THE Malaysian economy has done well in 2012. Economic growth has held up at above 5% despite strong headwinds in the external sector. Moreover, inflation has been contained, the external position remains robust and the fiscal position has improved a tad. Some may say that growth was resilient only because of election-related spending which cannot be sustained but the facts do point to positive structural elements in the growth picture. Without that, the share of private investment in economic output would not be steadily rising - from below 10% some 10 years ago to 13.4% in 2011 and around 15% in 2012.
Looking forward, the economy is likely to be resilient next year given the pipeline of investments and the reasonably firm outlook for consumer spending. The real question is about the economy beyond 2013: are the structural reforms currently unfolding sufficient to allow Malaysia to confront a more competitive world?
Fortunately, Malaysia has the wind behind its sails in a number of areas.
First, the government's reforms of the past few years are delivering solid results in improving Malaysia's business environment and competitiveness. This is seen in the improvement in Malaysia's rankings across many indicators. Malaysia has sustained its position as third most competitive economy behind India and China in business process outsourcing.
Its rank in AT Kearney's Foreign Direct Investment Confidence Index has also improved dramatically, from 22nd in 2000 to 10th in 2011. It has moved from 42nd position to 31st in the IT Industry Competitiveness Index. It is now ranked 12th best country globally for the ease of doing business, compared with its 23rd position in 2009, a clear testament to the government's efforts to improve in areas such as registering a business and issuing licences.
Second, some of the economic initiatives of the past few years are now bearing fruit. The Iskandar Malaysia region has reached critical mass this year - it is no longer just a real estate play as some would have it, with economic activity increasing as manufacturing, tourism, education and healthcare facilities start operations.
In this, Malaysia is helped by the fact that Singapore's business costs have escalated to such a point that substantial activity will have to be relocated out of the city-state. Since Batam and Bintan are no longer attractive to Singapore-based businesses because of less-friendly policies, Iskandar has become a compelling choice.
As Singapore's restructuring has only just begun, we are likely to see a powerful surge of business relocation to Iskandar from Singapore in the coming years. Another area of solid growth based on enduring competitive advantage is the Pengerang oil and gas centre, which is just beginning to take off.
But the challenges for Malaysia are growing. A number of trends are emerging in the world economy that will challenge Malaysia's economy, raising the question whether the improvements discussed above are sufficient.
First, we are seeing the rise of the laggards. Economies which underperformed for decades are getting their acts together and becoming more competitive participants in the global market place. The Philippines today is growing faster than it has for decades: with its public finances and external debt now no longer constraining growth, it is moving ahead to reduce infrastructure woes and exploit its expanding competitive advantage in areas such as business process outsourcing.
Myanmar has come out of its isolation and will attract sizeable foreign investment going forward. Bangladesh has grown steadily at above 6% in recent years, a far cry from the days when it was seen as a basket case.
Further afield, Latin American economies, such as Brazil, Mexico and Peru, have escaped from the low growth trap and are becoming attractive to foreign investors as well as more competitive in gaining market shares in manufactured exports. Similarly in Africa, countries such as Ghana are regaining competitiveness and confidence. Malaysia is going to face a lot more competition.
Second, some of the factors determining decisions about where multinational companies (MNCs) locate production are changing: it may not be as easy for Malaysia to attract foreign investment using the old playbook.
* MNCs are finding that large, populous econmies such as China, India and Indonesia are far more open to investment than before - and that the domestic markets in these countries offer economies of scale that countries such as Malaysia cannot offer.
* There is a process of re-industrialisation underway in the US and in the UK as companies there respond to the post-financial crisis economic malaise by re-engineering themselves. In the US, we are also seeing companies gain from lower energy costs as the shale revolution there expands. MNCs are finding that while the low-cost option of locating manufacturing in cheaper developing countries remains appealing, there are many products and processes which can now be done competitively in developed economies - whether because being near the consuming market is more important or because of concerns over intellectual property protection. So, Malaysia will have to compete not just against developing economies for investment, but sometimes against developed economies as well.
* Finally, China is moving up the value chain, with particular impact on economies such as Malaysia and Thailand. The previous strategy of MNCs locating component production in Southeast Asia and final assembly in China is shifting as China is becoming competitive in component production as well.
Third, economic integration within Asean and the broader East Asian region is expanding. Asean's integration efforts may have disappointed previously but there is enough happening in the Asean Economic Community process to increase competition within the region.
The option of protecting some sectors from foreign competition will become less and less viable. In addition, the Greater Mekong Sub-region is also seeing greater integration, allowing countries in the northern Asean region to gain from economies of scale and improved connectivity - a process which excludes Malaysia but benefits its regional competitor, Thailand.
We could go on but the point is clear - the world is changing, there will be much more competition and Malaysia will have to accommodate this challenge.
So, has Malaysia done enough? Unfortunately, there remain significant structural weaknesses in the economy which the reform process has not tackled sufficiently.
* Fiscal position reaching worrying levels: the ratio of public debt to GDP will reach about 54% in 2013, just below the legal cap of 55%. The proportion of revenues gobbled up by debt servicing will rise from 9.9% of revenues in 2012 to a projected 10.7% in 2013 - at a time of historically low interest rates. There is a structural problem in the tax base: only 11% of registered companies pay corporate tax and only 14.8% of employees pay income tax. In the expenditure side, the proportion of revenues consumed by personnel spending remains far too large.
* The economy remains overly reliant on cheap foreign labour. Although the number of legal foreign workers has edged down, it remains high at 1.8 million compared with 2.06 million in 2008. Low-cost foreign labour depresses wages at the lower end of the skill spectrum with severe consequences - income inequality worsens as low-wage earners see limited wage increases while companies have little incentive to raise productivity.
* Human capital development continues to under-perform Malaysia's needs despite the monies spent on education and the proliferation of private schools and universities, many of which are of dubious quality. Churning out graduates with high expectations but low employability could create political problems in the future. The brain drain continues, weakening Malaysia's competitiveness.
* Corruption remains a severe constraint on the business environment. Malaysia's ranking in Transparency International's Corruption Perceptions Index has deteriorated unremittingly from 36th in 2001 to 60th in 2011.
* GLCs constrain growth: the role of government-linked companies (GLCs) in the economy could be hindering the revival of private investment. Both the 2010 New Economic Model report of the government and a more recent Asian Development Report (Malaysia's Investment Malaise: What Happened and Can It Be Fixed? Asian Development Bank, April 2012) observe that the pervasive influence of GLCs could be hindering private investment.
* Crime remains a challenge. While government data seem to show a steady improvement, the average person's perception of personal safety has not. As the World Bank delicately put it, "public perceptions appear at odds with statistics". It is certainly a fact that there would be a faster flow of relocations of businesses from Singapore to Iskandar if the personal safety factor had been better managed. It is not clear that the underlying causes of crime - institutional weaknesses in the criminal judicial system and the marginalisation of certain communities - have been adequately addressed.
Where is the reform process heading? Some of these gaps are likely to be addressed soon. Take the fiscal position as an example, which has deteriorated sharply after more than a decade of persistent fiscal deficits. However, the solutions are available in the form of a goods and services tax as well as the rationalisation of fuel subsidies. If both of these are implemented after the elections, as we think, the fiscal position will improve.
However, underlying many of these problems are two more fundamental weaknesses - critical institutions in Malaysia have weakened compared with what they were in Malaysia's heyday of the 1970s and 1980s and the incentive structure has become distorted:
* Malaysia outperformed most other developing economies because its civil service, police, judiciary, universities, schools, political parties, regulatory agencies and development institutions were often first world in quality. It may not be a popular thing to say but it is a fact that Malaysia's institutional edge has diminished in the past 20 years. Without institutional revitalisation, Malaysia will not resolve corruption and crime. Neither will it be able to build the human capital needed to compete effectively nor will it be able to reverse the brain drain and attract the talent needed to excel.
* Building human capital in a way that contributes to economic development is not simply a matter of raising educational qualifications. It is also about the incentives for economic agents. If economic agents believe that the best way forward is to find ever more inventive ways of rent seeking or of leveraging off ethnic identity, the economy as a whole will not perform well.
In short, Malaysia has done well in bringing about enough reforms to place the economy on a stronger footing. But the transformation process needs a second stage of bolder reforms to rebuild institutions and rectify the incentive structure. This will be a harder task because entrenched interests who benefit from the current system of distortions will resist - but we are hopeful that reforms will succeed over time.
Manu Bhaskaran is partner and head of economic research at Centennial Group, an economics consultancy. This story first appeared in The Edge weekly edition of Dec 24-31, 2012.