The Malaysian quandary
Malaysia continues to inspire other nations seeking to avoid the so-called "Resource Curse". Yet the country that managed to circumnavigate "the Paradox of Plenty" struggles to reach escape velocity to break free from the much cited "Middle Income Trap".
To be sure, the "top down" policy cure that has been administered over the last five years has helped to deliver respectable GDP numbers. However, there is no running away from the fact that at this rate of expansion, the 2020 targets will likely be missed.
The risks are currently concentrated on the downside.
It seems that structural domestic factors rather than external constraints account for this relative underperfomance. Rather than facing a popular "Middle Income Trap" paradigm, Malaysia may be in fact experiencing another form of "Resource Curse".
Still rich in natural resources, Malaysia relies substantially on manufacturing and legacy low-cost advantages at a time when increase in productivity ought to be the dominant engine of growth.
The shift in productivity is taking place but very slowly. At around 4.55% a year, it is behind benchmark countries such as China that regularly posts productivity growth of above 8%.
Nowhere else is this more manifest than in the service sector statistics. Although services attracted the largest volume of approved investments back in 2011, it continues to account for just 54.6% of GDP compared to 70% and above common in advanced economies.
Service sector contribution would need to grow at least three times faster to reach the 70% benchmark by 2020.
The structure of services at a more granular level reveals a structural vulnerability. Some 50% of investment in Malaysia's service sector in 2012 came from the real estate compared to 0.3% in health services and 0.8% in education services.
In a country where already 73% of the population live in urban areas compared to 34.4% in Thailand, this could be seen as putting a lot of eggs in one basket.
Some analysts would argue that a great deal of new real estate stock is catering for growing foreign demand in retail and hospitality. However a run-up in household debt recently suggests another real estate bubble could be in the works.
Magic ingredient missing
To keep things in perspective compared to majority of Asean countries, Malaysia has run a tight macroeconomic ship with lower inflation and relatively stable sovereign and corporate balance sheets over the last five years.
It has done more to liberalise its transport, telecommunications and financial services sectors punching above its weight in FDI dollars. However the magic ingredient that will propel Malaysia to a higher income status still seems to be missing.
The real concern in the medium term as echoed by the credit rating agencies such as Fitch recently is that the engine of government stimulus and spending is about to be tested.
With debt to GDP at 51.7% compared to 39.8% back in 2008, the public sector has some room for manoeuvre.
However if Malaysia continues to add sovereign debt at the same rate, it may end up at 80% by 2018 roughly where Spain was before the 2008 crisis.
Economists often point out that as a net surplus country with a relatively high savings rate of 35% between 2008-2015 Malaysia has sufficient access to domestic liquidity and therefore does not need to borrow abroad.
The reality is with Malaysia's population aging along with the rest of Asia, its pension liabilities are also growing. Credit analysts also point to another 15% of government contingent liabilities.
The bottom line is that the Malaysian economy can no longer rely on government sector for growth – a central theme of the Economic Transformation Plan (ETP).
In that sense the government is right to say it should not allow its debt to exceed 55% of GDP because this could undermine investor confidence.
To shift away from government driven growth the government should expand the share of government welfare services funded through a broader tax base funded by consumption taxes.
This is in contrast to previous model of government-led investment which was largely funded through royalties from the national resource company Petronas that still accounts for a staggering 40% of government's revenue.
But therein lies Malaysia's quandary. What happens when the music stops? What happens when the government leaves the arena and lets private sector fend for itself?
Few companies in the private sector are genuinely comfortable with this prospect, especially in the fragile economic recovery the world is still experiencing post-2008 debt crisis.
The imperative of giving a lead to the private sector in economic development was stated already by the 9th Malaysia Plan back in 2006. Yet despite a few temporary surges in private sector activity, the overall picture is still one of strong parent reluctant to allow their children to stand on their own feet.
The Malaysian private sector remains addicted to government stimulus while the Malaysian public institutions are deeply embedded in the field of running economic affairs.
Overarching Keynesianism as opposed to Adam Smith's invisible continues to run the Malaysian economy.
One of the most often cited policy errors has been an attempt to try and solve the lack of private sector participation by forcing innovation and entrepreneurship from above as opposed to nurturing through education and incentives at a grass root level.
Recent studies show that contrary to popular belief the government does have a big role to play in stimulating innovation by providing infrastructure, investment in education and seed capital.
However without institutional reforms that promote risk-reward, create appropriate incentives for entrepreneurship and encourage meritocracy, innovation rarely takes root.
It simply becomes another pillar of the command economy which lacks in vibrancy and in the long run stagnates when the state can no longer afford to subsidise it.
This is however not an argument for removing state support and grants for SMEs. As the Scandinavian experience suggests, a state has an important role to play in protecting the vulnerable and providing a safety net for those risk takers and innovators that it seeks to cultivate.
When a small and medium enterprise embarks on a new venture, its founders should feel relatively safe in the knowledge that their children will be able to have access to education and medical care should things not work out.
Despite its better rankings, Malaysia, like the rest of South East Asia, continues to spend a disproportionate amount on subsidies compared to its spending on a welfare state.
A removal of the subsidy as was shown recently in Indonesia is a matter of educating the public and offering targeted subsidies, however imperfect these may be in practice.
The biggest challenge for Malaysia going forward is not one of reaching the 2020 goals but one of renegotiating the fundamental social contract with all the members of its society in a peaceful manner.
Achieving advanced income status in a purely statistical sense will be a hollow victory if it only benefits the top 20% of Malaysia's population. Since 2004, Malaysia's Gini coefficient has deteriorated from 37.9 to 46.2. The cost of living has increased faster than wages in urban areas.
Supporters of affirmative action cite these facts as a basis for more positive action. However well-intended these policies, there seems to be little evidence that they have addressed the core issue of economic inequality in the past.
If anything, these policies seem to make people who are supposed to benefit even less productive, denying them access to better employment opportunities.
While equality of opportunity is a necessary condition for social cohesion, active redistribution of wealth by limiting human capacity has usually backfired.
At an aggregate level, such policies cause market inefficiencies, monopolistic behaviour and skewed financial incentives. At an individual level, it has been the main cause for young talent outflow from the country.
In its turn, brain drain and lack of skills have been cited by Malaysian executives as the single most important factor in weighing on Malaysia's competitiveness, hampering its ability to move faster up the value chain.
For all the determination in economic policy-making and detailed implementation targets, this may be the missing variable in the escape velocity calculation.
Finding itself at a tough juncture, Malaysia is by no means doomed to failure, and defeatism that so often pervades European nations is not part of its national character.
Ambitious in setting goals and self critical in assessing its performance, it still has the ability to take its critics by surprise as it has done several times before. - October 5, 2013
* Paulius Kuncinas is the Regional Editor, Asia at Oxford Business Group.