile products 106.2 29.9 65.2 125.5 123.0 449.8 2.1 Leather and leather products 0.6 6.9 0.8 6.6 1.3 16.2 0.1 Wood and wood products 258.1 257.6 81.5 169.4 117.0 883.6 4.1 Furniture and fiztures 14.7 18.3 9.0 36.6 23.3 101.9 0.5 Paper, printingand publishing 248.4 38.1 14.1 231.7 1,815.5 2,347.8 10.8 Industrialchemicals and chemical products 371.5 2,249.6 95.9 799.3 195.0 3,711.3 17.1 Petroleum and coal 48.6 396.9 201.6 32.3 23.7 703.1 3.2 Rubber products 152.7 66.6 96.6 65.3 96.3 477.5 2.2 Plastic products 46.3 40.9 98.4 90.8 105.4 381.8 1.8 Nonmetallicproducts 1,586.6 374.1 447.5 494.4 533.4 3,436.0 15.8 Basic metal industries 545.2 1,149.1 90.4 266.2 621.4 2,672.3 12.3 Fabricated etal products 98.9 107.6 87.1 243.3 268.1 696.3 3.7 Machinery manufacturing 150.6 107.0 317.8 121.1 136.7 833.2 3.8 Electrical and electronics 207.2 163.6 356.4 353.: 240.9 1,321.4 6.1 Transportequipment 224.2 62.2 278.5 447W4 681.0 1,693.7 7.8 Scientific and measuring equipment 8.3 5.6 4.5 - 21.4 39.8 0.2 Miscellaneous 9.4 33.4 38.0 44.0 76.2 201.0 0.9

Total 4.448.4 5,434.8 2,358.6 3,801.1 5,686.9 21,729.3 100.0

/a Includes loan capital and paid-up capital.

Source: Fifth Kalaysia Plan 1986-90, Table 11.2

includingthe non-MIDA share, should have ranged around K$3.5 billion p.a. over the last five years. The troublewith these figures and what they indicateas being the level and directionof manufacturinginvestment, arises from biases introducedthrough aggregationand variable implementation. Most of the projects approved fall in the M$1-M$3 million bracket but because a few very large items are included, the average rises to above M$5 million for 1980-84. Because many of those issued a license never actually make an investmentthe MIDA approvals are of little use in predicting the structureof the manufacturingsector or the pace of investment. Hence, the very large jump in projectsapproved in 1984 and 1985 was not reflected in manufacturing investment during 1985 and does not necessarilymean that actual capital expenditures in 1986-87 will be unusually high. Nor can we draw much - 87 - inferenceabout the compositionof futureoutput by aggregatingthe values of investmentslicensed over a three to four year stretch. Nonetheless,it is useful to note that if the subsectoral information on amounts and growth rates during1980-84 is pooled, the center of industrial interests, if not actual investmentoutlay appears to be shiftingmore towardsproducer goods industries. Food,wood products,textiles and paper stillreceive substantial, albeit fluctuating amounts of capital,but the emphasisis now on transport equipment, machinery, fabricated metal products and industrial chemicals. 7.06 Though it is a trifleindistinct, this move towards heavy industries mirrorsa change in the structureof protection.A glanceat nominaland effectiverates suggeststhat conditionsin the early eightiesdid not depart much from those prevailingin the late seventies. Averageeffective protection (EPR)was 24Z in 1979 and 23Z in 1982. Table 7.4 givingrates for 2- digit groups,shows EPRs rising in just two categories: food and beverages, - 88 -

Table 7.4: STRUCTUREOF PROTECTION: DIC /a GROUPS (2 DICITS)

MIC 1979 1982 Division Description ij EPRVb Tj EPR/b

31 Manufacture of food, beverage and tobacco 31.7 15 15.9 20

32 Textile, wearing apparel and leather industries 31.5 54 24.2 35

33 Manufacture of wood and wood products, including furniture 22.6 37 22.2 35

34 Manufacture of paper and paper products: printing and publishing 18.3 31 18.2 31

35 Manufacture of chemicals and chemical products, petroleum, coal, rubber and plastic products 13.2 17 20.1 32

36 Manufacture of nonmetallic mineral products, except products of petroleum and coal 15.7 19 11.7 14

37 Basic metal industries 23.4 57 18.6 41

38 Manufacture of fabricated metal products, machinery and equipment 15.6 21 14.7 17

39 Other manufacturing industries 21.6 12 20.2 9

/a Malaysian Industrial Code. 7i The averages of effective protection rates on this table and Table 9.5 were calculated using value-added weights and at international prices.

Tj - Nominal tariffs EPR - Effective Protection Rates

Source: MIPS, 1984. - 89 -

and chemicalsand chemicalproducts. But from the end use angle (see Table 7.5) effectiveprotection did changeto substantiallyfavor machinery, transportequipment and petroleumproducts. Won-tariffbarriers, whose role in the system is greater than before, have given a nudge in the same direction. Overall,the effecthas been to reduceslightly the effective protection affordedimport competing sectors and significantlyraise it for the exportones, but with the latterstill receivingonly half as much protection as the former.

Table 7.5: STRUCTURE OF PROTECTION: END-USEGROUPS

1979 1982 Tj EPR Tj EPR

Consumption Goods - 57 - 46 Processedagricultural output -4.4 -13 -1.9 -4 Food and nonalcoholicbeverages 23.9 43 18.5 16 Alcoholicbeverages and tobacco 287.3 - 147.2 152 Nondurables 34.9 110 33.4 109 Durables 31.5 55 23.9 35

IntermediateGoods - 11 - 10 Petroleumproducts 7.3 22 25.2 42 Constructioninputs 19.7 28 18.3 25 Others 23.0 46 20.8 39

Machineryand Capital Goods - 64 - 90 Transport equipment 31.3 75 35.3 9 Other machinery 27.9 40 24.6 37

MemoItems: Exporting 9 5 10 12 Importcompeting 16 27 16 24

Note: Tj - Nominal tariffs EPR - Effective protection rates Source: HIPS, 1984.

Strategy

7.07 The makingsof a well roundedindustrial strategy can be found in severalof the initiativesalready taken by the Governmentor under consideration. One is the policyof privatizationwhich shouldprovide a much needed fillipto privateindustrial activity by transferringcertain dynamic public sectoroperations into privatehands, stabilizingif not reversinga trend towardsgreater state involvementin the productivesector, and by forcing - 90 - major industrial entities to foresake a sheltered existence and meet the test of the market, helping to increase overall industrial efficiency. After testing the waters through the privatization of an aircraft servicing company and a toll.road, the Government comienced the process that vill eventually bring its share in the national airlines (KAS) to 3OZ. Depending on the appetite of the market - and the response to the KAS offering was reassuring - other public enterprises will also be disposed of permitting the state to marshal its administrativeresources on a narrower front.

7.08 Another set of initiatives relate to measures calculated to enhance the market's allocative efficiency and modify some of the rules governing entrepreneurialaccess to industrial opportunities. A third involves taking the high ground of dynamic comparative advantage as described in the IndustrialMaster Plan. In other words, promoting the development of industrial subsectors that will eventually displace the traditional light manufacturing industriesas the major exporters and industrial employers of the late eighties and the nineties. The following discussion indicates how these initiativesmight be integratedand extended so as to comprise an industrial strategy for the long run.

Market Efficiency

7.09 The Malaysian Industrial Policy Studies (MIPS) completed in early 1985 has described the incentives available to industrialistsand traced out their distortionaryeffects. The major elements of the current industrial policy regime are: tariff structure, tax and tax-related incentives, and financial incentives. The analysis of the tariff and tariff related policy instruments on the manufacturing sector as given in the MIPS shows that;

(a) import tariffs in Malaysia seek to serve simultaneouslydifferent objectives concerning revenue collection,growth, exports and equity, often with inconsistentand conflicting results. The administrationof import duties has given rise to biases between manufacturing and other sectors; between different industries within manufacturing and firms within industries;between the importcompeting and export sector; between FTZ/LMW and non-FTZ/LMW manufacturing,between first and second phase manufacturing industries; between capital and labor intensive enterprises; and between large and small firms;

(b) the tax revenue base has been eroded by the use of exemptions from import taxes as well as by the large number of zero or low rates;

(c) the use of tariffs and surtaxes, tariff exemptions, specific and ad valorem duties is administrativelycomplex, sometimes inefficient, and to a degree obscures their combined effect on effective protection.

The tariff structure in Malaysia has undeniably fostered industrializationin the import-competingsector but the average level of effective protection and the wide range of effective tariff rates and domestic resource costs indicates that protection of the sector may be in excess of what is required to support efficient growth. - 91 -

7.10 The weightedaverage level of effectiveprotection afforded value added in manufacturingindustry was an estimated23Z in 1982. Relativeto other developingcountries, this is not high, but there is a wide dispersion in effectiveprotection, between as well as within industries,and there are signs that the dispersionmay be growing. For instance,between 1979 and 1982,the proportionof free tradevalue added in manufacturingreceiving effectiveprotection in ezcessof 50X remainedconstant at around llZ;in the same periodthe proportionreceiving effective protection less than 5Z, increasedfrom 11 to 24Z.

7.11 A move tovardsgreater uniformity in rates of effectiveprotection and a reductionof the 'made-to-measure'character of the presentsystem in Malaysiawould seem to be appropriateat this stage. The made-to-measure systemleaves much to be desiredbecause its administrationinvolves a great deal of detailedjudgment by tariffauthorities about costs,technology and processesof productienwhich may not alwaysbe wirhinthe technicalcompe- tenceof these authorities.It also introducesan additionaluncertainty into businessplanning. The more complicatedthe system,the more scope for ad hoc decisions.

7.12 The exceptionsto the above are:

(a) infantindustry including second-round of importsubstituting industries;

(b) where detailedsocial cost benefitanalysis indicates the presence of permanentexternalities; and

(c) nationalconcerns, such as defense,equity, regional dispersal. 7.13 Some of the existingimport competing industries, as the evidence shows,have remainedinfant for too long, and there is a need to reduce the level of protectiveassistance available to them, while some new "infants" are broughton stream. Whetheran industryis createdas an "infant"should be based on the introductionof a productiontechnique or technologynew to Malaysia. The phasing-outperiod, say 4 to 7 years,might be fixed from the first date of productionin Malaysiairrespective of later startsby other producers. Most of the secondround importsubstitution industries would fall in this category. 7.14 With these caveatsin mind, a phasedrestructuring of the tariffsis needed to bring the effectiveprotection rates to a suitablelevel such as to delivera subsidyequivalent on the export side that would approximatefree trade conditionsfor exporters. The analysisin the NIPS offersa detailed rationalefor aimingat a uniformEPR of around 13X. While this representsa first best solution,perhaps a more viablearrangement would be to aim for more modestgoals that concerntariff adjustment at the extremeends in the case of those industrieswhich have enjoyedprotection for a numberof years. For example,in the initialphase, adjustments in importduties may be undertakento raise tariffsfrom zero to 5% where full exemptionsare allowed, or a lowerrate of protectionapplies; and at the upper end, tariffsmay be phased in a selectivefashion on a sector-by-sectorbasis. These changes,at - 92 - the upper end will affect7X of manufacturingoutput, and at the lower end about 10 of output. Thus in terms of output,nearly 17X of manufacturing sectorwill be affected. Revenueand balanceof paymentseffects of these changes,likewise, are estimatedto be marginal.

7.15 Tariffand surtaxexemptions significantly alter the nominalprotection accordedto industries.The value of goods exemptedwas M$2.6 billionin 1982 and the revenueforegone is estimatedat M$110 millionper year of which less than half involvesexported output. Among exportindustries, 6 industries accountedfor 44% of exemptionsgranted; among industriesproducing for domesticmarket, 6 industriesaccounted for 37% of exemptionsgranted. The patternof exemptiontherefore is concentrated. 7.16 Leavingexport industries aside for the time being,a suitable approachwould be to allow the normalexemption period of four years expire for importcompeting industries, at least for those industrieswhich have enjoyedEPRs in excessof 25Z for previousyears. This proposaloverlaps with the recommendedincrease in tariffsfrom zero to 5% level. Hence, the number of industriesaffected is likelyto be small; the positiverevenue effect would be significant;no additionalstudy is needed.,and, Governmentcould easilyidentify these industries.

7.17 The effectsof non-tariffpolicy instrumentson the Halaysian industrialsector are quite differentexcept for the licensingsystem which exertsdirect control. A detailedassessment of theseinstruments is provided in the HIPS. The followingis a summaryevaluation.

(a) Importquotas: In 1984,nearly 50 items were subjectto quotaswith varyingdegrees of severity. Quotas,however, are prohibitivefor only threeindustries - iron and steel products(not all items), automotives,and sugar;closely followed by less prohibitivequotas for timberand cement. The Governmentmight replacesome quotas with tariffsin industriesother than those five identifiedabove.

(b) Local ContentPlans. This policy is mainlygeared to provide protectionto the automotiveindustry along with a few electrical products. Given the sector'simportance, the Governmentmay wish to initiatea subsectorpolicy study if not to liberalizethe sector, at least to iron out inconsisteaciesinherent in the overlapping policyinstruments. Some observationsmay be noted in this regard:

The ban on importsof completelybuilt-up units (CBUs)makes tariffs redundantas a protectionistdevice - tariffsare then equivalent to a consumptiontax on 'luxury'items. The observedprice differentialbetween a locallyassembled vehicle and equivalenttax achievesthe same objective. Given this segmentation,efforts at marketaccess by componentproducers is usuallyunsuccessful since they are saddledwith noncompetitiveitems.

(c) PriceControls. In 1984,14 manufacturedcommodities were under price control. Of these,six commoditiescould be freely imported, and eightwere subjectto partialor prohibitivequotas. The 93 - primaryobjective of price controlsof freely tradeditems is to even out price fluctuation,and protectionis unintendedeffect. But for the eight restricteditems, price controlas well as protection is a combinedobjective. When tariffsare super-imposed,it is too complexto determinewhat is being achievedbeside protection to the industry. The issue needs to be lookedat further.

(d) GovernmentPurchasing. The 'buyMalaysia' policy in the public sectorprovided the equivalentof an additionaltariff of 10Z, prior to 1983. Under the new guidelinesinitiated in 1984, the protective effectis there but very difficultto measure. Further investigationof this issue is needed. (e) Tax and Tax RelatedIncentives. The major tax instrumentsare corporateincome tax, tax holidays,capital allowances including those for accelerateddepreciation and reinvestment,export duties, sales and excise taxes. An importantfinding of the MIPS is that while tax and financialincentives did augmentcorporate profits, in absoluteterms their impacthas been well below that of the tariff. Accordingto the estimates,in 1980 tax and credit incentives togetherrepresented nearly 9Z of free-tradevalue added as comparedto the averagetrade EPR of 23Z. Further,the pattern of these incentiveswas such as to providerelatively more assistance to heavilyprotected subsectors with the exceptionof electronics- an exportingindustry. Tax and credit incentivesdid increasethe combinedrate of protectionto all subsectors,favored activities with low value-addedbut did not boost manufacturingas mu-h as was intended;favored FTZ/LMW exporters over others;as such did not providebackward linkages in the economynor did much to help exportersoutside FTZs; did not promoteregional dispersal; contributed to segmentationof incentivesreceived by firms between industriesand withina given industrydue to their case-by-case administration.Given these conclusions,the basic principlesto guide the futurereform process are similarto the ones offered in trade policyarea. The principlesare: economicviability of projects;neutrality of investmentincentives between various subsectors;clearly formulated eligibility criteria; less discretion; preferablyautomaticity in the award of incentivepackage; and clearlyformulated investment strategy to guide investmentdeci- sions. Superimposedupon these is the recognitionof externali- ties: regionaldispersal; ethnic participation and ownership; research,development, and technologytransfer; pioneer status and environment.

Regulation

7.18 Encouragingentrepreneurial activity in the industrialsector and m-cimisingthe flexibilityof resourceuse could be the seconastrand of the strategy. Currentlymost investorsare bound by three principalguidelines that emergedfrom the NEP in the mid-seventies.Thirty percentcf a company's equitymust be allocatedto Bumiputrainvestors; a proportionof those employedhave to be Bumiputras;and companieswhose size placesthem above an - 94 -

exemption limit are required to obtain a license from the Secretary General of the Ministry of Trade and Industry, advised by the Action Comittee for Incentives (ACI). Of these, it is the licensing process that has attracted the most attention. The ACI's decision is guided by the goals of the NEP, subsectoraldevelopment plans and supply conditions affecting each industry. The actual screening of applicationsand issuing of permits is done by the Malaysian Industrial Development Authority (MIDA). Licenses place limits on the production of the items sanctioned, and call for prior approval before a new product can be manufactured or capacity expanded. Further, they may subject firms to local sourcing requirementsand pricing guidelines. As stated by the MIPS "to the extent that entry to an industry is controlled by the Secretary General such decisions have clear implications regarding incentivesfor those firms already in the industry. To the extent that entry may be denied more efficient enterprises,economic rewards to existing firms are also affected." Having to go through the process of licensing is discouraging in itself, particularly for small investors, when allied with the necessity of arriving at a certain division of equity and employment, it dissuades all but the most perseverent and well connected. For years, a revision of the licensing limit has been the foremost request voiced by businessmen seeking greater freedom in the marketplace. In December 1985, the authorities responded by introducing significant changes in licensing regulations. Previously, the rule was that all manufacturing enterprises with 25 or more employees or with paid-up capital of more than M$250,000 were required to apply for a license. This was raised to 50 employees and M$l million. The Government also permitted export oriented firms to expand capacity and diversify without seeking prior approval. Through its actions the government has decisively signalled its commitment to an industrial strategy in which private initiative is the driving force and this is bound to strengthenbusiness confidence. However, the road leading to an industrial base that is on par with East Asian NICs promises to be a long and difficult one requiring a sizeable outlay of capital on risky ventures. The greater is the maneuvering room and the larger the rewards the more robust will be the entrepreneurialresponse.

7.19 Policies unveiled in 1985 involve a considerable departure in terms of content as well as tone from the approach taken over the past decade and suggest a willingness to adapt the NEP guidelines to suit changed circumstances as well as explore alternative pathways in the hope of finding an economic short-cut to the country's social objectives. But the process that will eventually lead to the growth of capital and skill intensive industries will require reinforcement and the authorities might wish to examine the political viability and economic merit of three further steps:

(a) the price inflation since the ICA was instituted and the anticipated increase in average project costs argues for raising the exemption limit to M$5 million, not M$l million, which would remove perhaps 80X (by number) of all investment decisions from MIDA's purview, clearing the ground of remaining bureaucratic and political obstacles to industrial deepening and market effectiveness without diminishing the Government's influence over major investment decisions; - 95 -

(b) the public sector's size plus the progress at putting corporate assets in the hands of trust agencies calls for a reappraisal of the equity restructuring program. Additional gains would certainly risk the success of the industrial strategy being forged. The entirely laudable goal of income redistributionmight henceforth be pursued by way of fiscal measures, e.g., the tax changes outlined in Chapter 2. It would appear from the relative stability of the Gini coefficient and the widening intragroup income disparities that restructuringcorporate wealth may have contributed marginally towards equity while undermining private investment, growth, and the efficiency with which the stock of industrial assets are utilized;

(c) for the leading manufacturing sectors the availability of skilled workers and efficient manning practices will be decisive for competitiveness. By doing away with some of the embedded rigidities that affect businessmen's flexibility in hiring and deploying labor in these segments of industry, the authorities would move Malaysian firms to an equal footing with their rivals in East Asia.

Industrial Deepening

7.20 Rapid growth for the purposes of raising incomes and generating employment, requires a motor, not just for the next few years but over a time horizon spanning the nineties and beyond. Since it is becoming increasingly clear that a crowded internationalmarket made more oppressive by protection, will not allow traditional light industries, textiles, footwear, leather goods, rubber and wood products, etc. to forge ahead, these industries which undoubtedly have served the developing world well for two decades, cannot propel the leap to industrial maturity. In reviewing more robust candidates, two kinds of filters might be empLoyed: one being the general guidelines listed below; the second being cost-benefitanalysis:

(i) an industrially ifmature economy should consider technologically demanding industries such as electronics, pharmaceuticalsand advanced machine tools, only after the research and technical skills have been accumulated;

(ii) subsectors where scale economies are not absolutely critical to achieving competitive costs might be favored;

(iii) initially, at least, the push should be into areas where marketing costs, service requirementsand a brand image are only moderately important and it is possible to either establish links with buyers in developed countries or depend upon MNCs to serve as marketing intermediariesor to sell the product with a minimal marketing overhead in the less developed countries;

(iv) where possible, the move upscale ought to commence in fields where the start-up costs in terms of capital and skill are not overly large; - 96 - (v) industrieswhere the longer-termvalue-added is highestshould score over others;

(vi) indirectas well as directemployment should be used in putting togetheran investmentportfolio; and

(vii) in the interestsof speedyexport returns, industries where long experienceis a decisivefactor, may be given a lesserpriority.

7.21 These guidelinescan be married to assumptionsemerging from the earlierdiscussion of trade,protectionism and HNC strategy: (i) machinery, transportand metal productshaving enjoyed the highestexport growth rates duringthe sixtiesand seventiesappear to be the strongestcontenders for futuretrading success; (ii) althoughDFI will continue,it will flow into the traditionalassembly industries, foreign investors may not be in the forefront of an attemptto launchnew exportoriented, capital goods industries,through the infusionof investmentand technology.Thus the next stage of Malaysia's industrialjourney will have to be managedindependently and the range of optionsmight be more limitedthan what emergesfrom the sectoralreviews containedin the IndustrialMaster Plan.

7.22 The medium-termstrategy must be to providesupport, by way of investmentand tax incentives,to the leadingexport subsectors - textiles, electronics,and leathergoods - and to try and raise the multipliereffects of these industriesthrough employment and productlinkages closer to the high level of the otherEast Asian economies. For possiblythe next five years the manufacturingexport mix will remainweighted with light manufacturesand assembledelectronic products, produced largely by the subsidiariesof MNCs. Given that the importantindustrial moves must be made elsewhereand there is a need to manage the flow of profitand dividendsfrom the country,it may not be fruitfulto manipulatethe level of effectiveprotection for the exporting sectorsor to embellishmuch furtherthe currentsuite of incentivesfor foreigninvestors, except where it comes to matchingthe inducementsoffered by neighboringeconomies and affordingMICs the opportunityof holding majorityshares in local,non FTZ subsidiaries.Where these industriesare concerned,it is not at the macro level of tax incentives,tariffs and credit for facilitiesthat changesare calledfor, but at the micro and organiza- tionallevel, to raise exportefficiency and to keep demandlinkages inside the country. Some of the measuresthat might be consideredwill be outlined later,let us turn now to long run strategy.

7.23 The messagecarried over from the reviewof internationaltrading circumstancesunderscores the disadvantagesof attemptingmajor export gains on narrowsectoral fronts. All the NICs are now in troubleprimarily because of their very successesat drivingdeep importwedges into a few vulnerable markets. Nibblingat many differentexport opportunities and occupying innocuousmarket nichesis far less likelyto inviteretaliation and can resultin stableand healthy,although not spectacular,export growth. There are five areas in which expandingmarkets worldwide may permitproto NICs like Malaysiato satisfytheir trade objectives.These are chemicalproducts, electronics,electrical goods, machinery and transportequipment, and metal products(see Chapter4, paras.4.32-4.36). All of these fieldsare hotly - 97 -

contestedwith advancedas well as industrializingcountries jockeying for largershares. Since decision-makerseverywhere are preparingindustrial blueprintsout of an identicalfund of past experienceand very similar projections,the trajectoriesbeing mappedare bound to resultin a trouble- some convergenceat a futuredate. Hence it might pay to aim for the greatest degreeof productand marketdiversity.

7.24 Smallnessof size makes it extremelydifficult for Malaysiato think in termsof exportingfinal engineeredproducts in all these areas. The research,marketing and engineeringcosts of independentlymounting an operation in an area such as farm machinery,where a few MNCs are entrenched,would be immenselyrisky and expensive. But sellingparts and componentsto the large producersof farm machineryor occupyingan untenantedniche with a small,well-engineered piece of equipment,is certainlypossible. The very same point can be made in each of the other fields.

7.25 If manufacturinginvestment can be raised,sustained linkages will multipyand more of the multipliereffects from these expenditureswhich today induceimports of machineryand intermediategoods will remainwithin the country. Researchon East Asian economiesreveals there is a strong correlationbetween sectoral multipliers and the dimensionsof the industrial system. But the broadeningof the manufacturingsector could also go a long way towardsmeeting employment goals. Intra and intersectoraldependence greatlymagnifies the employmentconsequences of investments.On the average somewhatover 50X of the employmentgenerated through manufacturing investment is direct,but the range is all the way from 107 to 85%. Input-outputdata indicatesthat most industrieshave more backwardthan forwardlinkages, with smallerfirms givingrise to greaterdirect employment. Light manufacturing (food,beverage, tobacco, textiles and leatherproducts) seem to createthe largestoutput and employmentmultiplier effects. Those of certainresource based industriesespecially lumber, wood and rubberproducts are high but pulp, paper and printingalong with petroleum give rise to less indirect employmentwithin manufacturing and acrosssectors. Multipliereffects in the remainingresource based industries,chemical products, non-metallic mineral productsand metal productsare strongand exceptionallyso in the case uf Japan. The "spreadeffects" from machineryand transportsector development are initiallyquite small since so much equipmentis imported,but they become very significantas industrializationprogresses.

7.26 Capitalintensive subsectors that are often criticizedfor the limiteddirect and indirectemployment they generatemay in fact come out ahead over a periodof years if they spur higher investment,saving and technologicalchange and help to accelerategrowth. Electronics,on the contrarydespite its reputation,has limitedbackward linkages and in the long run can have negativeindirect employment effects, as it threatensthrough - 98 -

automationof factoriesand servicesto displacenumerous blu 57/nd white collarjobs, changingthe very natureof companyhierarchies.- 7.27 The strategybeing proposed,with its emphasison industrial deepening,is bettercalculated to increasethe growthof total employmentin the longerterm althoughthe immdiate employmentgains might be limited becauseindustrialization in Malaysiais still at an early stage. It is also orientedtowards sustaining current manufactured exports and maximizingfuture trade prospects. Given the wage levels,and the pessimisticdemand forecasts for light manufactures,Malaysia has few alternatives(see Chapters4). To industrializeit must go beyondthe light manufacturingperimeter into intermediateand producergoods.

SectoralConstraints and Policies

7.28 The previoussection touched upon policiesand issuesof a general and macro nature,but while these may help to providea suitableenvironment, a host of micro level problemsmust be tackledbefore the strategywill make a dent on economicrealities. Since a detailedpicture of each manufacturing subsectorand the technicaldifficulties that they face is containedin the government'srecently completed Industrial Master Plan, we will concentrateon the contentand scope of mjcyo policiesthat must continuethe work begun by overallindustrial policy. _ From the list of possibilities,six subsectors were selectedto illustratethe natureof micro policiesthat will have to be definedto assistinfant industries.

Textilesand Clothing

7.29 Althoughit is relativelysmall by the standardsof the East Asian NICs, Malaysia'stextile industry has a significantpresence in the domestic manufacturingsector. Employmentin the mid-eightieswas close to 75,000and the industrycontributed a littleover 1% to total CDP and about 7Z to manufacturingoutput. More than a third of productionfound its way to the overseasmarket but even though it holds secondplace to electronicson the manufacturedexports ladder, textiles still accountfor less than 3% of merchandiseexports. In the world textilemarket, Malaysia remains a minor playerwith 0.39% share of textilesand 0.5Z of the market for apparel.

15/ See "Industrializationand EmploymentGeneration in the ServiceSector of DevelopingCountries: An Appraisal",UNIDP/IS.504, December 1984; P. Mellerand M. Marfan,"Small and Large Industry: Employment Generation,Linkages and Key Sectors",Economic Development and Cultural Change,Vol. 29, pp. 263-274,1980; F. Stewartand P. Streeten, "ConflictsBetween Output and EmploymentObjectives in Developing Countries",Oxford Economic Papers, Vol. 23, pp. 145-168,1971.

16/ The Missiondid not have an opportunityto reviewthe MasterPlan at the time the Reportwas being prepared,but tabularmaterial on the textile and electronic subsector was made available by the authorities. - 99 -

7.30 Nearly 80% of the production is divided between spinning and weaving imported natural and synthetic yarn, the manufacture of clothing and knitting operations. The bias imparted by foreign investment - foreign equity holdings amount to 41% - is towards finishing and assembly operations and in general, import dependence is fairly high, and the value-added under a third of the output. As is the case throughout East Asia, the export oriented wing of Malaysia's textile industry has lived under a suspended sentence and while its performancehas been quite creditable over the past several years, textile firms are feeling the strain from the tightening of quotas under a succession of MFAs (Multi-FibreAgreements); tariffs imposed by the industrial countries which are three to four times higher than the average for manufactures; competition from Thailand, China and Bangladesh; and steadily escalating wage costs. It is usually very difficult to obtain an accurate readirg of company profitabilityin developing countries because overinvoicingand transfer pricing distort capital expenses and the flow of earnings, but Malaysian manufacturersappear to have been living with narrow if not negative profit margins for the past three to four years. Most firms gained a breathing spell from the strong export and domestic demand in 1984, but the years ahead do not look especially promising.

7.31 The industry is subject to pressures from several different directions. Demand for clothing in western countries which grew 4.5% p.a. in the sixties, increased by only half as much in the seventies and early eighties. Now that women's participationrates in the U.S. and Great Britain have stabilized,expenditures on clothing, which benefitted from the increase in female job-seekers, is projected to expand by less than 2% p.a. Of course, demand in Malaysia will rise much faster - 6-7% p.a. - and in other LDCs by close to 4Z, but diminished opportunities in the industrial markets will not be easily offset, as it is clear that sales to other developing economies will be constrained by high tariff barriers. A second set of problems stems from the burden of labor expenses. In recent years textile wage rates have been increasingat a pace not much different from the consumer price index, but total payments, including social and incentive outlays, have risen more quickly, swallowing the improvementsin productivity. Textile labor costs in Kalaysia are now well above those of China, Thailand, Indonesia and Pakistan, some of its principal competitors. Automation, which has transformed the capital intensity of the textile industry, particularly in the advanced countries,would help to solve the problem, but the majority of Malaysian firms are too small - two thir4s have equity of less than M$1 million - and weighed down with cash flow problems, for them to find the necessary capital.

7.32 With the market for lower quality undergarments,hosiery and apparel besieged by low cost suppliers, the higher wage producers in East Asia are being forced to look for markets in quality products. The premium is now on design, styling, marketing and delivery which require different skills and a changed approach. Again, few Malaysian firms are in a position to effectively compete against the established East Asian NICs. Between them, slowly rising export demand, quality deficienciesand the costliness of labor reduce the chances of the industry remaining a dynamic force unless some of the domestic constraints can be eased. - 100 -

7.33 Textile producers are in difficulty throughout the world, in countries that are the foremost exporters such as W. Germany, Japan, Italy, Korea and Hong Kong as well as in others where the industry is reaching a state of decay. But there are plenty of successful firms sprinkled among those that are feeling the strain of the industry's stagnation. The aLility to thrive against odds seems closely related in the spinning, weaving, dyeing and fabric production segments of the business, to the type of equipment in use and the efficient management of a highly sophisticatedand automated process. Such an operation requires technical and managerial skills oi a high order, a dependable labor force and a reputation for quality. Garment production in the middle and upper price brackets, something in which Italy is preeminent, demands a flair for design, the ability to produce in small lots and meet exacting deadlines and a well-developed marketing system built around respected brand names and channels for dealing with numerous retailers in importing countries.

7.34 Malaysian firms are lagging badly on all these counts. Textile operations are undercapitalized,the equipment is often old, working conditions are unsatisfactoryand the cadre of textile engineers, foremen, repair technicians and professional managers is small. Textile mills can climb out of a deepening rut only by modernizing extensively and strengtheningtheir workforce. The latter will have to wait on improvements in the skill composition of the labor force; the former could be helped along by credit policies that provided the industry with funds which its low profitabilitycurrently put out of reach.

7.35 Cutting and sewing activities where labor costs are significant and which have yet to feel the breath of automation - although new equipment coming off the drawing boards will change this - are still inviting for South- east Asian producers. Scale economies are not important, capital intensity is low and as Italian firms have discovered, family run businesses using a cottag- industry approach can be enormously profitable. Unfortunately,Malay- sian firms are stalled by entry barriers related to skills: design, managing and marketing skills. Having been integrated into a trading system where MNCs provide orders and specifications,they find it hard to muster the talents which could serve as the springboard to independence, quality products, an internationalreputation, ties with foreign retailers and a rate of growth above the modest average.

7.36 Industrial policy cannot afford to remain only at the rarified level of macro concerns if it is to be of relevance in solving the longer range problems of competitiveness. Since competence in designing is a ubiquitous requirement across a range of industries and more important than R&D in up- grading consumer goods meant for fashion conscious markets, centers where these skills can be taught deserve priority. Advances in marketing can come through several avenues, for instance overseas trade centers, government sponsored trading companies, and trade fairs used to good effect by the Japanese and Koreans. - 101 -

ElectricalMachinery and Appliances 7.37 Electricalmachinery lies withinthe compassof the industrial categoriesidentified above as worthwhileprospects for a countrymoving beyond industrial adolescence. The nucleus of this subsector already exists but it is small - less than 3Z of manufacturing value-added - its growth since 1979 has been distressinglyweak, and progress at enlarging export volume has been poor. Most of the 350 firms operate on a limited scale, employing 25-49 workersand are dependenton importedraw materialsand components. Larger firms are either foreign owned or have partnership arrangements with foreign companies. They export a somewhat larger percentage of their output and have been more effective in creating a network of domestic parts suppliers. Though here again, parts production is at the very early stages. Of the three segments into which the industry is subdivided, the one producing refrigerating, ventilating and air conditioningequipment is the largest, the most export oriented and has the highest return on assets. The two others, electrical industrial machinery and electrical appliances cater more for the domestic market and have an undistinguishedrecord of profitabilityalthough the numbers of appliance manufacturers has been multiplying quickly.

7.38 The electrical industry in Malaysia dates back to the late fifties when a start was made at producing dry-cell batteries, cables and lamps. By the early seventies the subsector claimed 2Z of the manufactured output, but more than a decade later, Malaysia is still importing a large volume of appliances and electrical machinery, suggesting that the well-protected local market has not been able to excite sufficient entrepreneurial interest in import-substitution. One explanation offered by industry sources blames the MNCs who have been reluctant to go very far in promoting the manufacture of domestic parts since they prefer to import the high value-added items from their overseas factories. They have also discouraged exports where these conflict with their global sourcing and distribution strategies. Nor have foreign owned companies attempted to develop a regional center for R&D in Malaysia although this is probably related to the smallness of the market and the shortage of local researchers and engineers. Finally, the MNCs are blamed for practicing price discrimination which obviates much of the tariff protection provided and prevents Malaysian businessmen from establishing themselves.

7.39 A second set of reasons points towards deficiencies in skills and technology coupled with a reluctance on the part of small businesses and government alike to take up the challenge. For instance, metal working and plastic molding activities, complementary to electrical goods production, is extremely backward. Heat treatment, electro-platingand precision machining also have a long way to go before they can match the quality that assemblers take for granted with imported products. The shortage of engineers is perhaps a more serious hindrance to the deepening of this subsector than it is elsewhere and so long as machinists, fitters and jointers are in short supply there will remain a ring of truth in the industry's complaint that local subcontractorscan meet neither delivery schedules nor the exacting standards that are the basis of quality, finish and durability.

7.40 A third factor behind the industry's immaturity might be the government's penchant for turn-key projects contracted with foreign firms that - 102 - deal KaM'vsian producers out of the business they need, to gain experience, expand their facilities and raise earnings. Many opportunities that Might have been of advantage to the machinery industry and its affiliates were ignored to save a little time, money and effort at organizing local producers.

7.41 Small and medium scale machinery production and the associated metal working operations also suffer from numerous, minor, plant level ailments that collectivelyare a serious drag on progress. Plant layout and working conditions tend to be substandard. With that goes a lack of adequate technical material, documentationon how the machine works as well as its full potential, and detailed drawings for the operators. Cleanliness is neglected, machinery is casually maintained and there is a real dearth of in-house repair capability or skills that would allow for a rebuilding of equipment. Costs become inflated because of a relatively high scrap rate and inadequate conservation of the waste material. Parts producers have to worry about the purity of the raw material, especially if they are using automated equipment. To obtain material that is equal to specifications from foundries and other sources is frequently impossible and this sets off a chain reaction through the system leading to wastage in production, substandard quality of parts, excessive reject rates and extra work by buyers to make the parts usable.

7.42 These problems are not peculiar to Malaysia, they are encountered in varying degrees all over the world and are amenable to solutions. In Germany, where the machinery industry has a high reputation for quality and productivity, a widespread and thorough apprenticeship system helps avert skill shortage. Higher level training programs ensure a steady supply of accredited techniciansof sufficient calibre. Finally, programs sponsored jointly by industrialassociations and the government make available extension services for improving plant layout, selection of machinery and the setting up of equipment for most efficient use.

7.43 Reviewing the causes of slow growth in the field of electrical machinery brings us back to familiar imperatives: the need for skills, technical assistance through industrial extension services, support for local subcontractorsthrough government projects and development that increasingly is independentof the MNCs. But fiscal, trade and financial incentives should not be neglected. Currently,a firm with Pioneer status receives tax relief for 2-8 years. Others can apply for investment tax credit allowing them to deduct 25% of capital expenditures from taxable income. In addition, one- third of any outlay on R&D can be subtracted from gross income. Firms that export are permitted (i) an export allowance equal to 5% of sales value; (ii) accelerated depreciationamounting to 40% p.a.; (iii) double deduction for expenditureson export promotion; (iv) export credit refinancing at preferentialrates; (v) tax allowance for warehouses used to store export- able!; (vi) duty exemption on machinery imports; and (vii) duty drawback on levies paid on imported intermediategoods.

7.44 Adding to this list or raising tariffs would fatten profit margins but have little affect on sectoral vitality. Raising the efficiency of the administrativeapparatus that processes fiscal incentives might be a more important step and the government might also consider double deduction on - 103 - capitalezpenditures by componentsuppliers without whom the industrial foundationswill never be properlylaid. 7.45 Financialassistance could make more of a differencebecause producersthat do not have links with a majordomestic group or a foreign companyhave a hard time findingcredit at acceptablecosts. The recently createdM$l billionfund will certainlyease the situationonce the criteria governingeligibility have been clarified. But there is room for involving the developmentbanks in the modernizationof a few key subsectors,machinery being one of them. Specialfunds managedby public bankshave been quite effectivein Koreaand Japan; the possibilityof using them in Malaysiais worth studying.

AgriculturalMachinery

7.46 The periodof most rapid agriculturalmechanization was in the seventiesand earlyeighties and this generateddemands for equipmentthat were met increasinglyfrom domesticsources. Importsthat had supplied80X of needs in 1973 were down to 39Z in 1983,while the number of local firms rose above 50, and the labor force approached2,000 workers. Comparedwith the rest of the machinerysubsector, agricultural machinery notched up the fastest growth rate, the highestreturn on assets (stilla respectable23Z in 1983) and somewhatless hearteningly,the swiftestincrease in nominalwages - 35Z p.a. during 1973-81.

7.47 The government'sliberal policies towards the importof farm machinery,on which no importduties are levied,certainly seem to have served the interestsof agriculture,but the cost was reducedlinkages to the machinerysubsector. The local contentof simplemachines, such as rotovators and rotoslashersis now as high as 80X, only the enginesbeing importedfrom Japan, but most of the other equipmentis assembledfrom completelyknocked down (CKD) parts. Local contentratios for combinesand tractorsare as low as 5-10Z with only items such as the driverhoods and radiatorgrills being locallymanufactured.

7.48 The absenceof tariffrestrictions has not helpedthe smallerfirms that have to contendwith importduties on partsand materials,rising wages and scarcityof credit,but the 14 large companies,that accountfor two- thirdsof the assetsand half the employment,have also shownno initiative. In spite of the many years they have been in existencetheir expertise does not extendbeyond routine assembly. Links with foreign suppliers,several of which maintainsmall shares in local firms,have not been exploitedso as to inducetechnology transfer. And the assemblershave not been goadedby a policy regardingdomestic content to encouragethe manufactureof parts in Malaysia.

7.49 A pricelessopportunity may have been allowedto slip, becausethe advancedstate of agriculturalmechanization and the probabilitythat productionof rice and rubberwill stagnateor even decline,all suggestthat the domesticdemand for machinerymight expandno faster than GNP, i.e. 3.5-4.5Z p.a. Producers,therefore, can expect less of a cushion from rising local sales. Still,the chancesof carvingan exportniche for the simplerkinds of - 104 - farm machinery,are much better than for many other manufacturedproducts. Moreover,development of this subsectorwould dovetailvery vell with the deepeningof machinery,metal productsand transportindustries.

7.50 If the agriculturalmachinery subsector is to change directionand eventuallybecome an innovativeproducer of locallydesigned small machines and even items such as pedestriantractors, it will requirethe effective juxtapositionof incentivesand constraints.The incentivesmight have to come from a degreeof protection;the constraintsfrom encouragingfirms to substitutelocally manufactured parts for importedones. As the designand productionof partsfashioned to meet ezactingtolerances gathers headway, it will be easier to think of innovationswhich might lead the way to export possibilities.In its effortto stimulateindustrial deepening, Malaysia will surelybe helpedby the relativeease of obtaininglicenses in a technolog- icallystable industry.

Electronics 7.51 Electronicseuphoria is finallybeginning to subsideas marketsfor computersand peripheralsin the U.S. and Japan begin to show signsof indigestion.But the belief in electronicsas the great industrialhope for export-leddevelopers lives on, especiallysince demand in the European countriesand many of the East Asian economies,because of a late start,is still racingahead. Recentexperience should, however, be reflectedupon by all producersof electronicparts and componentsas it warns againsta pronouncedcommitment to this industryor the advisabilityof attemptinga move ups-reaminto electronicequipment and electronicbased consumergoods.

7.52 The world marketfor electronicproducts has grown from US$50 billion in 1970 to US$380billion in 1985. The share of semi-conductorswas 5.82 at the beginningof this periodand 9.0X at the end. Some projectionsenvis- age a doublingof the dollarvalue of electronicsproduction by the early ninetiesbut only a minor increasein the share of semi-conductorsas the price of logic circuitsis expectedto remainon a steeplyfalling trend. Even if this growthmaterializes, and doubtsare now being voiced,the manner in which worldwideproduction is organizedmay look very different,ten years from now.

7.53 The spreadof the electronicsindustry to East Asia, which commenced in the early seventies,was promptedby the desireof Americancompanies to preservetheir profitmargins and ward off Japanesecompetition by transferring some of their labor intensiveoperations to the oppositeshores of the Pacific. Where Japanesefirms used cheap and elasticcapital supplies to automate,U.S. corporationscontained labor costs by moving some factories overseas. The strategywas facilitatedby the easy separabilityof the productionsequence into segmentsand the practicabilityof shippinghigh value items by air. Thus assembly,bonding, testing and 'burn in' of semi- conductorsbecame a thrivinglabor intensiveindustry in East Asia. That it was a low value-addedoperation based on importedmachinery and raw material did not troublethe host economiessince such investmentprovided employment, held out the possibilityof technologytransfer and drew them into the fastest moving trade stream. Table 7.6 gives a glimpseof the Asian electronics Table 7.6: CHARACTERISTICSOF THE ASIAN ELECTRONICSINDUSTRY

Number of Production Dependence workers Dependence on foreign Country (million $) Composition on exports (1,000) investment Stage of development

Korea 3,300 Consumer appliances 40% 70% lRO 25% (50% including joint export base for consumer industrialappliances 10% ventures) electronicappliances and components 50% components

Hong Kong 2,000 consumer appliances 68S more than 90 approx 10% export base for low-to-medlum industrialappliances 2% 90% priced consumerelectronic components 30% appliances

Philippines 320 65% componentsotherwise 90% 34 extremelyhigh export base for componentsand mostly for consumer assembly base for electronic appliances appliances for local market

Singapore 1,850 consumer appliances 39% 90% 66 extremely high (more than export base for consumerelec- industrialappliances 2% 80% of total production) tronic appliances (depend- components 59% dance on importedcomponnents more than Korea and Taiwan)

Indonesia 541 more than 90% for 2% 43 high (foreign investmentis assembly base for electronic consumer appliances restrictedto some areas appliance for local market but most producersare I receivingtechnical asseis- tance)

Halaysia 990 902 components 75% 61 extremelyhigh (more than export base for low-to-medium 90% of the total priced consumerelectronic production) appliancesand components

Thailand 106 90% consumer appliances 102 40 extremelyhigh assembly base for electronic appliances for local market

Sri Lanka little small productionof 0 n.a. low assembly base of some elec- radios tronic appliances for local market

Source: Journal of the Asian ElectronicsUnit, July 1981. - 106 -

industry in the early eighties. Three features are very apparent. The foreign presence is high in every country; consumer appliances and components dominate production; and much of the output is exported. Where American firms are involved, it goes mostly to the US; in the case of the Japanese, consumer appliances are sold in East Asia and Europe, while the components might be shipped back to the home base.

7.54 Technology, competitionand now protection have wrought great changes in the electronics assembly industry and their direction is eroding the comparative advantage of the East Asian economies. To start with there has been a tremendous scramble for market share and firms have spared no effort at advancing technologyand paring costs. This has had the effect of greatly reducing the profitabilityof the industry, enhancing the importance of company sales volume - since profit per item is so depressed - and forced sellers to shore up the design and reliability of componentswhile still remaining cost competitive. It has also placed an enormous premium on technological change, as an entry barrier, a way of stealing a march on competitors,and a device for inflicting losses on other firms with a capital stake in earlier technologies. Inevitably it has tended to oligopolize the industry. Large, vertically integrated firms can most effectively reduce market uncertainty,finance R&D, cross-subsidize chip manufacture, offer stable internal markets for components and absorb the vast capital costs stemming from short product cycles and the rapid obsolescenceof capital equipment.

7.55 The exigencies of cost competitivenessand product reliability have also brought in their train a form of automation that is suited to small batch production. New stand-alone,bonding machines replace 30 operators and advances in software make possible automatic testing. These technological gains reduce defect rates and at the same time diminish labor costs that were instrumentalin the migration of the electronics industry to low wage developing economies. Protectionismin the western countries is also working to bring the farflung operationsof the MNCs back into the industrial world. France and Italy have been shelteringtheir electronics industries for some time, but as Europe worries over its shortcomings in the field, others may follow. Even the U.S. has become exercised over the consequences of exporting jobs overseas. MNCs, ever alert to shifting sentimentsand the configuration of future markets are acting to synchronize their worldwide operations and impose rationality upon a dispersed system of sourcing, created piecemeal over fifteen years. It is interestingto note that of new semi-conductor investments between 1979-84, all but a handful were in developed countries. Consumer electronics where assembly is labor intensive might continue to flourish in East Asia. However, component manufacture by MNCs may not remain a growth field in an industry headed towards customized chips for special uses that must be made in small lots and "garden variety" semi-conductorsthat can come off automated assembly lines.

7.56 If component manufacturedoes not expand or grows slowly, what lies ahead for the electronics subsector in Malaysia? As indicated in Table 7.7 Malaysian production is much more heavily concentrated on components than either Korea or Singapore. In 1983, the semi-conductorfirms employed 50,000 workers, 80Z of them being semi-skilled,female assembly line operators. For - 107 - the entireelectronics industry the labor force totaled83,000 (1984). Fized assetsper worker were a modestM$11,237 and value-addedas a ratio to output, in the most recentyear was close to 302. Gross value of outputwas almost M$6 billionin 1984, a twofoldincrease over that level in 1979, and semi- conductorsclaimed close to four-fifthsof this amount. As was statedat severalplaces above, it is the exportof electronicsproducts largely manu- facturedin the FTZs/LMWs,that has helped to boost the trade in manufactures, especiallythe large increaseregistered in 1984.

Table 7.7. COMPOSITIONOF ELECTRONIC SECTOR OUTPUT

Percentageshare of output Sector Malaysia Korea Singapore Japan

Industrialelectronics 5.7 16.0 14.8 35.9

Consumerelectronics 8.7 38.6 33.3 32.2

Electroniccomponents 85.6 45.4 51.9 31.9

Total 100.0 100.0 100.0 100.0

Source: IndustrialMaster Plan - ElectronicsSector, forthcoming.

7.57 Being an industryalmost completely in the hands of foreigncompanies,it has not encounteredmany of the problemscommon to the other sectors,but perhapsfor that reasonit has remainedan enclave,with the minimumof linkageswith the rest of the economy. Local subcontractorssupply plasticmouldings, fabricated metal parts,gold wire and precisionmachining services,but the amountsinvolved are not significant.By and large the foreigncompanies have met their needs from abroad,have not made a concerted effortto disseminateprocess technology to Malaysiansubcontractors and have explainedtheir lack of successin forginglocal linkagesby the poor quality of the parts availableand the unreliabilitvof suppliers. Techniciansand workerscertainly have receivedtraining, but the effectsof this have been less visiblethan in the NICs and producersof keyboards,disc drives, small electricmotors etc., a comonplace elsewhere,are surprisinglyrare in Malaysia. But on a secondglance it may not be so unusualgiven the degree to which productionis centeredon semi-conductors;given also that the electronicsindustry has few linkagesthat could be readilyexploited; and seeing that the scarcityof engineersand computerspecialists means that Halaysiais not a fertileplace for eithersoftware development or regionalresearch centers.

7.58 Of all industries,electronics must be the most difficultone for a newcomerthinly garbed with research,production or marketingexperience to enter. Undoubtedlythere are nicheswhich small firms in the U.S., the U.K. - 108 - and a few Asian economieshave been able to capitalizeupon. These are in softwareor specializedminicomputers, failsafe computers, and specially designedor customizedchips (19Z of the marketfor semi-conductorsin 1985). Indianfirms drawingupon the country'shuge reservesof cheap engin- aeringtalent have begun collaboratingwith foreigncompanies to produce specialized"applications software." Companiesin Korea have begun producing customisedchips along with personalcomputers, monitors, disc drives and keyboards. Virtuallyeverything else is managedand orchestratedby a few large Japaneseand Americanfirms. Their decisionson sourcingare decisive. 7.59 The gap betweenMalaysian wages and those paid in the NICs probably narrowedin the eighties,and the countryis less attractiveon purelyecono- mic grounds,than Thailandor Indonesia. Long associationand politicalsta- bilitywill help sustainMNC interest,so the mediumrun prospectsof the electronicsindustry are good. But as a dynamiccore for Malaysia'slong-term industrialization,the industryis probablytoo technologyintensive and oligopolisticto serve as an enginefor the developmentstrategy. WoodenFurniture

7.60 If theory is a guide,Malaysia's comparative advantage would appear to be in resourcebased industries,among which woodenfurniture could be a leadingcontender. Being a labor intensivesubsector that has enjoyedgreat successin the East Asian NICs only adds to its appeal. Actualaccomplish- ments,however, belie a priorireasoning. Secondarywood processingactivi- ties contributed0.86Z to manufacturingvalue-added in 1982 (X$154.5million); exportsof furniturewere a mere M$19 million in 1984;and Malaysiaimported an almostequivalent amount of luxuryhigh fashionpieces from the European countriesand mass produceditems from its industrializingneighbors.

7.61 That progresshas not been fastercannot really be blamed on the incentivesystem. Nominaltariffs on importedwooden furniture are 55% and effectiveprotection at 66-73%is among the highestfor any industry. Furnitureproducers are eligiblefor pioneerstatus, tax creditand locational incentives,plus there are specialbenefits for wood workingtools. The causesof sluggishdevelopment must be soughtelsewhere. One view is that primarywood production(logs and sawn timber)has long deflectedbusinessmen away from secondaryprocessing. The ease of producingand tradinglogs, high profits,the absenceof tariffimpediments in developedcountries and trouble- free financinghave cast furnitureproduction, which tests entrepreneurial mettle,into the shade.

7.62 This is only a part of the explanationand when we look at the microstructureof the industrycertain familiar problems can be espied. A lucrativedomestic market has providedfertile soil for new firms but the majorityare small operationsthat producehome furnitureof indifferent quality. They labor under five major difficulties:there is a grave shortage of craft skills;design capabilities, even when it comes to copying foreign models,are fairlyprimitive; firms are undercapitalizedand few possessthe requisitespecialized machinery without which decentstandards of quality cannotbe attained;many companiesthat are no more than glorifiedworkshops are unableto find the collateralneeded to obtaina sufficientvolume of - 109 -

credit;because international market prices make it profitableto export betterquality wood in the form of logs, domesticproducers have to make do with materialsof a lower grade;and the skill shortageextends to repair and technicalstaff so that equipmentat the furnitureplants is poorlymain- tained,aggravating the seriousnessof some of the other handicaps.

7.63 The ban on log exportsfrom PeninsularMalaysia since the beginning of 1985, will lessencomplaints about the qualityof raw materials,but trade and fiscalpolicies alone will not loosenthe other constraints.Transfer of technologymay be expeditedby a numberof recentjoint ventureagreements that have brokenthe prolongeddrought in foreigninterest. The companies involvedstand to gain both in terms of designand equipment. But unless the score of enterprisesthat have joinedup with overseasproducers can become nodes for disseminatingskills and ideas,furniture manufacturing will be unable to shake free from the inefficienciesthat have characterizedthe industry. Design,skills, machinery, capital and entrepreneurshipare the key words for a reformprogram aimed at raisingproductivity and quality. One can only repeat the earliermessage. Malaysiahas attemptedto changedevelopment tracksin a very short span of time and is now findingthat the craft, industrialand technicalskills which the East Asian NICs had two decades to develop,are insufficientto fuel the growthof subsectorsthat are tipped to become futureexport industries.Clearly, furniture production must first adequatelyfill its domesticrole beforeany exportplans can be considered. If qualityand efficiencyare to improve,competition from importsought to be maintainedand over time, increased,but the industrywill need assistanceat the very minimumin the areas of design,credit and skills;a discriminating local rzrketaware of fashionsoverseas and consciousof standardsadhered to by foreignproducers will do the rest. As the other NICs have shown, small size of firms is not a bar to export successas long as domesticproducers are preparedto familiarizethemselves thoroughly with tastesand demandsin the principalforeign markets and to then sedulouslycultivate the designand craft skillswhich will allow them-tofulfil these requirements.

7.64 The availabilityof domesticraw materialsis no guaranteeof success,but furnituremanufacturing, at leasthas the potentialfor effectivelydisplacing imports of medium qualityhome and officefurniture. Whetherthe slow growingand extremelycompetitive external market will be hospitableto Malaysia'sexports in the mediumrun is less certain.

Rubber Products

7.65 Malaysia'spreeminence as a rubberproducer has raisedhopes of the countryeventually becoming a world class centerfor the manufactureof rubber goods. As indicatedin Chapter4, tires and automotiveproducts are the main users of rubber,and it is in those areas that Malaysiawould have to venture to acquirea significantshare in the world market for rubber products. For the domesticeconomy to benefitfrom this strategy,acquiring equity in one of the multi-nationaltire manufacturerswould have a smallpay-off, instead production facilitieswould have to be developedin Malaysiaitself so that employmentand linkagescould be generated. As a core industry,rubber ranks lower than some of the others for a varietyof reasons. First, the demand for tires and rubberaccessories for motor cars is projectedto increaseslowly in - 110 -

the industrial countries and this is no longer an industry where large profits can be made. Imports of rubber goods, excluding footwear, increased in nominal terms by just 0.68% p.a. during 1979-83. Second, a dynamic manufac- turer must be at the technologicalforefront of a highly research intensive industry. Third, to join the industry'sgiants a producer must establish links with some of the principal automobile campanies so as to enter the market for original equipment and, in addition, an intercontinentalsales network has to be developed and backed by unflagging advertising campaigns. Fourth, tire production does enjoy scale economies, which is why market concentrationis so noticeable. This raises the capital costs of entry and limits the opportunitiesto large, vertically integrated companies, lessening spread effects and multi-nucleateddevelopment. Fifth, the tire industry in the West has suffered from the rough economic weather of recent years in the same way as certain other traditional subsectors, and tire producers are moving into other product lines. It has, therefore, joined in the call for protection and a degree of market closure against imports of cheaper tires from NICs such as Korea and Brazil.

7.66 World market circumstancesdo not look overly propitious and, at the moment, Malaysia's production, research and marketing base is below the standardsof even the East Asian NICs who have entered the tire business. The local industry is almost exclusively (93%) a user of natural rubber which it obtains at a discount over the internationalprice, as compared to the worldwide ratio of natural to synthetic rubber usage (30-70) that is tilted towards synthetics. But the industry still consumes only 4.2% of the rubber output. There are in the region of 140 companies of a size and capital intensitythat is a little above the manufacturing sector average. Production capacity is slanted towards latex products and cires (60% of total), the remainder being in general and industrial rubber goods as well as footwear. Capacity utilization is highest for latex items (70-80%) followed by tires (60-70%) and footwear (50-60%).

7.67 Local consumption of rubber products rose 8.2Z p.a. in the 70s and by 6.2% p.a. during 1980-83 and the industry, especially latex products, expanded strongly with the advantage of high effective protection (ranging from 98% to 224%). The effect on Malaysia's world market position was disappointing. Although 5% of the latex products demand worldwide has been captured by domestic producers, they can lay claim to only 0.1% of the total rubber goods market and their presence in the critical tire market is negligible. More surprisingly, the share of rubber goods imports rose from 18% in 1970 to 23% in 1983.

7.68 In the medium term, there are reasonable prospects for latex products, since the raw material is bulky to transport, and Malaysia can realisticallyaim to expand its international share. Domestic tire demand will receive a boost as the Proton Saga consolidates its position in the new car market. The profitability of tire manufacture would benefit if the costs of carbon black, produced by a single, heavily protected local firm, could be lowered either by allowing in imports or by scaling down the prices of the single indigenous supplier. - ill -

7.69 Longer term plans in the sphere of tire manufactures and export are not easily reconciled with the projected trends in the manufacturing sector. Electronics poses formidable problems because of research intensity and a vertically integrated, oligopolistic industrial structure, so too, does entry into the world tire market. It will be one thing to meet domestic demand, and another thing entirely to mobilize the diverse range of skills needed to mount a sustained export drive. Since natural rubber comprises little more than 7% of the cost of a radial tire, the ability to produce rubber is not an especially compelling advantage. Further, Malaysia's best strategy might be to concentrate its limited supplies of capital, trained manpower and organizational skills into subsectorswith the highest linkages and the greatest likelihood of bringing into existence a flock of smaller producers that can, after they mature, count on firm export demand. Tire manufacturing does not hold out as much hope as some of the other subsectors, and without tires, the remainder of the rubber products industry is sufficiently footloose that a single country cannot expect to corner more than a fraction of the market.

Summary

7.70 By traversing a few industrial subsectors it is easy to apprec5ate how far Malaysia must go to realize its plan of moving into the industrial circles peopled by the East Asian NICs. All of the sectors that might con- ceivably serve as building blocks for a modern export-orientedmanufacturing system are still diminutive in proportions and under-populatedby firms with a demonstratcd capacity to provide subsectoral leadership in the export arena. East Asian NICs have been unsparing in their efforts to accumulate human capital. Together with high rates of saving and investment, this has enabled them to colonize one manufacturing subsector after another. Malaysia, thanks to its natural resources is not strapped for investible resources, but it is short of technical and industrial skills and its business talent has been diverted, in part by government regulation, partly also by the pull of other opportunities,away from the task of industrializing.

7.71 Malaysia can be justly proud of its many faceted financial system, but when compared to that of Korea or of Japan in the fifties it is apparent that financial institutionsdo not see their principal task as that of serving industry. Financial activity has been influenced by Malaysia's long history of primary production and its outward looking stance. More recently it has been shaped by the intensive development of housing, infrastructureand real estate. Manufacturing industry is far from being the financial community's largest customer (see Table 1.5); it is certainly not the one with the most appealing credentials. Credit does find its way to industry, but it is the residual left over after other market participants have slaked their requirements. New credit channels to industry, possibly informed by the experience of Japanese and Korean development banks, might usefully be dredged. Without them, the medium and smallscale producers of intermediategoods might never take root and the entire objective of reaping an export spin-off from this type of development would be vitiated.

7.72 The message is simple: to the extent that political exigencies permit, businessmen should be unshackled from the Industrial Coordination Act (ICA) related regulations; engineering,design and vocational skills must be - 112 - greatlyaugmented;A71 and the financialsystem must be tuned so that the manufacturingsecror receives the actentionit vill now need. A study of Japan'sindustrial strategy since the fiftiesreveals how MITI nudgedmajor companiestowards a new subsectorwith information,credit, fiscal allowances, and technicalsupport, often throughgovernment institutes, and provided protectionuntil the industrywas fit to competeagainst foreign goods. At that stage,tariff barriers were lowered,but by then, the industrywas quite able to stand on its feet.

7.73 Developmenttheory has not yet improvedon this recipeexcept to underlinethe importanceof followingthrough with a schedulefor lowering tariffs. But the contrastingexperience of the Latin countrieswith import substitutingindustrialization suggests that such a strategymust be resolutelyexport minded and uncompromisinglydevoted to eventuallyachieving competitivenessif it is to culminatein a viableindustrial system.

17/ A lucid reviewof the contributionthat designhas made to the successof manufacturingcompanies is providedby, C. Lorenz,The DesignDimension, Blackwell,1986. - 113 -

CHAPTER VIII: THE FUTURE OF AGRICULTURE

8.01 Having scrutinized the most promising segments of the manufacturing sector, it is now the turn of agriculture. The number of questions which can be profitably pursued is limitless, but from the twin perspectivesof growth and trade, the question of greatest importanceis the following: given what is known about factor supplies, technology, institutionalprocesses and price trends, how much can rubber, oil palm, cocoa, and rice production contribute to Malaysia's growth and exports and import substitutionover the next five years? To limit discussion of the four subsectors to a reasonable length, the material presented will stray as little as possible from the above question.

8.02 According to the land use survey of 1980, there are 20 million hectares (ha) of agricultural land in PeninsularMalaysia of which 11.2 million are given over to farming (see Table 8.1). But of the land in use, 634,000 ha lie idle, 60% of which are suitable for tree crops. A further 2 million ha are alienated but not cropped. Of the balance - 6.8 m ha - about 3.8 m ha falls into soil classes I - III and could be drawn into cultivation. However, 3 m ha are forestry reserves held by State governments and off-limits to Federal agencies. Ecological concerns increasinglybeing voiced could also determine how much of the potentially available land is cultivated. From a 1975 survey, Sabah is known to have 5.3 million cultivable hectares, less than a fifth of them currently in use. Only half of Sarawak's agricultural land of over 13.1 million ha has been alienated but is not necessarily cropped. Of the remainder, 5-6 million ha is under native rights, leaving about 1-2 m ha of forested area accessible for commercial exploirition. When account is taken of the barriers interposedby the claims of individual states and native rights as well as the difficulties in the way of developing pockets of idle or abandoned acreage, about two million hectares could readily be utilized over the course of the eighties, a small fraction of the uncultivatedagricultural land. But, as will become clear, land supply is not the binding constrainL on agriculturalgrowth in Malaysia; labor supply, wage costs and the international market situation, described earlier, are well ahead in the hierarchy of constraints.

8.03 Malaysia still has 37% of the labor force employed in agriculture, but the ranks of younger workers are being depleted very rapidly and the effects are being felt throughout the agriculture sector, even in rice cultivation where labor saving mechanization has acted as a cushion against the loss of workers to the cities. Large areas of rubber acreage are sporadically tapped because of low internationalprices and manpower shortages. Recently, the much less labor intensive oil palm gathering activities have also been affected by the scarcity of younger men. And the opportunity costs of labor make upland smallholderrice cultivation an uneconomic proposition at current and projected world rice prices. Abstracting from demand, it looks as though the growth in production will depend to varying degrees on migration, mechanization, wage increases and changes in the productivity of land and labor from the applicationof better technologyand management practice. - 114 -

Table 8.1: LAND AVAILABILITY (Million ha)

Peninsular Malaysia (1980 survey):

Total suitable land (class I-IV) 20.0 Cropped 11.2 Alienated, not cropped 2.0 Balance 6.8

(of which) Peat soils 2.0 Hills 1.0 Balance (no limitations) /a 3.8

SABAH(1975 survey) Total suitable 5.3 Alienated 1.0 Balance 4.3

SARAWAK Total suitable 13.1 Alienated 6.7 Balance 6.4

/a Three million ha of which are forests or held by state governments. 7i Of this balance, some 5-6 million ha are under native rights, i.e. shifting cultivation, and therefore, not available.

Rubber

8.04 There are two million hectares of land under rubber in Malaysia, 401 owned by estates, the balance being worked in lots of under 40 ha by 454,000 smaliholders,just under half of whom make their entire living from this activity. Production grew by a comfortable 4.2Z p.a. from 1960 onwards, peaking at 1.6 million tons in 1976. Since then, most indicators point towards the beginning of a slow decline. Output has stabilized at close to the level of the mid-seventies (it was 1.53 m tons in 1984 and 1.51 m tons in 1985). Highly productive estate acreage has fallen by 300,000 hectares and production by 100,000 tons below 1965 levels. Yield per tapped hectare, which was rising by 41 p.a. prior to 1976, has also remained constant at 1.46 tons per hectare as the introductionof newer clones has slackened and, because replanting has been neglected, the average age of rubber trees has shifted upwards. Whereas, ideally about 3X of the area should be replanted to allow ror the 30-year lifetime of the rubber tree, replanting has dropped from 2.8% of the area in 1965 to 1.5Z in 1975 and 1.3% in 1983, even as the hectarage under rubber as a percentage of all land in rubber growing plantations (i.e. plantations producing solely rubber plus those growing rubber and other crops) has fallen from 78% in the early seventies to 58% in the mid-eighties. The immature area, which is the source of higher yield annual increments to the - 115 -

stock of trees, was just 14Z of the total in 1983, half of what it had been 20 years ago. To compound matters, the quality of the plantation labor force has deterioratedand the number of workers has fallen annually by 3.3Z since 1960 as a result of area cuts and productivity growth. Where once males outnum- bered women, and young workers made up 5Z of the total, females are a clear majority (56%) and migration has whittled down the numbers of the young to 1%. Thus skilled rubber tappers with productivitydifferentials of over 20% above the average, are in dwindling supply and the pool of estate manpower is aging, with an increasing number now in the 41-50 year age bracket.

8.05 Much of the decline in estate acreage has been offset by the 260,000 hectare expansion of smallholder acreage spearheaded by a number of government schemes. The Federal Land Development Authority (FELDA) has planted new areas under rubber and resettled smallholderson these more fertile and better designed units. By replanting and consolidating existing smallholder plots, another agency - the Federal Land Consolidation and Rehabilitation Authority (FELCRA) - has attempted to improve the smallholder production system. Finally, the Rubber Industry Smallholder Development Authority (RISDA) has taken the lead in creating mini-estates by agglomeratingadjacent units or by starting ventures for the peasantry in virgin areas. Such efforts, especially those of FELCRA, have often been obstructed by the problems associated with tracking absentee owners, obtaining consent and changing titles and RISDA has yet to achieve the managerial breakthrough required to make mini-estates a commercial success. Moreover, the Mid Term Review of the Fourth Malaysia Plan found that the poverty rate among rubber smallholdershad increased from 41.3% in 1980 to 61.1% in 1983. Unfortunately, the yield difference between the highest-yieldingestates and the lowest-yieldingsmallholdings is as large as ever - 1,900 kg/ha as against 700 kg/ha. Further, long experience has shown that the development and spread of new clones and techniques for maximizing yields depends on the involvementof the estate sector, owing to its size and dynamism. Should the estate sector be eclipsed, smallholder agriculture would also be dragged down. - 116 -

Table 8.2: PLANTED AREA AND PRODUCTION OF RUBBER IN MAIN PRODUCING COUNTRIES

Year of Planted Area ('000 ha) hectarage Small- Production /a Yield /b data Estates holdings Total ('000 m.t.) (mt/haT_

Malaysia /c 1983 476.6 1,533.3 2,009.9 1,562.0 0.78

Indonesia /d 1983 485.3 2,018.8 2,504.1 997.0 0.40

Thailand /c 1983 76.8 1,459.2 1,536.0 587.0 0.38

Sri Lanka /c 1983 140.4 65.2 205.6 140.0 0.68

India /c 1982 67.1 223.9 291.0 165.9 0.57

/a Production in year correspondingto hectarage data. lb A crude measure of the industry's productivity, since only mature hectarage should be used in this calculation,not total hectarage.

/c Rubber Statistical Bulletin, IRSC, various issues.

Id Indonesia: The Major Tree Crops - A Sector Review, Report No. 5318-IND, World Bank, for official use only.

8.06 Malaysia still enjoys a commanding lead over its closest competitors, Sri Lanka, Indonesia and Thailand (see Table 8.2), in the yield averages, but there is a view in some quarters that the Malaysian rubber industry will eventually be overtaken in terms of output, and its size greatly reduced by expanding cost competitiveproducers in Thailand and Indonesia, that have planted vast new acreages with the latest clones. Should Malaysian estates take this prophecy to heart, it is bound to be self-fulfilling,because a reduction in estate acreage under rubber to 20Z of the total will drag down production,yield and cost competitiveness. In the longer run, the waning interest of the estates would spell the end of what is still a dynamic industry. A move towards deliberatelycontracting estate acreage and rubber output will mean that even with the continued attempt to bolster smallholder rubber cultivation, the sector would pull down the growth of GDP at a time when the economy will be poorly supplied with leading sectors.

8.07 Could the decline of the rubber industry be averted and what is the desirable strategy for managing future production and investment? It seems the chief complaint voiced by the estates is that the profitability of rubber production is caught between the pincers of falling prices and rising costs and no longer compares favorably with returns from oil palm which competes for land under rubber, although not fully for labor. - 117 -

Table 8.3: MALAYSIA: COST OF PRODUCTION (COP) FOR RUBBER ESTATES 1978-83 (Sen/kg)

1978 1979 1980 1981 1982 1983

Cost of production of field crop 96.47 103.95 117.70 123.06 126.09 123.79 Processing cost 14.62 18.89 21.05 23.99 27.49 30.03 Immature area cost 9.63 9.46 11.06 9.45 20.73 22.10 Research cess 2.20 2.20 2.20 3.85 3.85 3.85

Total 122.92 134.50 152.01 160.35 178.16 179.77

Memo Items Average Annual Rate of Change 1978-83 (Z) COP (Nominal) 7.9 CPI (1980=100) 5.9 COP (deflated by CPI) 1.9 Price of RSS1 (nominal) 1.5 Price of RSS1 (real) -4.2 Price of SMR20 (nominal) 0.3 Price of S1R20 (real) -5.3

Source: Malaysian Rubber Crowers' Council (MRGC); various unpublished surveys.

The trend in costs can be seen from Table 8.3. During 1970-84, tappers' wages (531 of total production costs) have risen 0.2Z p.a. in real terms whereas productivityhas increased by 3.2Z p.a. Costs of fieldworkers (14% of total) have increasedby 3Z p.a. in real terms, fuel (3.4Z of total) by 15.51 p.s. and fertilizer (3.8Z of total) by 1.6X p.a. Taken together, we have the following picture: rubber prices fell by 1.5Z p.a. over the fifteen year period, and real costs climbed 3.3Z each year. Counterbalancingthese was a 2.51 p.a. growth in yield per hectare. Thus earnings have been squeezed but it is doubtful that the estates which were known to be highly profitable in the late sixties could now be at the "breakeven point." Further, costs are likely to be overstated, first because the export duty which is charged as a percentage of the difference between the gazetted price and the cost of production, encourages producers to exaggerate their expenses. A second reason is that wage outlay may also be overstated as many estates rely upon Indonesian migrant labor which is likely to be paid less than the local workers. - 118 -

Table 8.4: RUBBERESTATE WORKERS- INTERNATIONALWACE COMPARISONS (daily wages)

Indonesia Malaysia Wages in Wages Wages in Wages in rupiah in US$ ringgit /a US$

Tapping

1980 891.45 1.42 10.36 4.76 1981 1,050.46 1.66 10.64 4.62 1982 1,271.66 1.92 10.68 4.57

Field Workers

1980 838.4 1.34 6.76 3.11 1981 913.7 1.45 6.84 2.97 1982 1,118.1 1.69 7.52 3.22

Processing

1980 798.5 1.28 9.00 4.13 1981 983.2 1.56 9.36 4.06 1982 1,115.1 1.69 12.08 5.17

/a Assumes 25 working days a month.

Source: InternationalFinancial Statistics, IMF; Labour Indicators, Ministry of Labour and Manpower, various issues; Average Wage of Estate Workers: 1980-1982, Biro Pursat Statistik, Jakarta, Indonesia, Table 2.

8.08 That said, the problem of depressed profitability remains, and Malaysian producers worry about the effects on prices of increased production by Indonesian producers with wages that are between 40 and 60X of those paid to Malaysian tappers (see Table 8.4). While future price projections are troubling when it is apparent that costs will go on increasing and there may not be a commensurategrowth in productivity, a retreat from rubber by the estates might not be warranted. First, the large estate acreage, in an oligopolisticmarket, deters other producers from planting more for fear of a price war and a collapse of prices. If Malaysia were to unilaterally contract its highest yielding plantations,this would signal the start of a retreat and would trigger decisions elsewhere that would seal the fate of rubber in Malaysia. Second, controlling labor costs (70% of total outlays) might not be difficult in the future because a large portion of estate labor is a 'non- competing group', locked in by age, tradition, skill and scanty urban opportunities. It also bears a part of the risks from falling rubber prices since the daily wages paid to workers are related to rubber prices. For some time - 119 -

also, wages will be curbed by pressure from imigrants. Third, there remains room for productivity increase through better estate management and tapping practices as shown by the variation in yields (see Table 8.5). Fourth, in tomorrow's trading environment, it could pay to have a diversified mix of exports whose prices and demands are relatively uncorrelated, so that earnings are protected from unpredictablechanges in market conditions for individual items. Fifth, Malaysia can maintain its estate acreage under rubber while expanding oil palm output to the extent permitted by labor supply (and it should be noted that few of the older tappers could readily switch occupations) by making additional uncultivated acreage available and by altering the relative size of grants (as the Government has already begun to do), so as to promote oil palm instead of rubber cultivation by smallholderssituated near existing production centers. Sixth, as stated earlier, without the technologically dynamic estate core, the smallholder periphery is condemned to a lingering death brought about by rapidly diminishing competitiveness. Finally, an adjustment in the real effective exchange rate of the ringgit, back to the level of 1980, would about equalize the cost of prod-.=tionfor Malaysian estates with her major competitors in lIdonesia and Thailand.

Table 8.5: VARIATION IN COST OF PRODUCTION BY YIELD CATEGORIES

Estate average yield group Cost of production (sen/kg) (kg per ha) 1980 /a 1981

1,150 and below 138.03 142.91

1,151-1,350 123.59 131.74

1,351-1,550 120.70 127.47

1,551-1,750 113.07 119.04

1,751-1,950 106.99 111.40

1,951 and above 96.76 i05.85

Total 117.70 123 .06

/a This has been converted to kg/ha from lbs/acre.

Source: MRGC survey, 1980 and 1981.

8.09 Rubber could maintain vestiges of its export stature through the remainder of this century, contribute to employment and, more modestly, to growth, if measures are taken to arrest the decline in estate acreage and - 120 - replantingpolicies followed, that will safeguardproductivity well into the future. It would be poor economicsand tacticallyunfortunate, if the gradual withdrawalfrom rubbershould commence with the dynamicand highly productive estate sector,rather than stagnantsmallholder agriculture. For a small expenditureof capital,using land that is in relativelyelastic supply and labor that has few alternativeuses, rubberproduction could continueto supportthe nationalproduct and serve as the touchstonefor a flourishing rubberproducts industry.

8.10 Three productionscenarios can be visualized. In the first, the governmentachieves its announcedplans of signific.ntlyexpanding and reha- bilitatingsmallholder rubber stands. The vacuum createdby the withdrawalof the estatesis filledby aggregatingthe majorityof the smallholdersinto relativelyefficient estate-like organizations operating under the share system. This is consistentwith the government'sannounced plans. According to these,FELDA will establish26.4 thousandha of rubberon Peninsular Malaysiathrough 1990. After 1990, the plantingof rubberwill cease, since the agencydoes not intendto developrubber in Sabah where the majorityof FELDA activitieswill be concentratedin the nineties. ScenarioI also assumesthat over this periodfor every two ha of FELDA rubberland needing replantingonly one ha will be plantedwith rubber. This squareswith FELDA's proposalto add more oil palm and cocoa to its portfolio. FELCUA is currently operatingunder a governmentmandate to replant566.8 thousandha of 'idle' land duringthe 1984-1996period. As 20% is scheduledto be plantedunder rubber,it is assumedthat this will be done in yearly incrementsof 9.4 thousandha. Meanwhile,BISDA which intendsreplanting 80 thousandacres (32.4thousand ha) annuallyfor 1985-1990,with 70Z plantedunder rubber,is projectedto add 22.7 thousandha of rubberacreage annually.

8.11 Startingfrom a total of 65Z of estatecultivated land under rubber in 1983, it is assumedthat the area under rubberwill declineevenly throughout this periodto 33% rubberby 1990. After 1990, the acreagewill be held constant. The 'other'category of smallholdersis assumedto decreaseat the same rate as in the past ten years. The majorityof this declinewill be absorbedinto eithera FELCRAor a RISDA scheme.

8.12 Yieldswhich averaged1.4 tons per mature ha in 1983 and which rangedbetween 1.2 and 1.9 tons/haare projectedto increasesmoothly to 1.7 tons/haby 1995,a rate of about 2% p.a. The costs of achievingthese plantingprograms for the Fifth DevelopmentPlan will be about M$1.5 billion in 1984 Malaysianringgit. This assumesthat the 1984 FELDA costs of M$13,270 per ha are reasonableestimates for establishingFELCRA schemes ard RISDA mini-estateswith the necessaryinfrasturcture. For FELCRA lands,without infrastructure,the cost is assumedto be M$8,000;for RISDA replanting outsideof the mini-estateschemes, we assumeM$5,000 per ha.

8.13 We have also exploredtwo alternativescenarios. ScenarioII assumesthat neitherFELCRA nor RISDA will be able to completelyachieve cheir targets. This is basedupon their historicalperformance and the sheer magnitude of the plannedplanting programs. Therefore,we assume that both agencies achieveone half of the officiallyannounced targets. For FELDA and the estatesector, we maintainthe assumptionof ScenarioI. Yield levelsalso - 121 - remain the same. In Scenario III we assume a drastic change in the government's approach to the rubber sector. The Government persuades the estate sector to maintain rubber area at the 1985 level. Further, we set the achieved planting targets of RISDA and FELCRA at one quarter of the base case levels. For FELDA, we again assume no change from the base case.

8.14 The output projections for the three scenarios are shown below in Table 8.6. Under Scenarios I and II, rubber production drops over the 1985-95 period. This occurs for two reasons. First. decline in estate acreage lowers annual production substantially. Second, since the gestation period for rubber is six to seven years, even eig'ltyears for FELDA-type settlements, the effects of the large smallholder replanting program are not felt until well past 1995. Also, with the lover average yields of the smallholder sector compared to the estate sector, the efficiency of the rubber sector declines significantlyover the next decade. This decline is excerbated by the high proportion of immature rubber area in total area. In fact, the Government's objective of achieving the most efficient rubber sector in the world is adversely affected by its policy. Under Scenario III, rubber production is maintained at about the current level through 1990. But between 1990 and 1995 the effects of maturing smallholder hectarage and rising estate yields combine to produce about a 1Z p.a. growth in the rubber sector. Moreover, since a lower amount of land is under rubber, overall efficiency as measured by yields per ha has risen significantly.

Table 8.6: PROJECTIONS OF NATURAL RUBBER PRODUCTION VARIOUS SCENARIOS 1985-1995 ('000 tons)

Scenario I Scenario II Scenario III

1984 1,529.1 1,529.1 1,529.1 1985 1,515.6 1,521.9 1,531.6 1986 1,470.8 1,483.1 1,541.6 1987 1,41P. 1,435.9 1,540.5 1988 1,373.2 1,396.8 1,545.9 1989 1,347.7 1,378.4 1,570.6 1990 1,310.0 1,345.2 1,578.8 1995 1,327.3 1,360.0 1,628.0

Source: World Bank estimates - 122 -

8.15 As shown above, the Government's program for the rubber sector will not accomplishthe majority of its objectives until after 1995. The group which this program is designed to assist are the poor 61.5% of the 450 thousand families dependent upon rubbex for at least part of their livelihood. However, the average age of these farmers in 1983 was 47. By the year 2000, these smallholderswi]l be 64, and the male life expectancy at birth in 1982 was only 65. Therefore, this vigorous planting program must be designed for the next generation. But, the next generation is leaving the sector and rural life rapidly. For example, recent surveys of the children of FELDA settlers indicate that only 10- 5Z of these children wish to become FELDA settlers. The Government'sstrategy, therefore, raises the immediate question of whether there will be enough farmers to harvest the crop after 1995. Further, the large investment outlays necessary over the Fifth plan period will yield no growth for a very long period. Another consideration is the international rubber market. While our assessment of the internationalenvironment through 2000 foresee-,adequate markets for Ma.Laysianrubber, there are uncertainties to these projections. The market situation beyond the year 2000 is even more murky. By that time, major technological changes may have occurred in the synthetic rubber (SR) market or in the uses of natural rubber (NR). For the Government to pursue a strategy which would entail large amounts of rubber land entering into its most productive period at that time, is to choose the most risky course.

8.16 The third scenario, which enables Malaysia to retain a substantial presence in the market, as well as the flexibility to abandon the rubber sector quickly at a lower cost would seem to be the more prudent course. As is being currently demonstrated, the reliability of estate production and the ease with which it can be diversified can be an advantage over the mediumterm. Eradicating poverty among the poorer smallholderscan be accomplished by other means, such as actively encouraging diversification into oil palm or possibly cocoa production, and/or selective transfers to the neediest farmers.

Palm Oil

8.17 With rubber production on the way to becoming a sunset industry, Malaysia is pinning its hopes on palm oil. The export potential which was discussed in Chapter 4 still looks promising, the threat from other producers not especially serious till late in the nineties, and there are some profits to be made even at prices below US$300 per ton as production costs range between US$200 and US$270 per ton. The question is how much palm oil can Malaysia produce and what factors might influence its economics?

8.18 By 1984 an 11% p.a. increase in planted area since 1970 had raised the total to 1.4 million hectares, 16% of them immature. Estates owned 634,000 hectares, but of the remainder only 20% was in the hands of unorganized smallholders, the rest being managed mostly by FELDA and to a lesser degree FELCRA. Intensive planting of oil palm began in the seventies and it is over the past five years that the maturing of large areas has raised the production of Fresh Fruit Bunches (FFBs) to 26 tons/ha on some of the estates and 21 tons/ha for the country as a whole. Thus one estate hectare yields about 4 tons/ha of crude palm oil, 0.42 tons/ha of palm kernel oil and 0.55 tons/ha of palm kernel meal. As table 8.7 shows, the total palm oil - 123 -

productionin 1984 was 3.7 million tons. It rose by 9.3n to 4.06 million tons in 1985.

Table B.7: MALAYSIA: BASIC STATISTICs0 PALK OIL

1970 1975 1980 1981 1982 1983 1984

Oil palm hectarage('000 ha) 289.8 641.8 1,023.3 1,121.2 1,182.8 1,253.0 1,361.2

PeninsularMalaylia Estates 193.4 355.2 495.4 551.0 574.6 606.5 634.5 Smallholdings 67.5 213.4 411.2 445.5 473.4 493.2 572.9

Sabah 28.9 59.1 94.0 100.6 110.7 128.2 133.7 Sarawak - 1.1 14.1 22.7 24.1 25.1 20.2

Crude palm oil production 431.1 1,257.6 2,575.6 2,822.1 3,509.1 3,018.3 3,715.7 ('000 tons)

Price of locally-delivered crude palm oil (M$/ton) 641 1,055.0 919.0 964.0 829.0 991.0 1,407.0

Source: Ministry of Primary Industries.

8.19 Certain features of palm oil agronomics,production and organization are vital to an understandingof its future prospects. Research on tissue culture cloning is at an early stage so that it is realisticto expect that the FFB yield of 30 tons/ha will be achieved and handily surpassed. The industry is already benefitting from pollination by African weevil that displaced hand pollination in 1981. Palm oil production is less labor intensive than that of rubber, and labor accounts for 381 of costs, but collecting the FFB. at a time when they have reached optimal ripeness is a physically demanding job for younger and stronger workers. Trailers have mechanized operations to a degree (and cutting equipment is being experimented with), but limits to labor augmenting mechanization are apparent from the low 1.1X p.a. increase in harvester productivity since 1975, a period during which the productivity of other oil palm industry workers was rising 3.6Z p.a. Oil palm cultivationalso requires large applicationsof fertilizerand 25Z of production costs can be traced to this one item.

8.20 Unlike rubber, the productionof palm oil is a more structured process because of the nature of the fruit. Once the FFBs have been cut, the fruit must be quickly transported in a manner that prevents bruising to a pressingmill for extractionof the crude palm oil, failing which the free fatty acid (FFAs) content is elevated. Hence producing areas must be ade- quately supplied with transportinfrastructure and eztractingfacilities which explainsthe large role of FELDA and FELCRA in the smallholdersector: palm - 124 - oil production is best when disciplined factory-like procedures are followed, quality and volume being affected when it is left to unorganized smallholders.

8.21 The economics of palm oil production which can help explain its attraction for estates and smallholdersalike can be gleaned from two recent studies, one by the Malaysian Oil PaLm Growers' Council (MOPGC) conducted in 1984 and a second by Colin Barlow. The MOPGC's estimate of production costs for crude palm oil ex-mill was M$639, with immature acreage costs of M$77, mature field costs of M$431, and processing or milling costs of M$131. These data are consistent with the 1984 cost of production (COP) statistics compiled by Barlow.

Table 8.8: ESTIMATED ECONOMIC PERFORMANCE OF ESTATES AND SMALLHOLDINGS, MALAYSIA, 1984

Independent Estates smallholdings

EstablishingOil Palm Labor iLnputs(man-days/ha) 100 120 Costs (US$/ha) Land preparation and planting 672 588 Roads 168 42 Planting materials 168 252 Maintenance,fertilizers and agrocides 336 126 Managementand overheads 210 21 Others 42 21 Total (man-days/ha) 1,596 1,050 Producing Fresh Fruit Bunches (FFB) Yield (tons FFB/ha) 26 17 Extraction rate (Z) 20-22 17 Labor inputs (man-days/ha) 70 90 US$/ha US$/ton FFB US$/ha US$/ton FFB Costs Harvesting and collection 210 8.1 252 14.8 Maintenance, fertilizers and agrocides 252 9.7 168 9.9 Infield transportation 71 2.7 - - Management 210 8.1 13 0.8 Other 13 0.5 8 0.5 Total 756 29.1 441 26.0 Milling costs (US$/ton crude palm oil) 63.0 n.a.

Source: The Oil Palm Industry, Colin Barlow, unpublished mimeo, p. 25. - 125 - 8.22 Barlowestimates mature area cost to be US$29.1per ton FFB. Under his assumptionof 26 tons FFB per ha and assuminga 20S extractionrate, this producesa maturehectare cost of US$145.50per ton of crude palm oil (CPO), or M$349.20(at an exchangerate of 2.4 ringgitto the US$). His estimateof millingcosts is US$63 (M$151.20)per ton. This yieldsa maturehectarage plus millingcost per ton ex-millof aboutM$500, about M$60 less than the MOPGC estimate. However,the yield assumptionof 26 tons/FFBis too high for an overallestate average, but appropriatefor years 8-17. Addingto Barlow's estimate,the immaturefield costs from the MOPGC surveyof M$77 resultsin productioncosts of M$577. Since the cost-plusduty formulationmay have introdtucedan upward bias into the MOPCC'sestimate and Barlow'scost of production(COP) could be too low becauseof his averageyield assumption,the most accurateassessment of the averageCOP for a ton of CPO ex-millis around M$600. By comparingthis to the priceof locally-deliveredCPO shown on Table 8.7, which averagedH$926 for the period1980-1983, estates were obtaining a profitof almostM$326 per ton of CPO. The overallaverage (including smallholders)of CPO yield per ha in Malaysiawas 3.5 tons (estatelevels are probablyequal or slightlyabove 4 tons) for the period1980-1983, producing a profitper ha of about M$1,100. This averagefinancial pro'Lt ignoresthe extraordinaryprofits earned during 1984, when locallydeliLvered CPO prices exceededM$1,400 per ton.

8.23 Independentsmallholders (Barlow's comercial operators)also earn handsomereturns from oil palm cultivationas shown in Column2 of Table 8.8. For a typicalsmallholder, with a yield of 17 tons FFB per ha and a 17Z extractionrate, the COP for maturearea is K$367 per ton CPO. Milling costs are unavailable,but the cost per ton CPO is higher than for estates, since the smallholdershave a lower extractionrate, and the crop is of a more unevenquality than on the estates. With the prevailingprice for locally- deliveredCPO, the financialreturn per ha for these smallholdersis however, still good. Barlowestimated that for the 90 mandaysof work requiredon these plots,the daily wage was about M$31 per day for their harvesting labor. The averagereturn is probablylower since 1984 was a year of very high prices,although even a daily returnof one half this level would still be higherthan alternativessuch as rubberand would be enough to pull smallholder familiesabove the M$350 povertyline.

8.24 The most importantvariables impinging on the growthof the oil palm industrywill be internationalprices and demandbut certaindomestic con- straintswill also decidehow far the industrycan move to exploittrade possibilities.For the estates,labor and land are the two prirarycon- cerns. The size of the estate labor force has increasedby about 7% p.a. since 1971 and stood at 93,000 in 1983. Of these46Z were harvesters,the ratio being about 0.25-0.33harvesters per maturehectare. Other plantation workerscan still be recruitedwithout too much difficultybut the supplyof harvestersis relativelyinelastic and the situationcould grow worse as the agriculturesector is graduallydenuded of youngermale workers. As it is, some 150.6 thousandtons of FFBs could not be harvestedin 1984 becauseof manpowershortages and it is unclearhow the projectedexpansion of estate acreagein the Easternand Southernparts of PeninsularMalaysia as well as in Sabah can be achievedif workersare not to be found or, as in Eastern Malaysia,they are disinclinedto work on the estates. Suppliesmight be - 126 -

enhanced if better wages were paid but the elasticity of response does not appear to be large. For close to a decade, real wages of harvesters have been rising 5% p.a., far above the growth in productivity,with labor shortages persisting throughout the period. Nevertheless, given the magnitude of returns and the difficulty of mechanizing there may not be many alternatives to an upward shift in the wage schedule.

8.25 Estates complain that they cannot find new land for their schemes and are forced, therefore, to transfer acreage out of rubber production. This switch is undesirable for the reasons listed in the previous section and the most appropriate policy would be for the Government to find a way around this anomaly: plantations in which the State has a commanding share being unable to expand even though the country has an apparent land surplus. The longer the delay in finding a solution, the greater the loss of rubber acreage. But complaints from estate managers regarding their land problems do not sit easily with the emerging production constraints arising from having too few harvesters. If the latter is dominant, a limited supply of land is a secondary matter. There are empirical roads leading to an answer and before the estate sector makes some radical decisions concerning its portfolio of tree crops and the rate at which it will enlarge oil palm acreage, a fuller examination of emerging trends may be warranted.

8.26 Since the estate sector appears to have few degrees of freedom, there is more reason to encourage smallholder development of palm oil rather than rubber. This will require a three pronged policy drive. Agencies such as FELDA which have the land and resources will have to accelerate their programs for putting in place the infrastructureand organizationalscaffold- ing needed. Second, the Ministry of Agriculture. that now provides extension to smallholdersshould improve the quality, comprehensivenessand geographical coverage of its services. By the early nineties, the time will be approaching when smallholders'oil palm groves will need to be replanted, creating a demand for credit. A suitable program, if introduced in advance, would facilitate the renewal of smallholder stocks.

8.27 Other lesser problems in the areas of duty exemption on refined palm oil exports and refining capacity also beset the industry, but from the angle of growth, labor, smallholder development and land are in the forefront. The industry projects a 6.6% p.a. increase in palm oil production during 1984-90 with an output of 5.5 million tons in 1990, which would contribute significantly to the macroeconomic goals of the Fifth Plan. In the absence of detailed informationregarding rural labor markets or good quantitative projections of intersectoralmigration under the weaker economic conditions forecast for a part of the Fifth Plan period, the influence of labor supplies on palm oil output is difficult to gauge. But if the industry remains on its productivitytrend, the demand for harvesters will rise roughly by 3% p.a. or 8,625 in absolute terms.

Cocoa

8.28 The speed at which cocoa production has risen underlines the secondary nature of the much touted land constraint on the expansion of peren- nials. From negligible levels in 1970, the acreage under cocoa grew 26% p.a. - 127 - to 225,000 ha in 1985, 60% on previously uncultivated land. Out of a total production approaching 90,000 tons of dried beans, more than 75,000 tons were exported in 1985 (as compared to 66,000 tons in 1984), 15X in semi-processed form, elevating Malaysia into the ranks of the top five producers. Even if the rate of new plantings remains at the 10,000 ha/year reached in 1985 for the rest of the decade (as against 40,000 ha/year in 1981), Malaysia is likely to become the third biggest exporter, after the Ivory Coast and Brazil.

8.29 Malaysia owes its success to research that allowed vascular streak disease tolerant, Amazon hybrids to be grown in the country. Further, estates with 64% of the area are highly productive with yields ranging from 1,000 kg/ha to 1,350 kg/ha that rival Brazil's. Because of its stable climate, Malaysia is also a more reliable source of beans in a market subject to large oscillations induced by the cocoa trees' susceptibilityto rainfall variability. It is a very competitive supplier in spite of quite high wages because workers are 50-100% more productive than in Indonesia or the Ivory Coast and transport as well as marketing costs, at US$50 per ton, are a quarter of those charged in Brazil and West Africa.

8.30 Currently about 60Z of the acreage is accounted for by estates in Sabah with much of the remainder in Peninsular Malaysia and there is enough new land in Pahang and Sabah to more than double the area if demand and labor problems could be thrust aside. Cocoa is consumed mostly in the industrial countries, and there the price and income elasticities are low, the latter falling within the 0.11-0.35 range. Demand that was growing by 3% p.a. in the fifties and sixties more or less ceased expanding in the seventies and it is too early to say whether the resumed upward trend will persist. Thus the traditional West African suppliers and new entrants such as Malaysia and Indonesia will have to fight over a not especially buoyant market. Weather related price swings such as those which occurred in 1982-83 when crop failures induced a draw down of stocks and resulted in abnormally high prices, stimulate new planting, but do not change underlying demand realities. What makes the market doubly unreliable is that sellers such as the Ivory Coast and Malaysia and a major buyer like the US are not part of the International Cocoa Agreement that has tried vainly to bring a semblance of order into cocoa trading. In short, demand projections are distinctly unfavorable and even if Malaysia elbows its way into third place it will have to be at appreciably lower prices that would vitiate a sizable part of the gains from larger production. - 128 -

Table 8.9: MALAYSIA: COMPARISON OF TREE CROP COEFFICENTS (1985)

Rubber Oil Palm Cocoa Coconuts

Establishment (man-days) 230 76 90 120 Maintenance (man-days) 60 15 30 15 Harvesting (man-days) 140 35 30 30 Yield 1.1 20 0.8 5,500 Price (M$) 1,500 180 4,000 0.1 Gross Return (MN) 1,600 3,6n0 3,200 550 Return/Manday (M$) 9 72 53 12 Investment period (years) 7 3 2 5

Source: IBRD Staff Estimates.

8.31 Table 8.9, which provides comparative information on labor inten- sities and returns, shows that as of 1984 cocoa was close to palm oil in terms of profitabilitybut its overall labor requirementswere greater although still only a third of that for rubber. The labor needed to collect the cocoa pods does not require the strength which goes into oil palm harvesting or the skill essential for rubber tapping, but labor markets in Sabah and in parts of Peninsular Malaysia are very tight. Unless immigrant labor could be found, problems of collection would choke off growth in output even if demand had not done so already.

8.32 As with oil palm, smallholderscould buffer supplies if some inefficienciescould be remedied. Pradictably, the yields from small plots are low - between 210 kg and 574 kg per hectare. Substandard planting material, insufficientfertilization, intercroppingwith coconuts, poor drainage, indifferent plant hygiene that leads to a build-up of cocoa-moth and the casual farming practices of part time cultivators all collude to scale down the yields. But inattention by the smallholder is also the cause of uneven grading and fermented or mouldy beans finding their way into exports which raise the threat of quality discounts over and above the 8Z discount at which Malaysian beans trade in the world market because of their higher acidity.

8.33 Better extension can remedy some of these problems especially in Sabah and prevent the accumulation of pathogens that menace a disease prone tree. Certification by the Federal Agricultural Marketing Authority (FAMA) of the entire grading and packaging process, which was introduced in 1984, should improve quality standards, and new research will do away with the off-flavors released by hyper acid beans. These measures will ease Malaysia's progress up the export ladder and may allow for a respectable growth rate, albeit at falling prices. Unless, of course, some of the existing producers whose export options are fewer than Malaysia's fade from the picture, the long term demand constraints will remain, in the company of pressures resulting from domestic labor scarcities. - 129 - Tree Crop SectorS.mary

8.34 Malaysia'stree crop sector is arguablythe most efficientamong developingcountries and so far has enjoyeda successfulinnings under often ratherarduous market circumstances. It would be unfortunateif at this juncture domesticfactor supplies were to interferewith the quest for whatever additionalexport possibilities might materializein the comingyears. From reviewing the sector'sgrowth prospects, it seems that the problemis not so much of labor or land scarcityas the chronicallyinefficient way in which these factorsare utilizedin smallholderproduction. There would be little cause to think of expandingestate acreage under oil palm or cocoa or of reducingthat givenover to rubber if tne gap betweensmallholder and estate yields could be narrowed by 10-15Z every year. It is very clear that enlarging the estates by bringing new land into use will have undesirable ecological consequences,would be opposedby the statesand will necessitatecostly expenditureon infrastructure.On top of that, the estatesmight not find the laborto work the land or even if they could enticeworkers away by offering betterwages, they may not hold them for long. If ways could be found to elevatethe productivityof factorstied up in the smallholdersystem, the returnswould be immense. As an illustration(see Table 8.10) if all land under rubberwere to obtainthe averageyield registeredby the estates,the output for 1984 could be realizedfrom 1.05 million hectares using 306,700 workers, as compared to the actual area under rubber of 1.7 million hectares. Similarlypalm oil productionin 1984 could be obtained from 775,000 hectaresemploying 80% of the combinedmature estate - smallholderarea. Finally,just 105 thousandhectares and 52.5 thousandworkers could have raisedthe tonnageof cocoabeans producedlast year. There is a great deal of slack in the tree crop sector. - 130 -

Table 8.10: POTENTfAL PRODUCTION AND LABOR DEMAND FOR MAJOR PLANTATION CROPS, 1984

Palm Rubber oil Cocoa

PeninsularMalaysia

Total Area ('000 ha) 1,686 1,208 225

Mature area ('000 ha) 1,310 966 164

Actual production ('000 tons) 1,1486 3,408 126

Estate Coefficients: Yield per ha (tons/ha) 1.42 4.4 1.2 Ha per worker 3.41 6.5 2.0

Area needed to produce 1984 production at estate yield levels ('000 ha) 1,046 775 105

Workers needed to produce 1984 production at estate productivity ('000 workers) 306.7 119.2 52.5

Source: World Bank estimates.

8.35 Rather than bringing additional land into use, the future strategy should pursue three courses: giving managerial and financial attention to the weaknesses of the system that exists to supply inputs and extension to smallholders producing tree crops; encouraging the estates to draw nearby smallholders into their orbit, forming associations centered on the estates that function as a single articulated production system. The economics of such an arrangementare probably unassailable, but thought and effort will have to go into the mode of organizing and the nature of incentives. A third course would be for the government to take legislative and administrative steps that would facilitate the absorption of smallholder land by the estates through purchase or leasing. Now that the public sector has a majority holding in the large estates some of the problems with this move have been eliminated.

Rice Sector

8.36 Between 1973 and 1983, agriculture output rose 4.4% p.a. but it is the thriving tree crop sector that has generated much of the increase, production of foodstuffs has performed poorly and Malaysia now grows 70% of the rice consumed as against 90% in the early 70s. The rice subsector is a large one with 770,000 hectares under cultivation in 1984 and 300,000 households wholly - 131 - or partially engaged in paddy farming. Production peaked at 1.8 million tons in 1976 and by last year had fallen to 1.6 million valued at about 2% of GNP. Given the dynamism displayed by some of the other subsectors and the strides made by Indonesia, Korea and China, the eroding rate of self- sufficiency in rice, is conspicuous. Although the contribution that paddy makes to the national product is a fraction of that of rubber or palm oil, it is by no means negligible and the livelihood of Malaysia's poorer peasants is linked, in part, to rice. Hence the course that rice growing follows is important because of the effect it will have on growth directly, as well as indirectly by way of imports. It is also a matter of concern from another standpoint if rice production remains persistentlyunresponsive to the subsidies and price supports provided by the government, then the entire effort at alleviating poverty among rice smallholders might usefully shift to a different tack.

8.37 Compared to other countries in the region, Malaysia's rice sector strategy has been no less vigorous in promoting yields. More than a fourth of the agriculture development budget has been devoted to irrigation and/or drainage schemes for paddy and some 300,000 hectares now enjoy controlled water management permitting double cropping and the timely application of moisture recommended by the best scientific practice. In fact, the eight large schemes encompassing55% of the irrigated acreage supply 60% of the total rice produced. Since 1979, fertilizer has been provided free to all farms of under 2.4 hectares and as average farm size is 1.5 - 1.7 hectares and just 3% are in excess of 10 hectares, most cultivators enjoy fertilizer/paddy price ratios superior to any in the region. Water is frequently made available without any charge sufficient to recover capital costs while charges to defray operating expenses are quite inadequate. Seeds provided by the MOA seed production center are subsidized and what little credit is required by farmers is easily obtainad from farmers' associations or the agricultural bank. Labor shortages are not believed to be a constraint at current production rates in the traditional rice growing areas. In the single crop, rainfed areas, farmers rely on family labor whereas in the Muda Agricultural Development Authority (MADA) and other schemes mechanization has reduced labor application per hectare of rice to as little as 18-20 man-days from 80 in the early seventies. Farmers in these areas, 30% of whom are nonresident,make extensive use of contractors who harvest the rice using combines. Direct seeding has reduced the labor intensity of planting.

8.38 Although the size of the farm certainly does influence total incomes, yield seems unrelated to the size of the farm or to tenancy status, so that the structure of the farm system has not been a brake on progress. But in spite of all these benefits and the generous price supports, average yields (see Table 8.11) in Malaysia are no better than those of its neighbors and well below those of Japan and Korea. Closer examination reveals where the problem lies.

8.39 Rice agriculture in the major schemes is competitive enough. Wet season crops yield 3.6-4.5 tons per hectare or up to 9 tons p.a, which is high by any szar.dards. But yields are poor elsewhere, single crop, upland farms giving returns of 1.5 tons/ha. Thus productivity in the "rice bowl" areas is largely untouched by the frequently heard problems of small farm size, inter- - 132 -

sectoral migration, absenteeism and inadequate infrastructure. A farm unit in the MADA region can hold its own with the most prolific rice

Table 8.11: PADDY YIELD OF MAJOR PRODUCERS (average 1978-80)

Yield Country Yield growth rate (kg/ha) (1970-80, Z)

High Korea 6.3 3.4 Japan 6.0 1.3 Australia 5.5 -

Medium China 4.2 - Indonesia 3.0 2.6 Malaysia 3.0 1.0

Low Sri Lanka 2.4 0.2 Pakistan 2.4 0.2 Philippines 2.1 4.6 Thailand 2.0 0.7 India 2.0 1.8

Source: Computed from FAO Production Yearbooks and IRRI Paddy Yield statistics.

growing ptrts of the world. Fertilizer application is also not a culprit. The average for the country in 1983 was 416 kg/ha over the year on double cropped land and about 83 kg per cropped hectare, inclusive of single cropped and upland padi. Nor is Malaysia noticeably laggard in distributingnew seeds, HYVs being grown on 80Z of the cultivated lands. Once again it is the persistent and seemingly ineradicabledualism of the agriculture subsectors which circumscribesthe rice economy.

8.40 Even with all the subsidies and price supports, rice growing is marginally profitable in the major schemes. For peasants growing a single crop on unirrigated land, the returns are wholly insufficientfor their needs. As a consequence farmers, especially the younger ones, have been migrating to the cities and the area under rice has contracted by 100,000 hectares since 1979. The lack of irrigation is one factor throttling yields, a second is the higher incidence of disease amidst the less carefully tended rainfed area farms. There seems to be no way of exiting from the vicious circle created by geographical liabilities and small farm size that depress incomes, forcing paddy farmers to either emigrate or earn 60Z-75Z of their incomes from other activities,which then hardens the part-time cultivator syndrome, a canker afflicting productivity growth throughout East Asia. - 133 -

8.41 The Governmentis experimentingwith differentforms of land consolidationamong which are group and cooperativefarming, with centralized managementprovided by an agency. Resultsso far are mixed,and it appears unlikelythat these schemeswill providea solutionto the problemposed by low farm incomes. If the arithmeticof returnsfrom rice farmingand the land supplyis a guide, a sectoralredistribution of labor and diminutionof the least efficientlycultivated acreage may be the only eventualsolution. Estimatesof protectionand domesticresource costs in the contextof projectedinternational rice pricesbring home this point.

8.42 If border pricesare taken as a bench mark nominalprotection increasedfrom about 13Z in 1981 to about200X in 1985, (see Table 8.12), mainlybecause the paddy price was held stablewhile world priceshalved and the increasedcosts of inefficientprocessing were not passedon to the consumer. Given how the statisticsare compiledfrom surveyscarried out by the MADA and the NationalPaddy and Rice Authority(LPN) surveys,the error of estimateis likely to be large. However,the resultsare sufficientlyrobust to supportthe conclusionthat the paddy price subsidyhas grown from relativelysmall to very sizableproportions. Table 8.12: MALAYSIA- NOMINALPROTECTION, PADDY, 1981 and 1985 (in M$)

1981 1985

BorderPrice CIF/tonrice K.L. 1,041 529 Less 10% qualitydiscount 104 53 EqualsCIF/ton grade equivalent 937 476 Plus value of by products 60 60 Equalsborder price 1.5 tons paddy as rice 997 536 Less Processingand Handling Processingcost/ton rice 141 220 Equalsborder price 1.5 tons paddy 856 316 Borderprice 1 ton paddy,mill door 571 212 Actualmill door price paddy 648 650 Equalseconomic subsidy 77 438 NominalProtection Rate (Z) 13 207

Source: Computedfrom MOA data.

8.43 Whereasthe nominal protectionestimate is the ratio of the farm gate price of paddy actuallyreceived to that derivedfrom importparity, it does not measurethe net effect of input subsidies. Table 8.13 shows the derivationof effectiveprotection. The valueof traded inputsare subtracted from the value of paddy at both local and importprice to measurethe net effect. The per ton value-addedin 1981 at domesticprices was M$509 while at border prices it was M$257 to give an effective protection rate of 98%. By 1985 the value-addedat border pricesbecame negative and value-addedat - 134 - domesticprices remained constant to give a net subsidyof M$606/tonof paddy worth M$212/tonat internationalprices.

Table 8.13: MALAYSIA- EFFECTIVEPROTECTION, PADDY, 1981 and 1985 (in N$)

1981 1985

TradedInputs/ha At DomesticPrices Seeds 23 28 Fertilizer 6 6 Pesticides 8 14 Machinerycosts 311 320 IrrigationOM (watercharges) - - Credit - - Subtotal/Ha 348 368 At BorderPrices Seeds 23 28 Fertilizer 350 420 Pesticides 8 14 Machinerycosts 311 320 IrrigationOM 90 90 Credit 2 2 Subtotal/Ha 784 874 Value of Paddy/Ton Yield/ha ktons) 3.3 3.5 Value at domesticprices 648 650 Value at borderprices 571 212 Value of inputsat domesticprices 105 105 Value of inputsat borderprLces 238 250 EffectiveProtection Value addedTtonat domesticprices 543 545 Value added/tonat borderprices 333 -38 Subsidyon value added/ton 210 583 EffectiveProtection Rate (Z) 63 100

Source: Compiledfrom MOA data.

8.44 The obviousquestion becomes one of why grow paddy in Malaysiaat all if so much protectionis needed? There are two aspectsto protection. These are: (i) the need to raise producerincomes vis-a-vis other incomes withinMalaysia; and (ii) the need to cover the cost of technicalnon-competitiveness. The analysisof effectiveprotection covers the first,and domestic resourcecost anAlysishelps answerthe second. Using standardmethodology, Table 8.14 has been preparedon the basis of data from the EnterpriseBudget seriesof the Ministryof Agriculture.For 1981 and 1985, the value per ha of - 135 - labor,capital and land employedin paddy growingare calculatedwith the largestdifference between the two years being the declinein labor use and the increasein the wage rate. The value of these domesticresources used to grow 1 ha of paddy is estimatedat M$765 in 1981 and M$734 in 1985. The valuesof these factorsare adjustedto reflecttheir value in alternative uses. Under the assumptionof no distortionin labor and capitalmarkets, Table 8.14: MALAYSIA,DOMESTIC RESOURCE COST, PADDY (MN)

1981 1985

PrimaryFactors/Ha Domesti' Prices Labor (60 days e $5/m day, 20 @ 10) 300 200 Capital(118 z 2.5, 118 x 3.0) 295 354 Land, rentalvalue 170 180 Total DRC at domesticprices 765 734

PrimaryFactors/Ha, Marginal Opportunity Cost Labor 300 200 Capital 295 354 Land (in oil palm)/a 200 250

Total DRC at marginalopportunity cost/ha 795 804

Total DRC at marginalopportunity cost/ton 240 244

DomesticResource Cost/ton Value added at borderprices in M$ 333 -38 Value added at borderprices in US$ 138 -16 Implicitexchange rate in US$/M$ 1.74 15.25 Actualexchange rate in US$/M$ 2.38 2.38 DRC coefficient 0.72 6.42

/a Residualreturn to land in oil palm after costingall other factorsat MOC.

Source: Compiledfrom MOA data. only the land chargeneeds to be changedto reflectthe highestalternative use of paddy land, in this case oil palm. The value of primaryfactors measuredthis way increasesover marketprices. The total domesticresource cost at opportunity cost prices is M$240/ton paddy for 1981 and 3.3 tons/ha actualyield and is M$244/tonfor 1985 at 3.5 ton/haprojected yield. The value added by thesefactors is M$333 for 1981 and a loss of M$38/tonfor 1985 due to the precipitousfall in world rice pricesfrom US$433/tonto US$220/ton. - 136 - 8.45 The domesticresource cost (DRC) coefficientof 0.72 for 1981 impliesthat it cost M$0.72of domesticresources to earn M$1.00of value- addedand for 1985 it cost K$6.42to earn K$1.00. An alternativeinterpreta- tion is that an expenditureof M$240 of domesticresources per ton of paddy grown saved US$138of foreignexchange to give an implicitpartial exchange rate of M$1.74/US$1for 1981 and M$15.25/US$1for 1985, comparedwith an actualexchange rate of 2.38.

8.46 Reworkingthe DRC analysiswith differentvaluation assumptions leads to a consistentconclusion that at low yieldsand world prices,paddy productionis non-competitivebut that at actuallyachieved global yields and "normal"prices, paddy productionmakes economicsense. Protectionis substi- tutingfor fa-m size to increasefarm incomerather than making an econom- icallyl'nsou.me enterprise privately profitable.

Overview

8.47 These estimatesand their i'uplicationsfor the laggingsegment of the rice economymust be leavenedwith certainother observationsbefore policiescan be broughtinto focus. First there is considerableuncertainty regardingthe opportunitycost of the labor and land used in the singlecrop rice areas. Many of the farmersdevote a quarterof their time to paddy. If they were to abandonfarming altogether and move to urban areas,it is improb- able, given their age and lack of skills,that they could be readilyabsorbed even into informalsector jobs seeingthat growth in the mid-80swill be low. Hence it might be more accurateto treat the opportunitycost of the time that they put into rice growingas close to zero in the short run. Second,for these smallholdersmaking the switchto rubberis hardly to be recommended.Lengthy gestation period, low pricesand poor yield would dis- qualifythis optionfor the majority. Oil palm, with its shortergestation requirements,is marginallymore feasiblebut, exceptfor farms contiguousto areas where palm oil is produced,the changeovercould only be managedfollow- ing intensivedevelopment of infrastructure.Furthermore, the majorityof farmerswho are in their late fortiesand fiftiesmight take reluctantlyor not at all to this physicallydemanding activity with rhythmsvery different from rice cultivation.From this reasoningand becausepresent land prices have been elevatedthrough the compoundingof rice subsidilp it would follow that on averageland also shouldhave a low shadowprice._

8.48 The post-harvestingoperations of the rice industryis anotherarea of concern. Despitean installedannual capacityof twice the actual 1.2 million ton crop, the concentrationof deliveriesduring a shortertime resulting from mechanicalharvesting is leadingto large losses. The mills are not designedfor bulk deliveriesof wet grain and deteriorationis increasingwith longerqueuing time. Becausethe couponsubsidy payment is more accessible from direct sales to LPN and becausethe state milleris not able to ade- quatelydiscount sub-standard grain, the market share going to LPN has doubled

18/ For the purposesof projectappraisal, a more carefulstudy of land values is desirable. - 137 - since 1975 to 40Z even thoughit has only 16Z of totaimilling capacity. Privatemillers are unwillingto investin plant expansion,being unable to competewith LPN's subsidizedoperation despite milling costs which are 30Z less than those of LPN. Moreover,LPN is not able to developan adequate investmentprogram until the governmentdecides upon the structureof the millingsector. Clearly,there is a case for an urgentpolicy reconsideration followinga major technicaland economicreview of the industry,and only then can a sound investmentprogram be developed.

8.49 A thirdconcern relates to food security: can Malaysiaafford to dependon a thin internationalrice market,whose price volatilityhas become most apparentover the past decade,for a third or more of its needs? Bringingall the elementstogether: domesticsupply, consumption trends and projectionsconcerning world prices,two recipesemerge. One appearsmore appropriatefor the mediumterm, a secondmight be applicablefor the long- run.

8.50 For the next 3-4 years, growth,employment, poverty alleviation and the currentaccount deficit will be at the centerof attention. Seeingthat sectoralsources of growthare few in number,alternative urban job opportunities might be scarceand that there will be continuingpressure to conserve imports,it would be desirableto maintainproduction to the extentthat it can be managedin all the rice growingareas of the country. This would argue for retainingwhat, in the contextof prevailingworld rice prices,is an expensivesystem of subsidiesand transferpayments. However,even though some rice acreageand the labor of aging farmersmight have low opportunity costs,capital has a high value and therefore,it would be a misuseof resources to ploughlarge sums into developingthe infrastructureof water controls, that would permitdouble cropping and higher yieldsin the poorerrice growing areas. The returnssimply would not warrantsuch expenditures.In effect, the recipecalls for at best stabilityand at the worst a low declineof rice production.A 1.6 millionton productionrate, very helpfulfrom the standpoint of overallgrowth, would requirea reversalof the trend evidentover the past three years and a returnto the historical1Z p.a. increasein productivity. Alternatively,rice outputcould followthe curvedown to a lower bound of 400,000hectares and a productionof 1.3 milliontons.

8.51 Over the long haul, alteredworld rice marketconditions, preferences of Malaysianconsumers and the economicsof rice productionargue for a changein the pricingand subsidysystem. On balance,the paddy producerhas been subsidizedsubstantially over the past ten years with respectto import parity. Similarlythe consumerhas been taxed and the Governmentbudget has paid the balanceof the producertransfer. In additionsubstantial input subsidiesare given. A commensuratesupply response has not eventuated,quite the opposite,and paddy farmersare still poor. In the clasicalmodel, producer surplusis preferredover consumersurplus with budgetarycost valuedat zero. Times have changedand budgetresources are seen to have a positive value. The price mechanismhas not achievedincome or outputgoals and other measuresseem to be needed to promotethe welfareof the rural poor. There is a strongtheoretical basis for separatingthe incomeand outputgoals and using separateinstruments for each. An incomesubsidy tied to outputvolume clearlyhelps least those for whom the policywas designed. - 138 -

8.52 If one uses purchasing power parity as the reference, then a constant producer and consumer price since 1974 leads to a 30X decline in real price for both. During this period the real price (constant dollars) of rice traded internationallyfell 602. *To the extent that rice is a wage good, pricing has kept labor costs higher than in the absence of support. The practice is consistent with that of developed countries (US, EEC) in general and of the more industrializedcountries of East Asia (Japan, Korea). For example, the Japanese policy has kept producer price of paddy from two to four times higher than international prices since the late 1960s. The differences have been that in Japan a supply response was substantial but not in Malaysia, consumers were not able to pass the cost into wage rises in Japan, and budgetary resources were adequate. Because of these considerationsa continuation of pricing practice on the basis of the Japanese experience has hidden costs of a non-trivial nature. While it is not suggested that prices be tied to the rise and fall of internationalpaddy prices, it is recommended that some form of moving average relationship between domestic and import prices be adopted for allocative pu ses with separate instruments used for welfare and efficiency goals.-

8.53 Self-sufficiencyin food supplies has concentrated on rice productionand consumption because traditionally rice has been the staple food. However as Malaysia's population and income have risen the consumption of foods other than rice has risen faster and rice self-sufficiencyis no longer an adquate measure of food security. For example, while self-sufficiency in rice fell from 80% to 75% between 1981 and 1983 (see Table 8.15), self-sufficiencyin total grains fell from 50% to 39%. Malaysians now eat twice as much maize and 50% more wheat than rice. With almost no domestic feedgrain production, rising incomes and a high income elasticity of demand for wheat bread (0.9035), poultry (1.4507) and beef (1.2106), this trend can be expected to continue. Malaysia is import dependent for the bulk of its food supply.

19/ A detailed example of one such scheme is given in "Thailand: Pricing and Marketing Policy for Intensificationof Rice Agriculture," World Bank Country Study, 1985, pp. 27-31. - 139 -

Table 8.15: MALAYSIA, GRAIN PRODUCTION, IMPORT, CONSUMPTION (1981-1983 in tons)

1981 1982 1983

Imports Wheat 490,700 542,140 550,000 /a Maize 477,000 683,000 819,000 Rice 316,664 403,038 385,062 Total Grain Imports 1,284,364 1,628,178 1,754,062

Production Rice 1,302,900 1,213,300 1,148,100 Area Harvested ('000 ha) 648 620 655

Consumption Total grain 2,587,264 2,841,478 2,902,162 Self-sufficiencyin rice Z 80 75 75 Self-sufficiencyin grain x 50 43 39

/a Provisional

Source: FAO Trade Yearbook 1983: MOA, Import and Export in Food and Agriculture.

8.54 Food self-sufficiency,though, is not food-security. Insecurity occurs when consumption is not protected against total supply instability. In Malaysia's case domestic supply is relatively stable with respect to weather effects. Rainfall is well distributed throughout the year and the major part of land used for food crops is irrigated. What is the outlook for foreign supplies? The 1984 world cereal crop rose 10Z above that of 1983. World rice production rose 52 beween the two years and indications are that the 1985 harvest will be of the same size. Former large grain importers such as Indonesia, India and Korea are expected to remain out of the import market. On the export side, Thailand has large stocks and sees disposal problems. China's output in 1984 rose 52 over that of 1983 and is set to be a major long-run exporter. The outlook by major analysts (FAO, USDA/FAS, future markets) is for a grain surplus for the rest of the decade. The outlook is favorable for long-run contracts at bargain prices. For this plan period (1986-1990) at least there seems little support for expanding irrigation facilities or increasing support programs to increase domestic supply.

8.55 One of the consequencesof market oversupply has been export subsidies in producing countries. To the extent Malaysia imports it will capture foreign subsidies at no budget cost. Attempts to pass budget costs to consumers simply do not work. For example, the budgetary cost of Japan's Food - 140 -

Agency rice program is US$2.0 billion even though consumers pay two to four times import parity price.

8.56 Malaysia imports about M$4,500 million of agricultural products of which some M$3;500 million is for food. Its agricultural exports amount to M$12,000 million of which M$4,500 million is food. Food imports account for 14X of the total value of imports. An absolute shortage of foreign exchange is not seen as being likely to restrict needed food imports, and moving resources out of the commodity sector where there is a strong comparative advantage would reduce export income by more than the value of import savings. In conclusion, substitutionof import feedgrains under rainfed conditions and commercial-sizedfarms offers more scope for foreign exchange savings than rice. The import bill for coarse grains (maize, sorghum) is growing faster and will pass that of rice. Little coarse grain is grown because of low yields on small farms where returns are less than that for paddy. The potential for new development under market determined conditions with state support only through an expanded research effort warrants a closer look.

8.57 In closing, it might be useful to look at the rural labor market picture in its entirety. If steady efficiency gains can be made in the rubber sector they, along with a specialized labor force, should ensure that until well into the 90s rubber production can remain on target with increasingwages and some use of immigrant labor, the growth of palm oil and cocoa output should not be affected until the early 90s. Thereafter, shortages of harvesters might begin to pinch. There is little doubt that migration of rice cul:ivatorswill continue, but with further mechanization in the major scheme areas labor shortages could be avoided. By keeping intact the incentive system for rice growing and through progress with land consolidation and technological improvement the smallholder sector could also prevent much shrinkage in production, during the balance of the eighties. - 141 -

CHAPTERIX: SIMULATINGTHE FUTURE

9.01 A development strategy is perched on many assumptions about world trade and capital flows, about government policy and about changes in the structure of the domestic economy. Until all of these assumptions can be brought under one roof, it is impossible to divine the total implications for the future of the system.

9.02 Concerns regarding employment and income growth are a force arguing for a faster increase in GDP; the need to contain and ultimately reduce the current account deficit supports macroeconomic conservatism. A balancing of the two suggests that the appropriate target might be a growth in GDP averag- ing 4% during 1986-90 with the rate in 1986 being below 2Z and rising to 4.5% by 1990. The feasibility of this objective is tightly bound to certain external projections, namely:

(a) OECD growth returning to a 3.2-3.5% level in 1986 and subsequently remaining in the 3.5-4.0% range through 1990.

(b) International trade increasing by 5-6Z p.a. in the second half of the eighties, permitting Malaysia's agricultural exports to rise by 4.32 p.a., its sales of forestry products by 2% p.a. and manufactured exports by 6% p.a.

Cc) minimal improvement in commodity prices. Our projections assume that the slump in the palm oil market will persist for at least another two years; there will be a small recovery in the prices of rubber, logs and sawn timber by 1987 and petroleum prices per barrel will climb from a US$15 average in 1986 to US$22 in 1990.

(d) a rebound in the terms of trade index after 1986, but with the level in 1990 remaining well below that for 1984.

9.03 No less important are certain assumptions relating to investment, savings and the exchange rate:

(a) In line with the Government's stated policy to reduce the public sector deficit by tightly controlling operating and investment expenditures, it is assumed that investment will fall further by 4% in real terms in 1986 before it recovers gradually to a real growth of 4.5% by 1990. Behind this lies a substantial change in the composition of capital spending. Because private business activity is expected to be sluggish in 1985-86, public spending on infrastructure and other capital projects where ICORs are high will be the principal source of investment demand in the economy. There- after, such spending will diminish and private investment in manufacturing will supply more of the momentum. This change in the mix of investment should have two beneficial effects: the investment GNP ra-io will be slightly lower but growth will quicken as more productive manufacturing projects come on stream. Import elasticity will be close to unity throughout the remainder of the decade. - 142 -

(b) Gross national savings which fell to 29% of GNP in 1985 will slip even lower in 1986-87 to about 27Z of GNP as lower raw material prices and taxes depress government revenues and diminished income growth moderates private savings propensities. After 1987, a revival in public savings aided by new revenue measures should help recover lost ground and bring national savings to the level of 1985. This is a strong assumption and underlying it is the uncertainty regarding the Government'swillingness to increase tax revenues and thereby lift public savings.

(c) The nominal exchange rate will be M$2.65 = US$1 in 1986 and M$2.70 = US$1 for the remainder of the eighties (this assumes some additional depreciation of the US$ over the medium term).

9.04 Our base scenario rests on the successful implementationof a conservative expenditure policy, reforms that will augment federal revenues and an export oriented industrial strategy. A steady contraction of the public sector deficit to less than 1% of GI7Pin 1990 and a rebuilding of Government savings are crucial for the reduction in the current account deficit from about 8% of GNP in 1986 to 4.9% by the close of the decade. An expansion of manufacturing by 6-7% p.a. during 1987-90 largely on the basis of overseas sales will, together with the service sector, generate much of the growth in GDP and employment. According to the Base Scenario, the DSR will reach 19.1Z in 1986 but then begin descending gradually to 17Z in the final year of the Fifth Plan. Squeezing the maximum growth from an economy hemmed in by constraints, some inherited from the past, others arising from the conditions prevailing in internationalmarkets, promises to be no easy task and the adjustment program could be easily derailed by a failure of the industrial drive. The Low Scenario takes a look into the consequences for the principal macroeconomic variables of a slower growth in manufacured exports. It assumes that the authorities are unable to deviate from GDP targets in the face of rising unemployment and economic expansion is maintained at the rate given in the Base Scenario by means of public investment and private consumption. The consequencesare immediate and far-reaching. By the close of the decade the current account deficit is an unsupportable 10% of GNP, while the DSR climbs from 19% in 1986 to 22% in 1990, with worse still to come in the early nineties. A widening external imbalance could be avoided under the Low Scenario through greater domestic austerity but then the growth performance would sink below the modest levels being projected.

9.05 Many other scenarios can be constructed to describe trajectories which follow variations in external circumstances or a different blend of fiscal and industrial policies. But the above suffice to convey an idea of the system's sensitivity to parameter settings for manufactured exports and public finances. Given the proposed uncertainty that shrouds the future of commodity markets and fuel prices, building elaborate statistical structures around speculation about these would hardly ease the policymakers' task.

9.06 The Malaysian authorities must wrestle with three difficult challenges: one has to do with managing longer term structural change; the second involves squaring the need for a socially acceptable level of economic - 143 -

activity with the fiscal mathematics of adjustment; and the third requires solving the highly complex problem of providing businessmen with incentives sufficient to coax them into risky industrial projects while ensuring that the

Table 9.1: SELECTED MACRO-ECONOMIC INDICATORS - BASE CASE AND LOW CASE /a

Actual Base case Low case 1985 1986 1986-90 1986-90

Real Growth Rates (Z p.a.) GDP 2.8 1.6 4.1 4.1 Consumption 0.2 -4.3 3.0 4.1 Merchandise exports 0.5 3.5 4.2 2.8 Merchandise imports -11.0 -9.0 2.3 2.3

Actual Base Case Low Case Ratio to GNP 1985 1986 1990 1990

Investment 32.0 34.8 32.9 33.1 National savings 29.0 27.0 28.0 23.0 Current account balance -3.1 -7.8 -4.9 -10.1 Total foreign debt /b 40.2 42.9 57.1 71.1

iHemo Debt service ratio /b 14.0 19.1 17.4 21.7

/a The only difference in the assumptions between the two cases is the growth of manufactured exports. In the base case, manufactured exports are assumed to grow at an average of 6% p.a. between 1986 and 1990; in the low case, this is reduced to 2% p.a.

/b MLT debt.

Source: IBRD staff estimates.

claims of equity, of social justice and of racial balance in the distribution of wealth and jobs are given their due. The direction of structural change over the next decade is no great mystery. Agriculture's share of GDP and employment will diminish with rubber and rice being the biggest losers. Energy should stabilize by the close of the eighties and thereafter it could start to lose ground. A successful industrial strategy should enlarge the size of the manufacturing sector to a fifth of GDP or perhaps as much as 22-23% providing employment for 18-20% of the labor force. But most of the future jobs and a significant element of the growth impetus must come from services. The two primary long-term objectives will be income growth and job creation. As described in the report, growth can best be achieved by promoting the productivity of tree crops and concentrating manufacturing investment in a few chosen subsectors. To absorb the unemployed and the new entrants - 144 -

into the labor force require policies that will result in the expansion of a dynamic and efficient services sector side-by-sidewith the evolution of secondary activities.

9.07 The immediate worry for the authorities is the recession caused by adverse terms of trade and weak overseas demand for Malaysia's products. This has deflated private consumption and savings, worsened the slump in the real estate market and put the financial system under considerable strain. It is a poor time to think of adjustment when nominal GNP is slipping and only public expenditure can be a source of growth in the short-term. But to the extent that social and political pressures permit, restraint would be the wisest policy. There is no such thing as costless pump-priming expenditure in a small open economy. Investment multipliers are relatively small and an outlay sizable enough to add 1Z to GDP growth would, at a conservative estimate, have to be financed by borrowing equal to 3-4% of GNP, a decidedly risky under- taking. Further, the ICORs for the first half of the eighties and those projected over the coming five years point to the existence of a capital stock that is both inefficient and inappropriate for the country's stage of development. Far too much has gone into projects that will offer scant support to future growth. Fiscal conservatism should remain the government's watchword in the short-run and the first priority, as soon as conditions permit, should be to restore public revenues ravaged by the fall in oil prices.

9.08 For over ten years, industrial policy has been a creature of the NEP and the incentives provided to private business have been forced to coexist with the rules issued under the Industrial Coordination Act (ICA) and the soaring ambitions of the public sector. As is to be expected certain attitudes towards investment and risk have emerged and hardened. Beliefs regarding the scope for initiative, the intentions of the Government and the scale of long-run opportunities which any group can assume have had time to con- geal. It has become apparent to the authorities that an approach which allowed both growth and the restructuring of wealth could only succeed during a time of buoyant commodity prices. Now that a different situation prevails and industrial initiative rather than rent-earning, primary sector activities must underwrite economic advance, the rules governing the actions of the various players have to be drafted afresh. Small changes in the architecture of the ICA, which open a few windows in the system while keeping the structure largely intact may not bring about the decisive shift in business psychology that is called for at this juncture. To the extent allowable by the nation's politics, the Government might wish to divorce the goals of equity and enlarging the Bumiputra share of national wealth from the pursuit of industrial development. Malaysian businessmen are competing in an unusually tough international environment and the greater is the burden of licensing, the larger the social claims on their earnings and the smaller their flexibility in allocating resources and using the available skills, the more likely that the race to industrializewhich is sweeping the eastern margins of the Pacific will be won by countries where business endeavor is not saddled by stringent social obligations. As suggested in Chapters 2 and 7, fiscal, education and welfare policies should deal with the problem of fair shares and industrial policy should be drained of issues concerning rights. 100 104 108

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