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End ‘state capture’ to enable economic transformation and improve livelihoods

Tong Kooi Ong & Asia Analytica
Tong Kooi Ong & Asia Analytica • 25 min read
End ‘state capture’ to enable economic transformation and improve livelihoods
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"When the support structures are weak, it is short-sighted to replace the furniture as a means to make the home more attractive."

What does it take to get the Malaysian economy back on track? We hope the lessons we have ar ticulated in this three-part series will shed some light and initiate serious discussion.

Over the last two weeks, we have narrated the story of the tremendous economic success of South Korea and the abysmal failure of South Africa — despite both gaining democracy around the same time (in 1993-1994). Democracy is an ideology, not a solution. In part two, we highlighted the reasons for this diverging economic trajectory — based mostly on the research, analyses and publications of others. We are not experts on the two countries nor are we qualified development economists. We had acknowledged that direct comparisons of coun tries are difficult due to myriad reasons, including differences in demography, size, cultural and historical legacies. But we think one can still draw lessons and decipher contrasting facts, decisions and events as key takeaways. (Scan the QR codes for a refresher.)

Good storytelling necessarily requires simplification of a very complicated world. But we think we have truthfully captured the key essence within the narrow context of the question posed: Why do some countries prosper and continue to grow from strength to strength while the economic development and growth in others stagnate, or worse, falter and decline?

See also: 5G evolution and pinky promise: Back to the past, except worse …. Why?

We concluded that the major differences between these two countries are the extent of corruption in the economy, free-market competition and equal opportunity as well as access to, and the quality of, education.

No doubt there are other reasons, such as the geopolitical importance of South Korea to the US as well as the homogeneous race and culture of its population. Similarly, issues of trust in government and reliability of its decisions are critical factors. But there is no re liable, scientific and consistent data on these.

We also acknowledge that this article does not pretend to be comprehensive or definitive but rather, to raise questions and encourage debate with the aim of enriching knowledge and wisdom. Our objective is to have a better understanding of what it takes to bring economic progress, prosperity and jobs to na tions, particularly developing ones.

See also: The best performance for the Malaysian stock market in a decade. Is it sustainable?

It is in this context that we write part three — by including the statistics, data and a Malaysia narrative. It is not to apportion blame or to put anyone down but to initiate discussion (debate even) on lessons (both good and bad) that we can learn and actions we can take to provide better-paying jobs to Malaysians, to raise their standard of living, to become more efficient and productive, and to move from being trapped as a middle-income nation to one that is developed, prosperous and proud.

The Malaysia story

Malaysia’s economic progress in the early years, after achieving independence in 1957, followed the “traditional” route of most newly emerging countries. For the better part of the first two decades (1960s-1970s), economic growth was driven mainly by agriculture and mining, and exports of primary commodities such as rubber, timber and tin. Investments were focused on basic infrastructure and development of the two sectors. As the economy developed, there was a shift in emphasis towards manufacturing and export-oriented industries, supported by the creation of export processing zones, free trade zones and restrictions on unionisation to attract foreign direct investments (FDIs).

A key transformation came in the early 1980s when the then government, under the leadership of then prime minister Mahathir Mohamad, instituted the “Look East” policy to emulate the industrialisation success of Japan and South Korea. Focus turned towards the heavy industries to accelerate Malaysia’s own industrialisation programme. Perwaja was established in 1982 to supply the rapid growth in domestic demand for steel and Proton was formed in 1983 as the national carmaker — both are cornerstones of Malaysia’s heavy industrialisation efforts.

There was also robust growth in the electrical and electronics (E&E) industry, spurred by investments from multinational corporations (MNCs), particularly those from Japan and the US. The government embarked on a large-scale privatisation drive, to transfer the ownership of public entities to the private sector. The aim was to reduce government debt and presence of the public sector in the economy, improve efficiency and productivity, and further support economic growth.

Through the 1980s and into the 1990s, there were more trade liberalisation and in centives to attract investments, as well as focus on training and skills improvement. The Multimedia Super Corridor was conceptualised and officially launched in 1996 to spearhead Malaysia’s transformation to a knowledge-based economy. There were a wide range of incentives to boost investments to make Malaysia the regional hub for information and communications technology.

This period, from independence up until the Asian financial crisis (AFC) in 1997, was one of rapid economic growth, driven by investments, industrialisation and urbanisation. Both investments (including FDIs) and manufacturing as percentages of gross domestic product (GDP) rose strongly. And manufacturing was moving up the value chain (see Charts 1 and 2). Substantial progress was made in the eradication of poverty, jobs were created, standards of living improved and the stock market was buoyant. Yes, some projects like Perwaja ultimately failed and Proton did not fare well, either — but others like E&E succeeded. The key differentiator, we think, is this: Success has proven more probable when the government sets the macro policies — and any necessary guard rails such as safety regulations — but allows competition to drive the market.

For more stories about where money flows, click here for Capital Section

The AFC was the next major turning point for Malaysia. We had relied too heavily on debt to drive economic growth, and especially foreign debt and short-term capital. As the ringgit depreciated sharply — driven by currency speculative pressures and massive capital flight in the region — and the economy fell into a deep recession, the government (still under Mahathir’s leadership) turned to cap ital controls. The ringgit was pegged at 3.80 to the US dollar.

We have articulated the long-term repercussions of capital controls in great detail in past articles. So, we are not going to repeat them here. The point is that investor confidence was severely damaged and never fully recovered, even after capital controls were lifted. The country started losing out on FDIs in the region. Investments as a percentage of GDP have fallen sharply post-AFC, as has manufacturing — Malaysia suffered premature deindustrialisation. Consumption — fuelled by debt — became the biggest driver for economic growth in the decade after the AFC, but this proved unsustainable as household debt ballooned. Critically, instead of moving up the value chain, medium and high-tech sectors as a percentage of manufacturing declined! Malaysia failed to achieve its vision to be a high-income nation by 2020. In fact, the country now risks falling into a middle-income trap. These are all clearly evident in Charts 1 to 4.

State capture hurts competition and deters innovation

Malaysia’s economic trajectory since the AFC diverged from that of South Korea. As we discussed last week, South Korea chose to under take wide-ranging market-based reforms over protection of its biggest conglomerates, forcing the chaebols to restructure and insolvent businesses to shutter. The country suffered massive short-term pain, but businesses that survived emerged stronger. Importantly, the government liberalised imports and opened the domestic market to competition, attracting increased FDIs. Intensified competition domestically, in turn, forced the chaebols to compete and expand into the global market. To compete effectively, they spent heavily on research and development (R&D), which drove innovation and technological advancements. South Korean-made products gradually transformed from being known for their sub-par quality to reputable household brands globally. And the country’s participation in the global value chain has risen steadily.

Similar to South Korea’s chaebols, Malaysia too nurtured its own set of large conglomerates — “local champions” — as the catalyst for growth in the early decades of economic development. Like the chaebols, these corporates maintained close ties with the government and enjoyed many incentives and protective regulations. Unlike South Korea, however, we continue to offer these elites and the privileged protection in the domestic market.

Malaysia chose to impose capital controls during the AFC, in effect closing off the domestic market and buffering the overleveraged and financially distressed conglomerates from market pressures to restructure and, if necessary, go bankrupt. Some deemed to be of “strategic national importance” were bailed out by the state at the expense of taxpayers. Sheltering inefficient companies from market corrective forces, besides being prone to abuses and corruption, is a drag to future economic growth as human and capital resources are not being reallocated to where they are most productive. Why capital controls?

Last week, we also wrote about South Africa, providing the sharp contrast in its economic development from South Korea’s economic success. South Africa is the worst-case example of how “state capture” emerged, be came prevalent and directly resulted in the country’s current economic crisis.

“State capture” is defined as a type of systemic political corruption in which private in terests wield undue influence in the state’s decision-making process, shaping policies, laws and rules to their own advantage.

In the case of South Africa, a small group of private sector businessmen were able to amass massive wealth through political connections and corruption — including the redistribution of wealth from state to private sector — and with it, wielded significant influence in public policies and state-owned entities, including even the selection of cabinet ministers. Economic wealth is concentrated within this deeply entrenched patronage network while the majority of the population are impoverished as economic progress stagnated. State capture reduced South Africa’s international competitiveness and job creation. Unemployment is among the highest in the world. Corruption and mismanagement eroded public trust, social mobility is low while inequality is at elevated levels, fuelling crime and societal unrest.

To be sure, state capture exists in almost all countries, even in the US with political lobbyist groups, albeit in varying forms and degrees. It is the extent of which that is damaging. In this respect, Malaysia has demon strated a higher degree of state capture than South Korea, though not as prevalent as South Africa, yet. But the experience of South Africa must serve as a warning and wake-up call. Malaysia may well be at its next critical juncture, which could determine whether the nation progresses or regresses.

Malaysia’s Corruption Perception Index (CPI) stands at 47, slightly better than South Africa (43) but far worse than South Korea (63). The CPI represents the perceived level of public sector corruption on a scale of 0 to 100, where “0” means highly corrupt and “100” means very clean. And to quote Bank Negara Malaysia deputy governor Marzunisham Omar, “The National Risk Assessment 2020 found that corruption in the country has become systemic”. It hacks away at trust in our economic, political and law enforcement institutions, trust of investors and trust in the future of our nation.

Trickle-down economics simply does not work, but justifies rent-seeking

For decades, Malaysia subscribed to the “trickle-down” economic policies that favour a select group of businessmen and corporations, and fostering a patronage network. Existing policies such as licensing requirements and approved permits for imports are crafted to protect and benefit these elites — aka rent-seekers — in the belief that they will then increase investments and create jobs, and that benefits-wealth will eventually trickle down to the broader population, improving economic well-being for all.

The ringgit was fixed at a “crisis-triggered” low level of 3.80 to the US dollar from 1998 to 2005 — to protect local businesses against competition from imports (by making imports more expensive), at the expense of consumers (higher cost of living). Note that in the 25 years prior to the AFC — “normal conditions” — the ringgit has always hovered around 2.50 to the US dollar.

The low exchange rate peg also gave exporters a boost in competitiveness in the global market, thus allowing them “easy” profits without having to expend additional effort. This negated the urgency to innovate and improve productivity. Over time, protective regulations became a crutch, leading to gradual loss of competitiveness. We see evidence of this in the shrinking margins and returns on assets for many companies listed on Bursa Malaysia. And this explains why Bursa has been a chronic underperformer since the AFC.

Profits are determined by three main factors: price, costs and productivity. As we explained above, protectionist policies keep prices higher — and quality of goods and services lower — than they would be in the domestic market, by limiting competition from foreign companies. Case in point: Car prices are significantly higher in Malaysia than in many other developed countries. Rent-seeking activities further deterred investments from oth er domestic companies, including start-ups, stifling entrepreneurship.

Government policies also enabled a steady supply of cheap, low-skilled foreign migrant labour to keep costs low. Foreign labour rose from a low 3.6% of the total workforce in 1990 to 14.8% in 2019. And this data excludes the huge number of illegal migrant workers (see Chart 5). The availability of cheap foreign labour effectively depressed wages-salaries growth for all Malaysian workers. The companies themselves become over-reliant on high volume-low cost production, failing to move up the value chain. Eventually, competitive pressure from newer emerging countries with even larger pools of cheaper labour leads to falling price and profit margins. Case in point: China drove the global deflationary trend for manufactured goods for 30 years, until the Covid-19 pandemic.

South Korea has proven that the key to continued economic progress is through productivity gains, driven by innovation and technological advancements — facilitated by high R&D investments that are necessitated by competition.

Remember we wrote that total factor productivity (TFP) — which measures how efficiently and effectively inputs (labour and capital) are transformed into output — con tributed 20% to South Korea’s economic growth between 1970 and 2020? A higher TFP means that the economy can generate more output with the same inputs, which translates to higher incomes and standards of living. Well, TFP for Malaysia (as calculated by the Asian Productivity Organisation) is just 4% over the same period. Yes, 4%. Little wonder then that Malaysia’s per capita productivity and income are lagging far behind South Korea’s — per capita gross national income (GNI) started around the same levels in 1980, but South Korea’s income is now more than three times ours (see Charts 3 and 4 as well as Table 1 below). Again, the question is why?

Malaysia relied on transfer of technology from the MNCs in the 1970s to 1990s, but evidently, to little avail. In fact, many FDIs have been shown to form little linkages in our economy and there were limited efforts to expand the ecosystem. And this is not surprising. Foreign companies will protect their intellectual property and, let’s be honest, we are a very small part of the global supply chain. The focus of these MNCs is to optimise their production chain.

To make matters worse, protectionist policies limit competition and remove the motivation for domestic companies to spend on R&D and to innovate. Malaysia’s spending on R&D has been well below that of South Korea (see Chart 6).

The reality is that Malaysia’s domestic market is too small for economies of scale — companies need to expand into the global market, and importantly, to be part of the global supply chain. To do so, they must move up the value chain and raise productivity, instead of persisting in the losing bet on low-value-high volume production.

South Korea has taught us that productivity must be driven by homegrown innovation and technological advancements — enforced by competitive pressures in a liberalised domestic market. Quite frankly, any fear that opening up our economy to foreign competitors would mean the demise of local companies is likely misplaced. Where foreign competitors exist, such as in banking, property development and retailing, our local companies have succeeded. Indeed, these are the sectors where Malay sia is outperforming. How do we stimulate domestic R&D and innovation?

Inequality is rising within — not between — ethnic groups

The New Economic Policy (NEP) was developed in 1971 as a comprehensive affirmative action plan to address the inequality between ethnic groups and promote more inclusive growth in the country. In some respects, it has been successful; for instance, in eradicating hardcore poverty and improving the socio-economic conditions of the bumiputeras. Yet inequality remains relatively high and, over the years, has become structurally different. What do we mean by this?

The Gini coefficient for Malaysia improved from 51 in 1970 to 41 in 2022, indicating less inequality, on average. That said, inequality persists at relatively high levels 50 years after the NEP — we are ranked 115 out of 165 countries in the world. This is far worse than South Korea (ranked 36 with Gini of 31) and Vietnam (ranked 78 with Gini of 37).

Surely, this is evidence that the “trickle-down economics” embraced by every government of Malaysia since independence is simply not working as expected. Economic wealth is being created but most remain concentrated in the hands of the few. Statistics by the World Inequality Database (WID) show that the top 10% in Malaysia accounts for 47% share of pre-tax national income and 61% share of net personal wealth.

Notably, a World Bank report published in 2010 (Why updating Malaysia’s inclusiveness strategies is key) found that, “Nowadays over 90 per cent of the level of inequality is explained by differences within ethnic groups rather than differences between these groups”. In other words, there is widening income-wealth disparity between the rich bumi-Chinese-Indian and the average bumi-Chinese-Indian. So, yes, we have successfully created “local champions” and enriched the elite and the privileged — the bumi tycoons, Chinese tycoons and Indian tycoons. The problem is the economic gains are NOT trickling down to the masses.

Case in point: A study published by the World Inequality Lab (which also hosts the WID) in 2019 (“Income inequality and ethnic cleavages in Malaysia”) showed that the average growth in real national income per adult from 2002 to 2014 was the highest among the top 1% of bumi (8.3%) compared to 5.4% for the top 10% and only 4.1% for the middle 40% of bumi.

On the other hand, there has been notable redistribution between the ethnic groups. The top 1% (of all ethnic groups) retains a disproportionately high share of pre-tax national income of 14.5% in 2014 — but the share for bumi rose from 2.6% in 2002 to 6% while that of the Chinese fell from 15.5% to 7.7% (see Chart 7).

To be sure, data in these kinds of studies is hard to verify. Certainly, we cannot testify to their accuracy here. But based on our own observations and experiences, we do believe this trend of widening inequality within ethnic groups is real.

There is no question that state capture has hurt competition in the domestic market, reduced investments and job creation, and stifled innovation and productivity. It damaged Malaysia’s competitiveness in the global market and hampered the move up the value chain — translating to low growth in wages and incomes and higher cost of living for all Malaysians.

In part one of this series, we wrote that as inequality becomes increasingly apparent in the eyes of the people — whether real or perceived — it will lead to resentment and anger against the establishment and the elite, and, in turn, precipitate social unrest, racial tensions and political instability. But if inequality is no longer what it was five decades ago, then Malaysia needs a new playbook on its inclusiveness strategies. The fundamental principle, we believe, lies in enhancing equality of opportunity, not equality of outcome.

Focus on equality of opportunity, not equality of outcome

What this means is that the aim of public policies must be to foster a level playing field for all individuals to pursue their goals and ambitions, rather than attempting to ensure that everyone achieves the same results or outcomes in life.

Even in an ideal world, where we provide every person equal access to quality education and healthcare as well as employment and business opportunities, clearly, not everyone will achieve the same outcomes. Some will be more successful, others less so. But this disparity can be addressed separately, in the form of additional aid and programmes for the underachievers.

The point is, people are motivated by incentives and disincentives. Unjust redistribution will inevitably lead not just to slower economic growth and progression, but even to a shrinking pie. Here are some measures undertaken to improve equality of opportunity in other countries that are worth exploring further:

(a) Liberalising and opening up the domestic economy to both local and foreign investors and entrepreneurs;

(b) Improving ease of doing business, with greater transparency and governance;

(c) Removing licensing or exclusivity to imports, thereby forcing local entrepreneurs to invest in R&D, innovate and to compete in the global market through exports;

(d) Reducing the role of government and government-linked companies (GLCs) in private enterprises and businesses;

(e) Introducing a “gold standard” in government tenders and procurements;

(f) Enacting a “Political Funding Act” to regulate public and private funding of political parties. Ensuring that political parties are funded by public funds and not be held hostage by the business elite. Limiting the contributions by any one party-entity and how much each political party can spend (Bersih 2.0 had commissioned a similar report in 2021, Public Funding of Political Parties in Malaysia: Debates, Case Studies and Recommendations).

Urgent need to address deteriorating quality of education

You might have noticed that we have not really touched on education. This is a huge and very important subject — and it deserves a stand-alone article. A country cannot attract high-value investments if it does not have the required talent pool to support those businesses. And you need an educated workforce and the necessary skill set to move up the value chain. Without an educated and talented workforce, R&D spending will go nowhere.

We will certainly explore the subject of the quality of Malaysia’s education system in the near future. Suffice to say, the direction of changes over the past decades is not good. The quality of education in this coun try is deteriorating, as underlined by the drop in TIMSS scores (by the International Association for the Evaluation of Educational Achievement) in mathematics and science since 2000 — from 519 and 492 respectively to 461 and 460. These scores are well below that of students in South Korea and Singapore, and are, in fact, below the international average score.

Similarly, the PISA (the OECD Programme for International Student Assessment for reading, mathematics and science) scores for Malaysian students are well below that of South Korea, Singapore and even Vietnam (see Tables 1 and 3).

Education is a powerful predictor of the wealth that countries will produce in the long run. Indeed, human capital is the most valuable resource of a nation. In addition to deteriorating quality of education, Malaysia also has much lower percentages of population who have completed at least upper secondary education and holders of diploma or higher compared to both South Korea and Singapore.

Hence, there is an urgent need to de-politicise education, focus more on STEM (science, technology, engineering and mathematics) subjects and importantly, raise teaching standards in schools and universities. According to the QS World University Rankings, Universiti Malaya (UM) is the highest ranked local university at 70. The National University of Singapore (NUS) — the UM and NUS were once the same institution before splitting in 1961 — is the top university in Asia and ranked No 8 in the world.

Continuously lowering the passing marks just so that more students can be admitted into universities only serves to undermine the standard of graduates. There must be a willingness to direct less able students to vocational training.

One practical solution is to make schools competitive, like any other business. In the US, some states apply the school voucher programme. Students decide on the choice of schools and the state will allocate each school’s budget based on its number of students. In other words, more students, more money to hire better teachers, for capacity expansion, improve facilities and so on. When schools must compete for students, they will be incentivised to raise their standards.

Summary

Over the last three weeks, we have articulated a simplified story on the economic developments in South Korea, South Africa and Malaysia throughout the past decades. The main takeaway is that two variables likely account for a significant part of their economic success and failure, namely:

(1) Equal opportunity and access to, and the quality of, education;

(2) Prevalence of state capture in the economy.

The question then is the willingness and ability for an honest assessment of these two variables. And the ability to articulate policy solutions that are actually achievable — as well as how to execute and execute well. Many of these solutions would require bravery and huge political will and goodwill, especially in a democratic system where the population is already highly polarised.

We do not pretend to have all the answers, but hope this three-part series can initiate meaningful dialogue, exchange of views and debate. The Edge stands ready to host round-table discussions to facilitate the process.

For a start, we believe policies for the next 10 years should focus on income- and job-centred growth. That is, to increase income (GNI per capita) — not just GDP — by creating more (and better-paying) jobs, raising wages and reducing inequality. Higher income will, in turn, boost purchasing power of the population, especially the middle- and lower-income groups, and support sustainable consumption as the driver for economic growth in the long run.

In fact, we suspect the reason why Malaysia has a bloated civil service — higher number of civil servants per 1,000 population compared to South Korea, South Africa and Singapore — is due to the lack of jobs created by the shrinking manufacturing sector (as a percentage of GDP) and reliance on cheap foreign labour in the plantation, low-skilled manufacturing and services sectors. The percentage of civil servants as a percentage of total workforce increased from 7.5% in 1998 to over 10% in 2021. As a result, the average pay for civil servants is comparatively low despite rising fiscal budget — it has to be when you slice the pie into many more pieces (see Table 4).

It is clear to all that the country needs to attract investments, both domestic and foreign, to create more jobs. We mentioned earlier that investor confidence was badly hit by Malaysia’s decision to impose capital controls during the AFC and again in 2016, albeit to a lesser degree. That contributed to falling investments (as a percentage of GDP). Why not simply address the core issue head-on? Minimise the risk of capital controls in the future. Pass an Act of Parliament that makes it unconstitutional to exercise any form of restriction on flows of capital, both foreign and local. And if capital controls (or any degree of restriction on free flow of capital) were ever contemplated, they must first be debated and passed by parliament.

Future policies should also focus on innovation-driven growth — for instance, through incentives for R&D (but please, not the traditional tax breaks and so on) and digitalisation by domestic companies, as well as facilitating an easier financing environment for start-ups, and micro, small and medium enterprises (MSMEs). And, gradual reduction in migrant workers.

Last but not least, remove state capture, foster fair competition and level the playing field to spur private investments and entrepreneurship. Cut the umbilical cord between the business elite, top politicians and senior civil servants. Let competition thrive and the best succeed. The government could start with privatisation 2.0 — privatise the GLCs via transparent open tender. As with the privatisation drive in the 1980s to 1990s, the objectives would be to pare government debt and reduce the presence of the state in the economy — and crowding out effect on the private sector — improve efficiency and productivity. At the same time, divert subsidies and the gains from the removal of rent-seeking activities to fund a social safety net — to reduce inequalities and promote well-being for all. Simple, yet difficult to execute.

Let us circle back to the very beginning, part one of this three-part series, “Democracy is an ideology, not a solution”. While it is true, we also know that the wisdom and collective judgement of the many, as opposed to the decisions and actions solely by a few, provide a high chance of finding balance, objectivity, strength and stability.

Collective values, norms and shared interests tend to be more resilient to corruption and abuses than if such power is captured by a small, tight-knit group of elites. We are reminded of the wisdom of Aristotle: “The many are more incorruptible than the few; they are like the greater quantity of water which is less easily corrupted than a little.”

The Malaysian Portfolio fell 0.7% last week, paring total portfolio returns to 158.5% since inception. Hartalega Holdings was the sole gainer for the week, up 7.4%. In fact, the stock has far outperformed the broader market, gain ing 14.1% in the five weeks since we added it to the portfolio — despite persistent wide spread negativity for glove stocks within the analyst community. KUB Malaysia (-6.3%), Star Media Group (-1.2%) and Insas (-1.2%) ended lower last week. This portfolio continues to outperform the benchmark FBM KLCI, which is down 21.1%, by a long, long way

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

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