Malaysia – a simple institutional analysis

The works of Angus Maddison on world economic history identifies that economic growth only took off after the British Industrial Revolution. Maddison notes that from the year 1000 – 1820, advance in per capita income was a slow crawl with per capita income rising by about 50 per cent but population increased fourfold. Since 1820 however, per capita income exceeded population growth with per capita income rising by more than eightfold and population more than fivefold. Maddison also notes that these growth rates were concentrated in Western Europe.

Michael Spence, in a lecture based on his latest book, The Next Convergence: The Future of Economic Growth in a Multi-Speed World quotes the works of Maddison and points out that the higher growth rates since the British Industrial Revolution benefited approximately only 15 per cent of world population, namely the elites in Western Europe and its European offshoots. However, since World War II (WWII), far more people in far more geographical regions have benefited from this open international economic order created after WWII.

Why is this so?

Elhanan Helpman captures the above the phenomenon brilliantly with this quote in his book The Mystery of Economic Growth.

“…What makes some countries rich and others poor? Economists have asked this question since the days of Adam Smith. Yet after more than two hundred years the mystery of economic growth has not been solved…”

The growth mystery has yet to be solved but economists have after two hundred years, isolated what are the determinants of long term sustainable economic growth. Economists divide these determinants into two categories: deep and proximate determinants. In general the deep determinants are institutions, geography and trade while the proximate determinants are capital in all its forms (resources, finance, knowledge, ideas, and technology). The combination of the deep determinants when done correctly facilitates the proximate determinants which lead to productivity rising faster than wages. This leads to welfare gains to all stakeholders in the economy. However, more often than not, countries get this wrong, hence the disparity in economic performance.

The role of institutions in explaining the difference in economic performance was not always explicit. It was Douglass North who first forcefully and successfully advocated the primacy of institutions in explaining the difference in cross – country performance. In summary, the ability to combine the various determinants of growth and the factors of production optimally relies on the proper institutional set-up. Institutions function as the meta-structure within which other determinants are able to function properly. Challenges and opportunities related to trade, geography, human capital accumulation (entrepreneurship, ideas, knowledge and innovation) and investment in factors of production — physical and technological — can be mitigated, overcome, synergised and optimised through the correct institutional structures and arrangements.

In post WWII, East Asian economies, including Malaysia, appears to have got this right, notwithstanding the dissenting views.  In 1993, the World Bank in its publication, The East Asian Miracle: Economic Growth and Public Policy, identified eight miracle East Asian economies – including Malaysia – that had real GDP growth of around or above four per cent from 1960 to 1990, which was far better than the rates achieved since the Industrial Revolution. More importantly, these economic growth benefited the poorest in society.

Malaysia was also one of thirteen countries identified by the Growth Report to have recorded average growth rates of more than 7 per cent per year for twenty five years or more. Malaysia achieved this spectacular performance from 1967 to 1997.

Since the East Asian Financial Crisis (EAFC) of 1997/1998, Malaysia’s economic performances when compared to previous decades are lacklustre and most macroeconomic indicators are trending downwards (declining rates of growth). This was confirmed by Prime Minister Najib Razak himself in the publication of the New Economic Model – Part 1 (NEM – 1). This was a very brave move but a necessary one by the Prime Minister as he acknowledged publicly the failures of Malaysia’s current economic model in order to demonstrate urgency for reforms.

There are other studies that have come to the same conclusion. Among the more prominent ones are Tiger Economies Under Threat by Yusuf and Nabeshima (2009) and Malaysia’s Development Challenges – From Middle Income to Advance Economy by Hill, Mat Zin and Tham (2011). The World Bank through its Malaysia Economic Monitor has also produced a series of reports identifying the same key problems that are effecting Malaysia’s growth.

The NEM – 1 identifies domestic factors such as weak investor confidence, capability constraints (weak human capital, entrepreneurial base and innovative capacity) , productivity ceilings and institutional degradation and external factors such as a sluggish global economy caused by the global financial crisis (GFC) and the rise of neighbours in the region in contributing to the declining growth trajectory.

Now IF we revisit the determinants of growth and agree with the view that proper institutions are the meta-structure that determines long term sustainable growth, then the logical response is to reform Malaysia’s institutional set-up as it must be the deepest determinant of what is hindering economic growth.

This view is further strengthened as the other deep determinants, geography and trade, are favourable in the case of Malaysia. Malaysia has abundant natural resources, is shielded from natural hazards and is located strategically both geopolitically and economically. Malaysia has also benefitted tremendously from being an open economy especially in the merchandise sector.

The NEM – 1 also reports that regional challenges (e.g. China, India and Vietnam) are a cause for Malaysia’s declining economic performance. What has changed about these countries? They have all undertaken institutional reforms: China since 1978, India since 1992 and Vietnam since 1986 and are reaping the benefits while Malaysia has stalled in its institutional reforms since the 1990s, regressed in some ways and is suffering from the consequences.

The above points stress the importance of institutional reforms in Malaysia, something that Mr. Najib Razak has ironically neglected in his signature policies – 1Malaysia, Government Transformation Programme and Economic Transformation Programme.

What are institutions and how do we go about analysing them?

There is no consensus of what is meant by institutions or institutional analysis. I use the most widely quoted definition on institutions. North defines institutions and its impact on economic performance as:

…Institutions are the humanly devised constraints that structure human interaction. They are made up of formal constraints (rules, laws, constitutions), informal constraints (norms of behaviour, conventions, and self imposed codes of conduct), and their enforcement characteristics. Together they define the incentive structure of societies and specifically economies. Institutions and the technology employed determine the transaction and transformation costs that add up to the costs of production…

Geoffrey Hodgson simplifies this to:

…systems of established and prevalent social rules that structure social interactions. Language, money, law, systems of weight and measures, table manners, and firms (and other organisations) are thus all institutions…

The key terminology here are norms and incentives. I add ideology to these key terminologies. Incentives (and disincentives) I define to include psychological and material benefits and penalties. Therefore, institutions provide the incentives that structure human behaviour in a society.

Thus far, we’ve established that institutions play an important role in driving growth. We’ve also established what constitutes institutions broadly. Analysing institutions and the role it plays in economic growth is a challenge when there is no consensus on what are institutions and its definition is very broad. However, Hollingsworth provides an approach which is meaningful for our purpose. Hollingsworth suggests that institutions are best compartmentalised by the strength of their resistance to change and by extension, the ability to exert influence. Once compartmentalised, they can each be analysed.

Hollingsworth notes that:

The five components (levels) are arranged in descending order of permanence and stability with Level 1 being the most enduring and persistent compared to all other components. Each component is interrelated with every other component, and changes in one are highly likely to have some effect in bringing about change in each of the other components.

Level 1: Institutions – ideology; norms; rules; conventions; habits and values

Level 2: Institutional arrangements – markets; states; corporate hierarchies; networks; associations; communities

Level 3: Institutional sectors – financial system; systems of education; business system; system of research

Level 4: Organisations

Level 5: Outputs and performance – statues; administrative decisions; the nature, quantity and quality of industrial products.

According to the Growth Commission:

“…fast sustained growth is not a miracle; it is attainable for developing countries with the “right mix of ingredients.” Countries need leaders who are committed to achieving growth and who can take advantage of opportunities from the global economy. They also need to know about the levels of incentives and public investments that are necessary for private investment to take off and ensure the long-term diversification of the economy and its integration in the global economy…”

Michael Spence, the Chair of the Growth Commission, reflected and elaborated further on his extensive experience working with developing countries on growth issues in his latest book by affirming the findings of the Growth Report and emphasising two important characteristics for developing countries to ensure long term sustainable growth – the role of political leadership and democratic norms. He suggests four characteristics for governments that are necessary requirements to underpin long term growth:

1. The government takes economic performance and growth seriously.

2. The governing group has values that cause it to try to act in the interest of the vast majority of the people (as opposed to themselves or some subgroup, however defined)

3. The government is competent and effective and selects a viable sustained-growth strategy that includes openness to the global economy, high levels of investment, and a strong future orientation.

4. Economic freedom is present and is supported by the legal system and regulatory policy

Manifestations of Malay/Muslim Supremacy 

Malaysia is classified as a non – democratic state by all international index measuring quality of democracies. This is also affirmed in academic circles. During the boom years, Malaysians accepted this trade-off – restricted  freedom for economic growth. Since 1997/98, this has changed as expected. The government has not delivered on growth, therefore the natural demand for reforms and by extension freedom.

There is consensus that Malaysia needs extensive economic, political and social reforms. This is all the more evident IF we agree that institutions are key to long term growth. Also, IF we agree with Spence, these reforms must come from a government with the four characteristics identified above.

Astute observers of Malaysia know the reasons why the present administration and the ones before were unable to make fundamental reforms in Malaysia. This has much to do with the ideology of Malay/Muslim Supremacy as defined by United Malays National Organisation’s (UMNO) and accepted by large swaths of Malaysians, Muslims and non-Muslims alike.

From the literature we can infer that the ideology of Malay/Muslim supremacy has provided the perverse incentives that has manifested itself in many ways. The more critical ones are:

– Institutional degradation: The deterioration in the quality of Malaysia’s institutions, particularly during Mahathir’s years such as  the lack of independence between the branches of government; the politicisation of the civil service, producing a culture of risk aversion and a lack of creativity; and the expansion of the non-transparent Government Linked Corporations (GLCs);

– Crony capitalism: Affirmative action in the name of Malays have become a smokescreen  for crony capitalism. Affirmative action is the instrument for rampant elite-based (elites from all races, not only Malays) corruption. High levels of income inequality in Malaysia in general but more so within the Malay community proves this.

– Race based affirmative action: Race-based affirmative action in itself is recognised as one of the important reasons for Malaysia’s declining economic performance. Malaysia’s focus on the ex-post equalisation of outcomes across ethnicities rather than ensuring effective ex-ante equalisation of access to opportunities has had important direct efficiency implications, affecting growth by distorting incentives and thereby the competitive process.

– Excessive centralisation: An interesting institutional feature is the lack of decentralisation in the country which is nominally a Federation and the top-down approach in public policymaking. This is a key disconnect in the reform rethoric in the ETP and GTP. To strengthen public service delivery, local communities need to be empowered. Fiscal relationships between federal-state-local also demonstrates institutional failure.

– Feedback mechanisms:  Related to Malaysia’s top-down approaches is an almost complete disregard of the monitoring and evaluation function. As a result there is little feedback from outcomes into policy design. The obsession with centralising policy making is also evident in lack of information sharing both within government and with the public.

The need to remove UMNO to create a new “people based ideology”

First let me put forward what I think are the two most critical issue affecting Malaysia: competency and competition.

In relation to competency, the quality of the human capital base in Malaysia is suspect. This is due to the quality of education from pre-school through tertiary and on-the-job. It is linked with ethnicity issues and is exacerbated by the outflow of high-skilled individuals and affected by the inflow of low-skilled labour. There are not only problems on the supply side of the market for skills, but also on the demand side, where firms may not be competitive enough to offer higher wages. The market for skills itself is also problematic in that the price mechanism does not work adequately and this is were wage setting issues play a role.

A bigger and more important challenge than competency is internal competition. This is quite distinct from external competitiveness, on which front Malaysia has scored relatively well in the merchandise sector given its stage of development and the nature of its manufacturing processes which is still dominated by competitiveness identified by low cost rather than high value.

Internal competition refers to the process of allocation in factor (labour, capital, land) and product markets. Internal competition works well when there is good governance, openness and transparency. It relates to the need for deregulation, liberalisation and competition policies especially in key areas such as government procurement and the activities of GLCs in the domestic economy.

All of these are also needed to produce effective competition for good ideas and good policies as well as competition in the political arena. This of course challenges the basic idea of meritocracy and affirmative action in Malaysia.

To reform these will ostensibly mean changing the embedded incentives and thereby institutions in Malaysia. This definitely means undoing the manifestations of Malay/Muslim supremacy as discussed earlier.

Can UMNO implement these reforms?   

My hypothesis is that the present leadership in Malaysia within the Barisan Nasional framework is incapable of institutionalising reforms as the present leadership does not meet the criteria set out by Spence. More importantly, it is unable to meet these four criteria for a simple reason – its “ideology” . This ideology that overrides and at the same time influences all other norms, rules, conventions, habits and values is the “ideology” of Malay/Muslim Supremacy. Hence this ideology resides in Level 1 and is more important than all other elements of Level 1.

As the Prime Minister of Malaysia always comes from UMNO it will be impossible for him/her to undo the cornerstone ‘ideology’ of his/her political party and its adherents in Barisan Nasional (which includes Malays and non – Malays.)

The logic above is discussed extensively in the political science literature. To summarise, the Malay/Muslim ideology provides psychological and material benefits to its adherents. This makes its a potent force for groups that rely on this ideology. However, since it is deeply embedded, it is also extremely difficult to counter when needed. Malaysia’s present institutional equilibrium is a reflection of the strength of the adherents of Malay/Muslim supremacy.

I use the institutional analysis tool as suggested by Hollingsworth to provide a different method to demonstrate this point.

There are many examples to illustrate Malay/Muslim Supremacy but I use one that is cited most often as holding back Malaysia’s economic reforms – affirmative action. Affirmative action in Malaysia is the most comprehensive in the world. It has by inference been touted as the one of the key reasons for Malaysia’s declining economic performance although causality has not been explicitly demonstrated.

Utilising Hollingsworth multi-level institutional analysis, theoretically, these reforms should be the least problematic among the five. What operationalise affirmative action is categorised as Level 5 as it constitutes statues; administrative decisions; the nature, quantity and quality of support for the Bumiputera community.

Supporters of affirmative action argue that Article 153 of the Federal Constitution provides the Bumiputeras the right to this extensive affirmative action and thus makes it a Level 1 category and therefore most difficult. However this is factually incorrect.

Article 153 of the Malaysian Federal Constitution states that:

153. (1) It shall be the responsibility of the Yang di-Pertuan Agong to safeguard the special position of the Malays and natives of any of the States of Sabah and Sarawak and the legitimate interests of other communities in accordance with the provisions of this Article.

(2) Notwithstanding anything in this Constitution, but subject to the provisions of Article 40 and of this Article, the Yang di-Pertuan Agong shall exercise his functions under this Constitutions and federal law in such manner as may be necessary to safeguard the special position of the Malays and natives of any of the States of Sabah and Sarawak and to ensure the reservation for Malays and natives of any of the States of Sabah and Sarawak of such proportion as he may deem reasonable of positions in the public service (other than the public service of a State) and of scholarships, exhibitions and other similar educational or training privileges or special facilities given or accorded by the Federal Government and, when any permit or license for the operation of any trade or business is required by federal law, then, subject to the provisions of that law and this Article, of such permits and licenses.

In more simple words, the Federal Constitution limits affirmative action to placement in the civil service at the Federal level, scholarships and permits and licences for Bumiputras and only if necessary and in a reasonable manner by the Prime Minister who advises the Yang diPertuan Agung.

Does the Prime Minister have the power to revoke or reform affirmative action policies?

Yes, he does.  Malaysia is a constitutional monarchy where the monarch reigns but do not rule. Article 153 is subject to Article 40 and Article 40 states that the Yang diPertuan Agung must act on the advice of the Cabinet.

40. (1) In the exercise of his functions under this Constitution or federal law the Yang di-Pertuan Agong shall act in accordance with the advice of the Cabinet or of a Minister acting under the general authority of the Cabinet, except as otherwise provided by this Constitution; but shall be entitled, at his request, to any information concerning the government of the Federation which is available to the Cabinet.

The decision to continue or reform affirmative action policies and the attendant institutions in Malaysia lies solely at the prerogative of the Prime Minister along with his colleagues in Cabinet as stated in Article 40.

With power centralised in the Executive (Cabinet), and with the Prime Minister already having six Ministers out of 31 from the Prime Minister’s Department – which the Prime Minister heads – in the Cabinet, and with the Prime Minister himself holding two portfolios (Prime Minister and Finance Minister I), and legitimised by the Constitution (Article 40), the Prime Minister should on all counts, be able to implement these Level 5 reforms without much difficulty.

Yet, he has been unable to implement these reforms for the simple reason that the Federal Constitution may be the law of the land but it is clearly not the supreme power/ideology in Malaysia. The supreme power/ideology is the primacy of Malays/Muslims as defined by UMNO – at the pinnacle of Level 1.

Hence the Prime Minister may have de jure power to reform, but he does not have de facto power to reform. This power resides among the Malays and non – Malays who support Malay/Muslim Supremacy and the current institutional set-up.

Until and unless this supreme ideology of Malay/Muslim supremacy is removed, Malaysian politicians will be constrained in making the necessary institutional reforms to move Malaysia towards long term sustainable growth.