Malaysia's MIT: The Middle Income Trap

Introduction 

Just a few years after gaining independence in 1957, Malaysia would have been classified as a middle-income country by the World Bank’s standards (specifically lower middle-income), had they existed then (Yusof & Bhattasali, 2008). Since then, Malaysia has experienced significant economic growth, initially driven by its status as a commodity exporter. From 1970 until 2000, Malaysia’s total income grew at an annual rate of 6-7%, which led to a dramatic reduction in poverty, decreasing from about half of the population in 1970 to fewer than 6.2% of its 33.9 million people by 2022. By this time, Malaysia’s per capita income reached approximately US$11830, positioning it as a middle-income country. 

Given such a track record in the 20th century, how is Malaysia still a middle-income country today? Such a question inspires this article, which aims to examine Malaysia’s rapid economic development post-independence and untangle the reasons behind Malaysia’s stagnant (relative) income. 

A (very) Brief Economic Journey Post-Independence 

Malaysia, a country rich in natural resources like rubber, tin, palm oil, and minerals, has inherited an economy focused on exporting commodities since Independence, laying a strong foundation for its economic development. Featuring an almost 8-fold increment of income per capita, Malaysia’s economic narrative unfolded over several phases, each marked by strategic policy interventions aimed at socioeconomic restructuring and diversification. From the New Economic Policy (NEP) introduced in 1970 to the National Vision Policy (NVP) extending up to 2020, Malaysia embarked on a transformative journey. 

Shortly after gaining independence, Malaysia promptly transitioned from commodities to more lucrative manufacturing industries. This strategic move was driven by the recognition that agriculture-based sectors tend to be less efficient, resulting in lower pay and restricted opportunities for skill development. This was partially accomplished through the implementation of export-oriented policies and the progressive elimination of import barriers. 

Malaysia observed the successful economic development of other Asian countries, such as Japan and South Korea, which achieved prosperity through a state-led development model (Jomo,1993). Convinced of the effectiveness of this approach, the Malaysian government shifted its economic focus towards state-owned industries. Inspired by Japan and Korea, the 'Look East Policy’, an exemplary instance of this phenomenon, was introduced in the 1980s, under Prime Minister Tun Dr. Mahathir bin Mohamad, often referred to as the father of modernisation. The policy focused on two main strategies: sending Malaysian students to Japan to cultivate a skilled workforce in engineering, medicine, management, and academia (including Mahathir's own son, a graduate of Sophia University in Japan), and industrial collaborations with Japan. 

As part of this effort, the Heavy Industries Corporation of Malaysia (HICOM) was established, which led to the creation of heavy industries such as steel and automobile production with the support and safeguarding of the government. The emblem of this industrialisation was the partnership with Mitsubishi Motors to create the first local Proton Saga car, showcasing Malaysia’s industrial prowess. Indeed, by the late 1980s, Proton Saga was not only the best-selling car domestically, but the brand was also one of Southeast Asia’s most renowned car manufacturers. 

Apart from the automobile industry, Malaysia actively invited foreign direct investment (FDI) to foster economic growth. While it seemed to serve the country well, excessive reliance on foreign influences rendered it vulnerable to the flows of international capital and laid the groundwork for future challenges.

In 1991, Tun Mahathir announced the ambitious Vision 2020 (Wawasan 2020), aiming to elevate Malaysia to a high-income nation within 30 years. This led to significant infrastructure projects, including the Petronas Twin Towers, the longest highway in Malaysia (North-South Expressway), the Kuala Lumpur International Airport (KLIA), and the Multimedia Super Corridor, a high-tech business zone. The country transitioned from a developing nation to an emerging industrial one. Before 1997, Malaysia was the 21st most competitive economy globally, with a per capita income more than doubling and only trailing behind Singapore and Brunei in Southeast Asia. 

However, the Asian Financial Crisis in 1997, which started in Thailand, severely impacted Malaysia and other Asian countries. Malaysia was among the quicker countries to recover, but its politics and economy were still affected. From 1988 to 1997, Malaysia’s labour productivity growth rate averaged 5.5%, but this declined to 2.9% from 1998 to 2007 (Arshad & Ab Malik, 2015). During this period, China's labour productivity surged from 4.5% to 9.2%, overtaking Malaysia's demographic dividend. This loss of global competitiveness was partly attributed to China’s accession to the WTO in 2001, which coincided with the sign of Malaysia’s premature deindustrialisation since 2000 (Bank Negara, 2019). Foreign investors began shifting their factories to China, where Malaysia started to feel the consequence of its over-reliance on foreign investment. Multinational corporations kept high-end production in their home countries, leaving Malaysia with lower-end assembly work. Even with initiatives like the Multimedia Super Corridor, advanced nations were reluctant to transfer technology, stalling Malaysia's industrialisation. Malaysia still lags behind other countries in this respect. 

Despite early rapid development and decent infrastructure in West Malaysia, achieving high-income status remains challenging. Per capita GDP growth has stagnated, and the gap with other Asian tiger cub countries, especially Indonesia, is widening. Malaysia has become a classic case of the middle-income trap, where reaching high-income levels is increasingly difficult despite comfortable living standards and reasonably low prices. 

What is the Middle-income Trap? 

The Middle-income Trap (MIT), though it does not have a clear and definite definition, generally refers to a situation where a country experiences rapid growth and reaches middle-income status, but then fail to transition into high-income status due to various structural and institutional inefficiencies. This trap is characterised by slowed growth and an inability to compete with low-income, low-wage economies in labour-intensive sectors like manufactured exports and with advanced economies in high-skill innovations and high-value-added exports. 

A country is in the lower-middle-income trap if it has been a lower-middle-income country for 28 or more years. For upper-middle-income countries, the trap is defined as remaining in this status for 14 or more years (Felipe et al., 2012). These thresholds are based on historical transitions of countries from lower-middle to upper-middle-income status and from upper-middle to high-income status. To avoid the lower-middle-income trap, a country needs to sustain an average income per capita growth of at least 4.7% per annum for 28 years, and to avoid the upper-middle-income trap, it needs to sustain an average growth rate of at least 3.5% per annum for 14 years. 

The MIT is notoriously hard to escape. In fact, in a 2010 sample, only 9 out of 167 countries have moved to high-income status in the previous 40 years (Cherif & Hasanov, 2015). To be fair, 7 out of those 9 nations were European countries, only 2 of them, namely the Republic of Korea (South Korea) and the Republic of China (Taiwan), had a lower average income than Malaysia at the start. 

Country	Year country turned lower-middle	Year country turned upper-middle	No. of years as lower-middle	No. of years as upper-middle
South Korea	1969	1988	19	7
Taiwan	1967	1986	19	7
Malaysia	1969	1996	27	27 (until 2023)

Source: Felipe, J., Abdon, A., & Kumar, U. (2012) 

What contributed to Malaysia being stuck in this trap? 

To understand how Malaysia has fallen into this trap, we must analyse the country's labour productivity trend compared to Korea and Taiwan. Both nations had a factor productivity growth of 1.8% from 1970-2010, while Malaysia’s was merely 0.8% a year! To add fuel to the fire, Malaysia’s stagnating growth in GDP per capita is contributed by negative deindustrialisation in the manufacturing sector, where manufacturing value-added share to GDP fells by 7.8% from 2000-2018 while employment share fell by 6.1% (Asyraf, et.al, 2019). 

As both sluggish productivity growth and premature deindustrialisation push Malaysia into the middle-income trap, several factors can be blamed for the occurrence of these phenomena. Firstly, the shortage of high-skilled workers like scientists, engineers and technicians, coupled with the heavy reliance on low-skilled foreign workers represents some main factors contributing to Malaysia being stuck in the middle income trap. As the manufacturing sector witnessed rapid value-added growth rates in the early 1990s (see Table 1), the supply of skilled workers reduced drastically, hampering the process of industrial deepening needed to shift towards higher value-added activities. 

Table 1: Sector GDP growth rates, (1990-2010)

Source: (Rasiah, 2014)

Investing in human capital development is vital as high-skilled labour supply helps ensure sustainable labour productivity growth rates. However, Malaysia's ratio of low-skilled workers to the labour force of 27.2% is much lower than the government's target of 35% by 2020, which explains how the quality of labour contribution to GDP was only mere 8% throughout 2001-2018 (Asada, et.al, 2019). Despite a significant demand in sub-sectors like Electronics & Electrical, and chemical or fabricated metals, there remains a shortage of 50,000 engineers to support the boom in the semiconductor industry, which is part of the E&E sector (Poo, 2022). 

Although it is wise for firms in the manufacturing sector to innovate and shift towards higher-value-added activities like R&D and designing since their advantage in labour-intensive activities was eroding, unfortunately, this did not materialise. Instead, local firms imported a supply of low-skilled foreign workers, mainly from Indonesia, since they could be paid at lower wage rates than locals and ensure firms could still compete with other low-cost, labour-intensive firms from China and Vietnam (Kanapathy, 2008). Malaysia’s government implemented policies to reduce dependence on foreign workers and stimulate upgrading in the manufacturing sector however, the number of foreign workers rose from 290,000 to 1.78 million from 1990-2005, where 98% were low-skilled workers (see table 2). Not only does a higher supply of low-skilled foreign workers suppress the productivity of industries (see chart 1), their influx depresses wages as well, which contributes to the out-migration of local workers who search for better career opportunities overseas with higher pay (Ang, et.al, 2018). With an available supply of cheap, low-skilled foreign workers, local firms have no incentives to innovate and move up the value chain by engaging in capital-intensive activities. 

Table 2: Labor Market Indicators, 1980-2005

Source: (Kanapathy, 2008). 

Chart 1: Productivity of Industries negatively correlate with share of foreigners

Source: (Ang, et.al, 2018). 

Although Malaysia possesses the basic ingredients for sustainable growth, like good infrastructure, trade openness and a relatively high level of schooling years, the major constraint to its labour productivity has been the absence of local technology creation and diffusion from MNCs to local firms. This situation can partially be blamed on previous factors. If Malaysia lacks sufficient skilled workers to operate new IR 4.0 technologies such as cloud computing or the Internet of Things (IoT), there isn't any use of technology buyers to import or acquire new technology potential suppliers (MNCs). On the other hand, Malaysia's lack of spending on R&D is evident, as R&D as a percentage of GDP in 2011 was only 1%, while countries that escaped the trap successfully, like South Korea, had R&D spending of 2% back in the 1990s (Cherif, Hasanov, 2015). 

It's bad enough that local firms lack technological absorptive ability due to poor investment in innovation, MNCs, on the other hand, rarely engage in R&D activities since R&D is mainly done by parent companies located in their respective home countries. Malaysia has launched initiatives to stimulate technology transfers by creating technology parks, implementing a Vendor Development Program to foster stronger linkages between MNCs and local firms,  and setting up research institutes like MIMOS. Unfortunately,  these initiatives had limited success in stimulating technology diffusion. By analysing the number of Malaysian patents granted in the US compared to Korea, Malaysia has a relatively low number of patents. In 2013, Malaysia’s patents were 220, which is still less than Korea’s number of patents of 330 per year in the 1990s, when both countries had similar levels of national income (Cherif, Hasanov, 2015). 

The Economist, 2023

So what now for Malaysia? 

Looking at countries' relative national income as % of US GDP, Malaysia has come a long way, from having 25% of US GDP to nearly 40% (The Economist, 2023). With a GDP per capita of $ 11,993.2 in 2022, few international financial organisations, like the World Bank, note that Malaysia could transition to a high-income nation status between 2024 and 2028. On the other hand, local economists like Professor Yeah from Sunway University agree that  Malaysia is on the path to escaping the middle-income trap by 2026 as long as GDP growth stays above 4% annually and population growth grows at 1% in the next three years (Huong, 2023). However, Malaysia has had its work cut out since its recent GDP growth in 2023 slowed down to 3.7% due to weaker external demand for exports (Bank Negara, 2024). 

Does this mean there isn't any hope for the nation? Certainly not, as the Madani government has launched the New Industrial Master Plan 2030,  which aims to re-industrialise the country by creating more high-skilled jobs, improving manufacturing sector’s value-added share to GDP and raising median workers wages (Ministry of Investment, Trade and Industry, 2023). 

The devil lies now in the implementation of this master plan. Strong political will is needed in the Madani government to implement bold economic reforms like phasing out the supply of low-skilled foreign workers in each sector, ensuring horizontal coordination between research institutes, universities and private firms to invest more into R&D, restructuring the tertiary education system to be modelled after German Vocational Education and Training system where programs are designed through coordination among universities and local private firms. These policies, as well as other economic reforms, are vital to help ensure Malaysia is able to achieve sustainable higher GDP growth in order to escape the MIT and achieve a high-income nation status.  

Written by Lau Hui Geng & Kishenaendra Devindran, Economics Undergraduates at the University of Nottingham Malaysia.

References: 

Felipe, J., Abdon, A., & Kumar, U. (2012). Tracking the middle-income trap: What is it, who is in it, and why?. Levy Economics Institute, Working Paper, (715).

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Yusof, Z. A., & Bhattasali, D. (2008). Economic growth and development in Malaysia: policy making and leadership. Washington, DC: International Bank for Reconstruction and Development/The World Bank.

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https://www.bnm.gov.my/documents/20124/766189/p3ba.pdf 

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