Bẫy thu nhập trung bình ở Malaysia và thực tiễn của Việt Nam (Middle income trap in Malaysia and lessons for Vietnam)

After the Asian financial crisis (AFC) of 199798, a large number of countries found themselves able to escape their lowincome position and start climbing the higher income thresholds. Many of those thought that they took for a long period of sustained growth in order to catch up with the highincome countries. However, most of these countries were found being stuck in a “middleincome trap” (MIT) phenomenon, like Malaysia

FOREIGN TRADE UNIVERSITY FACULTY OF INTERNATIONAL ECONOMICS

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GRADUATION THESIS

‘MIDDLE-INCOME TRAP’ AND LESSONS FOR

TABLE OF CONTENTS

LIST OF ABBREVIATIONS iii

LIST OF TABLES iv

LIST OF FIGURES v

INTRODUCTION 1

CHAPTER I 4

THEORETICAL BACKGROUND ABOUT MIDDLE-INCOME TRAP 4

1.1 Concepts of Middle-Income Trap 4

1.1.1 Concept of Middle-Income 4

1.1.2 Concept of the Middle-Income Trap 5

1.2 Criteria to be defined as having fallen into the Middle-income Trap 10

1.2.1 Determining the number of years to be in the Trap 10

1.2.2 Countries in the Trap 12

1.3 Causes for falling into a Middle-Income Trap 14

1.3.1 Exhaustion of cheap labor 15

1.3.2 Changes in economic structure 17

1.3.3 Low quality of labor 18

1.3.4 Growing income inequality 19

1.3.5 Poor institutional quality 20

1.3.6 Population ageing 21

CHAPTER II 22

MALAYSIA AND THE MIDDLE-INCOME TRAP 22

2.1 Overview of Malaysia’s economy since getting Middle-Income level 22

2.1.1 Income per capita and economic growth 23

2.1.2 The economic structural change 25

2.1.3 The quality of labor 27

2.1.4 The income inequality 29

2.1.5 Political system reform 31

2.1.6 Population age distributions 32

2.2 Causes of falling into the Middle-Income Trap in Malaysia 35

2.2.1 The inconsistent New Economic Policy framework (1970-2009) 36

2.2.2 Low human capital quality 39

2.2.3 An investment rate slump due to currency crisis 41

2.3 Malaysia towards becoming a high-income nation by Economic Transformation Programme (ETP) 44

2.3.1 Overview of ETP 44

2.3.2 Achievements of Malaysian economy since the launch of ETP 50

CHAPTER III 57

STATUS QUO AND RECOMMENDATIONS FOR VIETNAM AVOIDING THE TRAP 57

3.1 Status quo of Vietnam’s economy since achieving Middle-Income level 57

3.1.1 Situation of Vietnamese economy since achieving the Middle-income 58

3.1.2 Vietnam faces challenges in falling into the Middle-Income Trap 63

3.2 Recommendations for Vietnam avoiding Middle-income trap based on experiences of Malaysia 70

3.2.1 Recommendation for human resources 70

3.2.2 Recommendation for population ageing 72

3.2.3 Recommendation for reducing income inequality 73

CONCLUSION 76

REFERENCES 77

LIST OF ABBREVIATIONS

No Abbreviations Full name

LIST OF TABLES

Table 1 1: GNI per capita US (Atlas Method) 4

Table 1 2: Economies in the lower-middle-income trap in 2016 13

Table 1 3: Economies in the upper-middle-income trap in 2016 12

Table 2 1: Classification of Malaysia’s income threshold in each period 22

Table 2 2: Sectorial Share of GDP 25

Table 2 3: Share of employment as %GDP 26

Table 2 4: Expenditure as percent of GDP 28

Table 2 5: Enrollment by educational level, 1975-2015 28

Table 2 6: Gini coefficient by Ethnic group, 1971-2014 30

Table 2 7: Fertility rate, Life expectation and mortality in Malaysia 33

Table 2 8: Average rates of increase in labor productivity 42

Table 2 9: NKEAs- KPI scorecard, 2012-2015 51

Table 2 10: SRI – KPI scorecard, 2013-2015 52

Table 2 11: Comparing NKEA targets and actual jobs created (2010-2015) 53

Table 3 1: Vietnam’s ICOR, 2000-2010 64

Table 3 2: Some factors about income distribution and inequality in Vietnam 66

Table 3 3: Income per capita on average in urban and rural areas 66

Table 3 4: "gold" population structure period in Vietnam 68

LIST OF FIGURES

Figure 1 1: Development stages of an economy 6

Figure 1 2: Stages of the catching up process in Ohno’s MIT model 8

Figure 1 3: Aoki's five phases 9

Figure 1 4: Becoming stuck in the Middle-Income Trap 16

Figure 2 1: Malaysia’s growth rate from 1971 to 2015 (%) 24

Figure 2 2: Malaysian Population per Age Group 2014 34

Figure 2 3: Malaysia corruption rank, 1996-2016 37

Figure 2 4: Control of corruption in Malaysia, 1996-2015 38

Figure 2 5: Trends in Math (left) and Science (right) from 1999–2015 40

Figure 2 6: The investment rate in Malaysia 42

Figure 2 7: Fixed capital formation/GDP 43

Figure 2 8: Determinants of ETP 45

Figure 2 9: The national key economic areas (NKEAs) 46

Figure 2 10: Six strategic reform initiatives (SRIs) 48

Figure 2 11: Traffic Lights of methods 1 and 2 49

Figure 2 12: Traffic Lights of methods 3 49

Figure 2 13: Employment by sector 53

Figure 2 14: Investment accelerated post-ETP 54

Figure 2 15: GNI per capita continues to growth from 2009-2015 55

Figure 3 1: The ETP Scorecard KPIs 50

Figure 3 2: GNI per capita in Vietnam, 2008-2015 58

Figure 3 3: Vietnam GDP’s growth rate from 2008 to 2015 59

Figure 3 4: Structural change 60

Figure 3 5: Dynamic economic structure 2008-2015 61

Figure 3 6: Percentage of trained employed workers at 15 years of age and above by qualification by Qualification and Year 62

Figure 3 7: 2016 A.T Kearney global services location index 69

INTRODUCTION

1 Rationale of the study

After the Asian financial crisis (AFC) of 1997-98, a large number of countries found themselves able to escape their low-income position and start climbing the higher income thresholds Many of those thought that they took for a long period of sustained growth in order to catch up with the high-income countries However, most of these countries were found being stuck in a “middle-income trap” (MIT) phenomenon, like Malaysia

In 1971, Malaysia became the lower-middle income country with Gross Domestic Product (GDP) per capita at $2.036,859 which was calculated by the World Bank From then on, Malaysia experienced a high growth performance and reached to upper-middle income level in 1996 However, Malaysia’s robust growth over the last three decades was interrupted following the Asian financial crisis (AFC) in the period of 1997-98 Since then, Malaysian growth has been relatively volatile and unable to make the leap to advanced income status In addition to the AFC, some of the factors that also prevent or delay the shift to high-income status include a larger risk of a growth slowdown, insufficient human capital, or the impact of New Economic Policy from 1970 to 2009

By 2010, the country had taken to well over than 14 years to participate as upper-middle income country and become stuck in the “upper-middle income trap”, based on Felipe (2012a)’s method that a country is in the Middle-Income Trap if it has been in lower-middle-income category more than 28 years and if it has been in an upper middle-income category more than 14 years Up to now, Malaysia has been in the upper-middle income nearly 22 years and still trying to break through the upper-middle income trap, advancing into the high-income phase of development

In such context, crucial questions remain whether Malaysia can reach high-income status and which policies it needs to implement to succeed This is why, the author would like to analyze the problems that this country are facing and bring Malaysian economy out of the middle-income trap, so as to recommend appropriate strategies to Vietnam

avoiding Middle-income trap because Vietnam is since 2008 in the lower-middle income level, so it is more than 18 years to prepare against the lower-middle income trap

To conclude, realizing the essence of the topic and also positive outcome that might be produced during developing the Vietnam economy with purpose of overcoming

“Middle-income trap” as the Malaysian has been doing implemented, the topic “How Malaysia can break through Middle-Income Trap and lessons for Vietnam” has been chosen for my graduation thesis at Hanoi Foreign Trade University

2 Objectives of the study

The study attempts to determine the causes of falling into the Middle-income trap

of Malaysia and how that country can break through the Trap From those dimensions, the author would analyze this problem in Vietnam and give some implications on policies to promote the Vietnam’s growth and recommend feasible suggestions for Vietnam to avoid Middle-income trap

3 Scope of the study

Within the framework of a graduation thesis, the author would like to focus on analyzing economic development, outstanding issues and limitations in Malaysia and Vietnam’s economies since getting the Middle-Income level

In addition, the thesis also focus on analyzing an idea given by the Malaysian government to turn Malaysia into a high-income economy by the year of 2020, that is titled “Economic Transformation Programme”

5 Structure of the thesis

Apart from introduction, conclusion, references and appendices, the thesis comprises the following sections as main elements

Chapter 1: Concepts of Middle-Income Trap

Chapter 2: Malaysia and the Middle-income Trap

Chapter 3: Status quo and recommendations for Vietnam avoiding the Trap

6 Acknowledge

The author would like to express deep gratitude to Assoc.Prof.Dr Vu Hoang Nam, Ph.D Associate Professor of Foreign Trade University for his critical comments and encouraging support as a supervisor He has employed his strong research expertise and experience not only to orient the topic, structure the outline but also to have overall and detailed looks into the study to help the author accomplish it in a better way

Being aware of the importance of the thesis, the author has paid serious attention

to study and research However, due to limited time, reference resources and professional competences as well as practical experience, the thesis does expose a number of shortcomings Thus, any feedback or comment for this study would be of great value for the author to improve it later on

CHAPTER I THEORETICAL BACKGROUND ABOUT MIDDLE

The classification baseline is altered one time per year It is made public on July 1

of every year based on the per capita GNI from the previous year and is not changed for the duration of the year It is based on nominal exchange rate, and so it is revised annually

so that real value does not change

Table 1 1 GNI per capita US (Atlas Method)

Unit: millions of US dollars Date 1-Jul-2011 1-Jul-2012 1-Jul-2013 1-Jul-2014 1-Jul-2015 1-Jul-2016

From the table, we can see that the latest income classification of the World Bank defines low-income countries as those with GNI per capita of $1.025 or less in 2015, lower-middle income if its GNI per capita lies between $1.026 and $4.035, upper-middle income if its GNI per capita lies between $4.036 and $12.475, and high-income if its GNI per capita is $12.475 or above

Under this classification, it is clearly to see that middle-income is further divided into lower-middle and upper-middle income with a per capita GNI for at least $1.026 and less than $12.475

1.1.2 Concept of the Middle-Income Trap

The term “middle-income trap” (MIT) first appeared in the World Bank’s An East Asian Renaissance: Ideas for Economic Growth, which stated that “middle-income countries…have grown less rapidly than either rich or poor countries” (Gill and Kharas, 2007)

Nowadays, the term “Middle-Income Trap” is being widely used and discussed among researchers and policymakers Especially, the number of papers mentioning this supposedly observable phenomenon, as well as indirect references to it, has increased significantly For instance, in April 2016, there are 231 total search results in EBSCOhost4 and 52 in the Web of Science (Core Collection, by Thomas Reuters, 2016) There are huge researches as well as many different ideas about what MIT is Thus,

it is desirable to have a clear and precise definition of MIT From that, I chose three different perspectives that are the most common explanation in order to have a clear see about this phenomenon

The first elementary explanation approach of Trap is based on growth slowdowns theory by the Dual-sector model developed by W Arthur Lewis (1954), also known as the “Lewis model” The second explanation approach is given by Ohno (2009) with different development stage that an economy has to pass on the way to the stage of a developed, high-income country Finally, another phase concept is developed by Aoki (2011) It is quite similar to Ohno’s approach but focuses on China, Korea, and Japan

1.1.2.1 Lewis model (1954)

Lewis (1954) introduced a dual economy model in order to describe this development process His dual economy consists of a ‘traditional’ and a ‘modern’ sector The distinction between these two sectors is mostly based on the distinction

“agricultural” and “industrial”

Figure 1 1 Development stages of an economy

⃗⃗⃗⃗⃗ : Stagnation – “middle-income trap”

A country starts as a traditional society, being underdeveloped and facing the

poverty trap ( 𝐴𝐵⃗⃗⃗⃗⃗ ) Once this country is able to escape the poverty trap, it can start its development of markets

In this second stage of development (𝐵𝐶⃗⃗⃗⃗⃗ ), a country faces a structural transformation with a shift from agricultural production towards industrial production The initial surplus of labor in the ‘traditional’ sector provides the modern sector with

low-cost labor keeping the costs of industrial production low The country is able to compete in international markets producing labor-intensive, low-cost products

Over time, the surplus of labor in the agricultural sector is absorbed by the industrial sector till the point where the surplus disappears In order to keep attracting labor, the modern sector has to raise wages, thereby eroding competitiveness We arrive

at the “Lewis turning point” (point C)

At this point, it is important for the country to generate the right circumstances in order to be able to pass fluently on to the next stage of sustained growth towards being

a high-income country ( 𝐶𝐷⃗⃗⃗⃗⃗ )

A country that fails to create these circumstances will get squeezed between low wage poor country competitors and rich country innovators and will be trapped as a middle-income country with low growth rates as the line from C to E – “the middle-income trap”

1.1.2.2 Kenichi Ohno (2009)

Ohno (2009) primarily considers the ASEAN countries (Association of Southeast Asian Nations) to complete this model According to the basic structure is displayed in figure 1.2, the Middle-Income Trap is defined as the “glass ceiling” between the second and third stages The transition from stage two to stage three is separated by an “invisible glass ceiling” a country has to break through if it wants to reach high-income status According to the Kenichi Ohno’s perspective, economic take-off starts with the arrival of a sufficient mass of manufacturing Foreign Direct Investment (FDI) firms that perform simple assembly or processing of light industry products for export

In this early stage (stage one), design, technology, production, and marketing are all directed by foreigners, key materials and parts are imported, and the country contributes only unskilled labor and industrial land While this generates jobs and income for the poor, internal value remains small and value created by foreigners dominates Vietnam’s industrialization up to now has been basically characterized by this situation

Figure 1 2 Stages of the catching up process in Ohno’s MIT model

Source: Kenichi Ohno (2009), the Middle-Income Trap

In the second stage, as FDI accumulates and production expands, the domestic supply of parts and components begins to increase This is realized partly by the inflow

of FDI suppliers and partly by the emergence of local suppliers As this occurs, assembly firms become more competitive and a virtuous circle between assemblers and suppliers sets in The industry grows quantitatively through the internal supply of physical inputs Internal value creation rises moderately, but production basically remains under foreign management and guidance Thailand and Malaysia have already reached this stage The next challenge is to internalize skill and knowledge by accumulating industrial human capital Locals must replace foreigners in all areas of production including management, technology, design, factory operation, logistics, quality control, and marketing As foreign dependence is reduced, the internal value rises dramatically The country emerges as a dynamic exporter of high quality manufactured products challenging more advanced competitors Korea and Taiwan are such producers

In the final stage, the country acquires the capability to create new products and lead global market trends Japan, the United States, and some members of the European Union are such industrial innovators

However, progress is not guaranteed for all A large number of countries that receive too little manufacturing FDI stay at stage zero Even after reaching the first stage, climbing up the ladders becomes increasingly difficult Another group of countries is stuck in the second stage because they fail to upgrade human capital It is noteworthy that none of the ASEAN countries, including Thailand and Malaysia, has succeeded in breaking through the invisible “glass ceiling” in manufacturing between the second and the third stage A majority of Latin American countries remain middle income even though they had achieved relatively high income as early as in the nineteenth century This phenomenon can be collectively called the middle-income trap

• moderate structural change

• moderate growth of per capita income

K-phase

• high growth of per capita income

• fast structural change

It is quite similar to Ohno’s approach but focuses on China, Korea, and Japan Aoki (2011) also divides the development process into five phases, namely the Malthusian (M), the government-led (G), the Kuznets (K), the human capital based (H), and the post-demographic-transition (PD) phase, which according to him - apply to all three countries According to Aoki (2011), a country becomes caught in the MIT if it does not succeed

in completing the transition from the K- to the H-phase

Also, Aoki (2011) starts in his first M-phase with the Malthusian model Aoki (2011), however, adds between the M-phase and the K-phase, which describes the dual economy, a G-phase, which takes into account the actions of the government After the Lewis turning point has been reached and the K-phase ends, it takes by Aoki (2011), an H-Phase, which is based on human capital in order to achieve the high-income level The last phase, the PD-phase is then the last phase before the high-income level

1.2 Criteria to be defined as having fallen into the Middle-income Trap

1.2.1 Determining the number of years to be in the Trap

To determine the duration that a country has to be in the Middle-Income group, it

is calculated by examining the historical experience of the countries that graduated from lower- to upper-middle income and from the latter to high-income, thereby leading to take the answers that how many years a country was in the two Middle-Income group

By this way, we can easily identify which middle-income country is trapped in the middle-income trap and which is not

As the benchmark classifications of the World Bank listed in part 1.1.1, World Bank classifies countries based on their Gross National Income (GNI) per capita as four groups: low income, lower-middle income, upper-middle income and high income However, these classifications were from 1987 onward This is too short a time series in order to use this classification for identifying countries in the MIT, as many economies were already high income in 1987 Moreover, some other economies were upper-middle income in 1987 and made it into the high-income group afterward Determining income threshold an economy has to be in the middle-income trap before it

can be considered that its transition is slow requires time-series data longer than those provided by the World Bank

Therefore, Felipe (2012a) proposed a method to adapt the classification coming from the World Bank to the dataset from Maddison He extended this database for the countries that needed up to 2010 using growth rates for GDP per capita measured in constant prices from the World Economic Outlook database (International Monetary Fund, 2013) and restricted the data to 100 countries for which have now a balanced dataset for the years 1950–2010

This set thresholds is defined as follows: 𝑡1 = $2000, 𝑡2 = $7.250, 𝑡3 = $11.750

𝑡1 = $2000 Separating low from lower-middle income

𝑡2 = $7.250 Separating lower-middle from upper-middle income

𝑡3 = $11.750 Separating upper-middle from high income

These thresholds are constant over time

From that thresholds, Felipe et al found that a median number of years for a lower middle-income country to join the upper middle-income group is 28 years and for an upper middle-income country, it takes 14 years to become a member of the high-income group This implied that if a country is in the Middle-Income Trap if it has been in a lower-middle-income category more than 28 years and if it has been in an upper middle-income category more than 14 years

Given this thresholds, it is a possibility to calculate that a lower middle-income country needs to grow at least 4,15% per year over 28 years in order not to get trapped

An upper middle-income country will need to sustain a minimum growth rate of 3,95% over 14 years before being defined as trapped

1.2.2 Countries in the Trap

The middle-income trap can be divided into a lower middle-income trap and upper middle-income trap The extension the database of Maddison for the years from

1950 to 2016 instead of 1950-2010 to have the result of countries in the trap Thus, the result is that 28 countries fall into the middle-income trap, 23 of them are in the lower middle-income trap and the remaining five are in the upper middle-income trap The majority of the middle-income trap countries are from the Latin America constituting 11 countries out of 28 countries in the region

Table 1.2 and Table 1.3 below list out the detailed information of which countries were in the lower middle-income trap and upper middle-income trap, based on the criteria given above

Table 1 2 Economies in the upper-middle-income trap in 2016

Unit: Current Dollars

Country Region 2015 GDP per

Source: Abdon, Felipe, and Kumar

Table 1 3 Economies in the lower-middle income trap in 2016

Unit: Current Dollars

Country Region 2015 GDP per capita No years as LM

until 2016

Source: Abdon, Felipe, and Kumar

To summarize, 28 out of the 52 income countries today are in the income trap, 23 countries in the lower-middle-income trap and 5 countries in the upper-middle-income trap 11 of those in the trap are in Latin America, 10 are in the Middle East and North Africa, 3 in Sub-Saharan Africa, 3 in Asia, and 1 in Europe The transition through the middle-income may not be a trap in the same sense it is used to describe the problem of the poor low-income countries, but it can be a long walk for many countries

middle-1.3 Causes for falling into a Middle-Income Trap

Becoming a high-income country is not an easy walk The transition from middle income into upper-middle income, and then into high-income, can be a slow process Some countries have been stuck in the long middle-income trap for decades Others are passing through it now and hoping to become high-income as quickly as possible Various explanations have been put forward to explain the existence of middle-income traps

lower-As Eichengreen et al (2011), he emphasizes that high growth rates in earlier periods, unfavorable demographics, very high investment rates, and undervalued exchange rates support a growth slowdown, and hence the probability of getting stuck in

an MIT

Jimenez et al (2012) and Jitsuchon (2012) also underline the importance of human capital accumulation and quality of education They add that growth slowdowns occur less frequently in economies where a relatively large share of the population have higher secondary and tertiary education

Felipe et al (2012) state that the knowledge and skill capabilities of the labor force

in these countries are critically low to produce and export the high-tech commodities Similarly, Jankowska et al (2012) list important reasons of the trap These reasons are low productivity of labor and lack of structural labor transformation, respectively Aiyar et al (2013), who emphasize the importance of institutional, demographic, and infrastructural factors, as well as trade structure, present their empirical results in a very detailed, country-specific way They develop a “trap map” for Asian, Latin American, and MENA middle-income countries The trap map shows which of the seven

identified factors (Institutions, Demography, Communication, Road, Output Composition, Macroeconomic Factors, and Trade) presents a particular growth slowdown risk for a country compared to the other countries

Eichengreen et al (2013) associate middle-income trap with some demographic and economic factors Aging of the population, unproductive investment decisions and undervalued exchange rates which prevent technological progress

Kanchoochat (2014) and Kanchoochat and Intarakumnerd (2014) poor quality of education and institutional structure are important reasons of the middle-income trap According to the descriptive analysis by Bulman et al (2014), countries that managed to escape the middle-income range experienced higher Total Factor Productivity (TFP) growth, low inflation, as well as a relatively rapid structural transformation process (from agriculture to industry) compared to the countries that were not able to make a successful transition to the high-income range

Clearly, we can see that there must be a multiplicity of reasons given by economist, preventing a country which cannot graduate from lower-middle income into upper-middle income and from the latter into high income Instead of trying to identify all the possible reasons that may underlie failure of transitions, I chose some factors that most had mentioned many times in listed studies as labor aspect (Kaldor, 1967; Chenery and Taylor, 1968); income inequality (Flechtner und Panther, 2015); institutions (Aiyar et al., 2013; Kanchoochat and Intarakumnerd, 2014) and age-structured population (Aiyar,

2013); Eichengreen et al., 2011; Eichengreen et al., 2013) These factors will also support

for my thesis in the following chapter

1.3.1 Exhaustion of cheap labor

According to Lewis-type (1954) development process as noted earlier, factors and advantages that generate high growth during an initial phase of rapid development - low cost labor and imitation of foreign technology- disappear when middle- and upper-middle income levels are reached, thereby requiring new sources of growth to maintain sustained increases in per capita income This process is displayed in figure 1.4

Figure 1 4 Becoming stuck in the Middle-Income Trap

Source: Author’s illustration

Indeed, during the initial phase of development, low-income countries can compete

in global markets by producing labor-intensive, low-cost products using technologies imported from developed countries (Agenor and Dinh, 2012) Subsequently, these countries can achieve large productivity gain through a reallocation of labor from the low productivity agricultural sectors to high-productivity manufacturing sectors However, once these countries reach middle-income levels, the pool of underemployed rural workers drains and wages begin to rise, reducing competitiveness Productivity growth from sector reallocation and technology catch-up are eventually worn out, while increasing wages make labor-intensive exports less competitive on global markets, especially when other low-income countries become engaged in a phase of rapid growth

As economies moves from low- to

middle-income status, they can compete internationally

by moving from agricultural to labor intensive,

low-cost manufactured products

Using imported technologies, late-developing

economies reap productivity gains as workers

shift from the agricultural sector to the

manufacturing sector

The pool of transferrable unskilled labor is

exhausted, or the expansion of labor-absorbing

activities peaks

As countries reach middle-income levels, realwages in urban manufacturing rise or marketshare is lost, and gains from importing foreigntechnology diminish

Productivity growth from sectorial reallocationand technology catch-up are eventually exhausted,international competitiveness is eroded, outputand growth slow, and economies become trapped

Consequently, growth slowdowns will meet with the point in the growth process where it is no longer able to boost productivity by transferring additional workers from agriculture to industry and the gains from importing foreign technology diminish radically whereby this analysis basically agrees that productivity slowdowns are a major cause of middle-income traps (Agenor Canuto and Jelenic, 2012)

1.3.2 Changes in economic structure

According to Kharas & Kohli’s studies (2011) and Felipe (2012), the reason for most countries to fall into a middle-income trap is the inability of changing strategies as well as insufficiency in economic diversification and structural upgrading when reaching

a middle-income status If without enhancing, they will less likely to sustain growth and will be more exposed to the downside risk in the global economy Effective strategies for economic growth and transition to higher income levels vary across income groups When continuing the strategies that helped the countries growing from low- to middle-income status, this may prevent them from reaching high-income levels

An example of this is seen when comparing the countries of Latin America with those in East Asia Where many East Asian countries rapidly shifted their growth strategies when reaching middle-income status, and continued to grow towards higher levels of income, most Latin American countries did not, and experienced growth slowdown (Felipe, 2012)

Besides, numerous countries in Latin America and the Middle East achieved middle-income status in the early of 1960s and 1970s, but, the majority of them have remained there ever since In the case of Brazil where it is the largest economy in Latin America, accounting 40% of total GDP of the region2 They were one of the wealthiest developing countries with a per capita income of $1.700 (in 2007 dollars) due to its rich resource base It grew persistently until 1978 when it reached $5.500 per capita, with average growth of almost 9,5% per annum; subsequently, Brazil entered a series of

2 The World Bank database, updated in 2017

declination and stagnation It did not recover its 1978 per capita income until 1995 and was wracked by macro instability again in the East Asian crisis Not until the commodity boom which took place in 2006, Brazil once again outperformed its 1978 income Brazil spent nearly 30 years without additional advancement in its average living standard after

a century of growth Although recent growth has improved, Brazil has not shown a trace

of continuous rapid growth that assures its sustained convergence with advanced economies

Many countries in the Latin America who are similar to Brazil have a good run of

10 to 20 years but when growth fades, they tend to “middle-income trap” Hence, many countries in the region continue to be trapped in the middle-income country status and challenges of sustaining growth are rising from the changing structure of the world economy

1.3.3 Low quality of labor

Another factor that may explain a middle-income trap is the poor quality of human capital (Eichengreen, Park and Shin, 2013) Tertiary education rates may be relatively high and increasing over time, yet the productivity of workers may remain relatively low and their skills insufficiently diversified Poor quality of human capital acts as a constraint on the ability to absorb more advanced foreign technologies and on the expansion of innovation activities, thereby preventing the productivity growth that may allow a country to sustain high levels of economic growth According to Stone and Shepherd (2011), the availability of skilled labor is a particularly important determinant

of a firm’s ability to generate productivity gains from intermediate and capital goods imports, that is, to realize dynamic gains from trade

The inability to improve the quality of the labor force as countries get closer to the world technology frontier is an important factor in understanding not only the emergence but also the persistence of middle-income traps, especially in Latin America which region reported in Hanushek and Woessmann (2012a, 2012b) An example is seen that poor quality of human capital is also one of the key issues for Malaysia (see Hill et al.,

2012 and Flaaen et al., 2014) Although a net labor importer, Malaysia remains a net

skills exporter, with growing numbers of professionals migrating to Singapore and other industrialized countries Partly as a result of the “brain drain”, workers in Malaysian manufacturing remain largely low-skilled, with more than 80 percent holding only a high school degree, and just 7% of manufacturing employees holding a university degree (Menon and Woo, 2014)

Thus, to escape from the trap, policies that contribute, in particular, to reducing fixed costs increasing the probability of innovation, or improve the quality of time spent

in education, are necessary

1.3.4 Growing income inequality

Another possible cause of a middle-income trap is changing income inequality over time (Flechtner und Panther, 2015) The well-known Kuznets Curve suggests that greater income inequality is a price to pay for rapid growth in the early stages of economic development As low-income countries develop, with production shifting from agriculture to industry, income gaps between the top and the bottom income groups tend

to increase After reaching a middle-income stage, mass education and continued industrialization combine to foster reductions in income inequality However, persistence in inequality during the middle-income stage may act as a constraining factor

on growth

Egawa (2013) for instance offers a similar line of reasoning to explain why a middle-income country cannot continue to grow at sustained rates if income inequality remains high or worsens at that stage of development Some observers had indeed argued that countries like China, Malaysia, and Thailand are suffering from inequality in income distribution that may hinder their prospects for sustained economic growth It has also been argued that one reason why Brazil was unable to transition into an innovation-based economy is a high degree of income inequality However, between 2001 and 2014 witnessed a significant fall in income inequality in that country During that time, the income growth rate of the poorest of the population was 7% per year, while that of the richest was 1,7%; as a result, income inequality (as measured by the Gini index) fell markedly, from 0,5933 in 2001 to 0,5148 in 2014, that is, a fifty-year low Thus, it is

hard to argue that income inequality has been a major factor in explaining the country’s persistent growth slowdown

More generally, there appears to be no formal evidence to suggest that greater inequality is associated with a sustained drop or stagnation in productivity

1.3.5 Poor institutional quality

Earlier empirical studies, Knack and Keefer (1995), Mauro (1995) and Barro (1997) reveal that institutions are important for investment and long-term sustainable growth.Hall and Jones (1999) demonstrate that differences in the institutions across the globe cause huge variations in capital accumulation, education attainment, and productivity growth hence accounts for income gap

More recently, Rodrik, Subramanian, and Trebbi (2004) find that rule of law has

a positive impact on the development of one country Similarly, Acemoglu, Cutler, Finkelstein, and Linn (2006) concluded that private property right institutions are the main drivers of long-run economic growth, investment, and financial development These studies suggest that institutions are the fundamental determinants of the long-run transformation into new income group across countries

On the other hand, good quality of institutions may promote incentive structure that leads to higher economic growth through reducing uncertainty and promoting efficiency (North, 1990) What’s more, good quality of institutions enhance the ability

of a country to adopt new technologies invented elsewhere which may play an important role in upgrading the development process of a country (Bernard and Jones, 1996) However, institutions also cause development differences across countries, thereby leading hamper the economic activities due to poor quality institutions Rights and obligations of citizens, enterprises, and investors could not be guaranteed; the economic recession is likely to occur

1.3.6 Population ageing

The process of demographic transition, mostly associated with increasing longevity and decreasing fertility, has led the world to the era of the ‘aging population’ (Hodgson, 1988)

According to Eiras and Niepelt (2012) and Lisenkova et al (2012), when a country faces an increase in the old age population, public spending on social security expenses and the medical system will be higher than the corresponding spending on education and other forms of development Additionally, an increase in the old age group will also affect a country’s sources of income A decline in the working age group and

an increase in the old age group will provide less tax revenue This demographic evolution may also affect Foreign Direct Investment (FDI)

Indeed, Davies and Robert (2006) show that foreign firms will not invest in a country with an ageing population since the working age population is scarce, therefore negatively affecting the country’s capability to produce wealth The potential imbalance

in the government budget, meaning increasing deficits due to the ageing problem, may also impact on the economy (Tosun, 2003; Lisenkova et al., 2012)

As a result, considering the consequences of population ageing on economic growth, in a country with a high old age population and a low working-age population, the overall growth of an economy will decline and remain a position, thereby getting stuck in the Trap

CHAPTER II MALAYSIA AND THE MIDDLE-INCOME TRAP

2.1 Overview of Malaysia’s economy since getting Middle-Income level

Just a few years after independence from the United Kingdom in 1957, Malaysia has transformed from a low-income economy to a middle-income economy since 1971 (Table 2.1)

Table 2 1 Classification of Malaysia’s income threshold in each period

Unit: Current Dollars, Not Seasonally adjusted

Low-income

Number of years participated as income country

Low-16

Lower-middle income

Total number of years participated as Lower-middle income country

Total number of Years participated as Upper-middle income country until

Source: Author (based on Maddison’s database)

From the given table “Classification of Malaysia’s income threshold in each period”, Malaysia have taken 27 and 22 years to participate as lower- and upper-middle income country Based on the criteria of determination that a country falling into the Trap or not: a country is in the MIT if it stays for more than 28 years in the LM range or for more than 14 years in the UM range, where LM stands for the income range between

$2.000 and $7.250 and UM stands for the income range between $7.250 and $11.750 Thus, a conclusion can be shown that Malaysia has succeeded in moving from LM to

UM within 25 years, which is definitely shorter than the 28-year period that Felipe (2012) calculated as a critical MIT threshold for passing the LM However, until 2017, Malaysia have still been in the UM for 22 years and are trying to enter the high-income stage By making similar calculation, Malaysia is falling into upper-middle income trap when period in the UM is up to 22 years, which is higher than 14 years that criteria’s Felipe (2012) calculated as a position for stuck in the trap, meaning for a significant characteristic is that the country has been in UM trap from 2010 (excluding 14-year standard of making UM)

In brief, Malaysia has achieved the middle-income level since 1971 and has been stuck in the upper-middle income trap since 2010

2.1.1 Income per capita and economic growth

Since getting the Middle-income level, Malaysia has witnessed strong economic growth and has earned it membership into a group of economies that the World Bank in its report The East Asian Miracle (World Bank, 1993) called High Performing Asian Economies The Gross Domestic Product per capita in Malaysia was last updated on April 2017 at 10.878,39 US dollars in 2015 (Table 2.1)

The GDP per Capita for Malaysia is equivalent to 142 percent of the world's average, reached an all-time high of 11.305,9 USD in 2014 and the lowest income of 2.036,859 USD in 1971 since getting Middle-Income level (see World Bank database updated 2017)

Seriously suffering from Asian financial crisis in 1997-1998 and the global financial crisis in 2008, Malaysia quickly recovered and maintained the growth rate of above 5,5 % ( figure 2.1)

In 2014, GDP growth was measured at 6% Malaysia's economy was considered

as one of the most competitive markets in Asia in the last financial year 2014 – 2015 The economy was ranked 6th in Asia region and 20th on the worldwide basis that means

even higher rank than that of South Korea, France and Australia (The World Economic Forum, 2014)

Figure 2 1 Malaysia’s growth rate from 1971 to 2015 (%)

Unit: Percentage (%)

Source: World Development Indicators, last updated 4/17/2017

Together with remarkable growth, poverty was shown to have positive signs as the proportion of the poor in Malaysian society declining from 49,3 % in 1971 to 0,6 %

in 2014 (Department of Statistics Malaysia Official) However, inequality in society reflecting through citizen income was quite high For example, the Gini-coefficient of income inequality of Malaysia reached 0,389 in 2014, in comparison with 0,31 and 0,33

in the South Korea and Japan The stability of Malaysia's short-term financial standpoint over the medium-term relies on the execution of structural changes to help abilities and rivalry inside the economy, alongside the monetary advancements in Malaysia's fare markets and patterns in worldwide oil and gas markets The fastened usage of profit upgrading changes to build the nature of human capital and make more rivalry in the economy will be a solution for Malaysia to secure an enduring spot among the positions

of high-wage economies The country is making every effort to tackle the problems

Economic transformation programme (ETP) which is a project to bring the country to high-income level by 2020 but still makes sure growth is inclusive and sustainable, came into effect in 2010 The ETP incorporates various changes to accomplish monetary development that is fundamentally determined by the private area and forces Malaysian’s economy into a higher level

2.1.2 The economic structural change

The Malaysian economy has undergone rapid transformation since achieving middle-income level The Malaysian economy underwent a number of structural changes, mainly caused by the reorientation of industrialization strategies as well as by variation in the composition of domestic demand Since 1971, the economy had been transformed from agriculture to manufacturing-based economy that heavily relied on manufacturing products for exports Its production base has broadened, with manufacturing accounting for a growing share of national output and employment The Malaysian economy has become more open and outward looking over the years

The changing structure of the Malaysian economy is reflected in the changing composition of the country’s GDP

Table 2 2 Sectorial Share of GDP

Source: Economic Reports, Ministry of Finance

The share of the agricultural sector in GDP declined from 33,3 percent in 1971 to 13,5 percent in 1996 and reduced to 8,6 per cent in 2015, notwithstanding significant agricultural diversification, while that of the manufacturing sector grown rapidly from 13,9 per cent to 30,2 per cent between 1971 and 1996 However, since 2000, the

manufacturing sector dropped by 2,3 per cent over the 15 years, from 2000 As the evidence indicates, the services sector is an important component of GDP

Clearly, in the period from 1971 to 1996, the manufacturing sector had played a key role in the modernization of the Malaysian economy And, in this regard, the decision to reorient the manufacturing sector towards the export markets certainly made

a big difference The 1970s witnessed the establishment of many export processing zones

in which multinational corporations (MNCs) have played a pivotal role Significant industrial restructuring has taken place within the manufacturing sector, with electrical and electronic (E&E) products playing an increasingly dominant role

However, since 2000, the manufacturing sector dropped in its contribution to exports from Malaysia The decline of manufacturing-oriented exports has been compensated for by increases in exports of the agriculture sectors and services

Structural changes in the Malaysian economy also reflected in the changing pattern of sectoral employment

Table 2 3 Share of employment as %GDP

Source: Economic Reports, Ministry of Finance

In 1971, the services sector accounted for about 32,5 percent of total employment and the manufacturing sector contributed to 8,7 percent In the same year, employment

in agriculture contributed to 53,5 percent of employment As these figures indicate, the agriculture sector was the most important source of employment in the economy, followed by the services and manufacturing sectors However, the profile of employment has been changing over time The sectorial demand for labor has been shifting, with the

agriculture sector witnessing a sharp decline in being a source of employment The shift

in the employment pattern, as the table shows, has been strongly in favor of the services

sector, and this is particularly pronounced in more recent years

2.1.3 The quality of labor

Education is one of the primary mechanisms utilized by the Malaysian government to enhance the socioeconomic status of its population and sustain general development Malaysia has policies to implement free education at the primary and lower secondary levels since the early 1970s, and at the upper secondary level since the early 1980s, connected with increased provision of higher education since the 1990s In recent years, Malaysia had overall expenditure as a proportion of both GDP that is about the same as, or higher than, that of its immediate geographical neighbors (including Singapore, Indonesia, Thailand) as well as developed countries such as the United States and the United Kingdom3 For instance, in 2015, the Malaysian government invested 4,98% of GDP in education, which ranks 46 in the world for education expenditures This investment has contributed to better educational attainment among its people

Gross enrolment ratios at all levels have increased since 1971, the greatest increase being recognized at the upper-secondary level Enrolment at the primary level has been nearly universal for decades while post-secondary enrolment has also expanded rapidly, with the share of enrolment increasing from 7,5 percent in 1971 to 37,6 percent

in 2015 Gross enrolments in lower secondary education were estimated to stand at nearly 83,9 percent in 2015, while net enrollments in upper secondary education were estimated to increase from 31,0 percent to 74,9 percent between 1971 and 2015 Since

1985, the rate of children enrolled in primary school has been more than 95 percent of children in the 6 – 11 age group4

3 Malaysian economic report, 2000

4 Ministry of education Malaysia

Table 2 4 Expenditure as percent of GDP

Source: UNESCO Institute Statistics database

Indeed, the rapid increase in enrollment at primary and secondary levels of formal education as well as improved job training are major contributions to the economic success of the region

Table 2 5 Enrollment by educational level, 1975-2015

However, tables 2.4 and 2.5 do not indicate any governmental commitment to education in Malaysia in terms of the overall allocation of resources What this suggests

is that if reforms are required they are more likely related to the structure of the educational system than to the total educational expenditure Educational attainments of the labor force are widely rendered as a better parameter representing human capital in

a country than government expenditures Where there is an increase in the proportion of those workers with tertiary education, this somewhat shows that there is insufficient supply to meet the growing demand for a highly skilled workforce By 2010, the proportion was at 24% of the labor force but this is still much lower compared to the levels achieved by developed countries in 2003 such as Japan (36%), the United States

of America (41%), Ireland (43%) and Finland (36%) (World Bank, 2010)

2.1.4 The income inequality

Since independence that Malaysia achieved in 1957, Malaysia has inherited a multiracial society consisting Malay (Bumiputera), non-Malay (non-Bumiputera) like Chinese, Indian and others Even in the early years, the income inequality between races has existed and this was also one of the reasons why a racial riot happened in May 1969

To solve the racial tension that happened at that time, the government came up with the New Economic Policy (NEP) in 1970 The NEP was to be implemented in the span of twenty years (1971-1990) The approach of the NEP to overcome the perceived socio-economic imbalances in society was by giving preferential treatments to the Malays and other indigenous people The ultimate aim of the NEP was to achieve national unity and

to foster nation-building The way to unite the multiethnic population visualized in the NEP was through active government intervention to reduce inter-ethnic inequality by employing preferential treatments in favor of the Malays There were two specific objectives of the NEP The first was to eradicate poverty by raising income levels and increasing employment opportunities for all Malaysians irrespective of race, while the second was to restructure the society so that the identification of ethnic groups with economic function was eliminated (Malaysia, 1991)

Since the introduction of NEP, the Gini coefficient for Bumiputera in 1971 was 0,466 and it has increased to 0,506 in 1976 After that, it declined in 1979 to 0,468 and

it continued to drop until the year 1989 at 0,429

NEP came to an end in 1990 and National Development Policy (NDP) was introduced Since then, there were fluctuations in Gini coefficient for Bumiputera

Table 2.6 shows the income distribution changes in Malaysia since from the 1970s to 2014

Table 2 6 Gini coefficient by Ethnic group, 1971-2014

Starting at 0,442 for 1992, and it decreased to 0,441 in 1995, then increased back

to 0,442 in 1997 Subsequently, Malaysia’s Gini coefficient followed a downtrend after

1997 Inequality fell sharply in 1999, likely due to the financial crisis, then slightly inched upward Thanks to NEP, income inequality declined during the 1971 and 1990, however, has not changed much since then Average income disparities also declined during the NEP period, but appear to have risen in the 1990s (Jomo, 2004)

In addition, for other races, Chinese for instance, there was a significant increase

in Gini coefficient from 1971 to 1976, from 0,466 to 0,541 but it then decreased to 0,474

in 1979 followed by 0,452 in 1984 It continued to decrease until the year 1999 at 0,434 The latest figure for Chinese is 0,405 in 2014, slightly higher than Bumiputera at 0,389

in the same year

On the other hand, in 2010, Malaysian Prime Minister NajibRazak has unveiled

a new economic plan, New Economic Model (NEM) aimed to shift affirmative action from being ethnically-based to being need-based to become a high-income nation by

2020 As a results, the Gini coefficient for Malays in 2009 was 0,440, Chinese 0,425, Indians 0,424 and others 0,495 (Table 2.6) All of the ethnic groups had a decrease the

in 2012, two years after NEM was introduced except for the Indians The Gini coefficient rose from 0,424 to 0,443 However, the latest data in 2014 shows that all of the ethnic groups have narrowed down the gap and reduced the Gini coefficient It could be said that NEM was one of the contributing factors to this

2.1.5 Political system reform

Malaysia is a country of constitutional monarchy federal election The system of government modeled close to the Westminster parliamentary system, a legacy of British colonial rule5 Yang di-Pertuan Agong is the head of state, or usually known as the

"King" King was elected to a 5-year term from next nine episodes of the monarchy Malay states The rest four states have nominally head of governors, but not involved in recruiting According to the unofficial agreement, Sultan will position by rotating

5 Politics of Malaysia, Wikipedia

monarchy holds nine states, the role of the monarch largely ceremonial since changes to the constitution in 1994 Legislative power is split among state and federal legislatures Executive authority is given to the Cabinet headed by Prime Minister

Since getting the Middle-Income level, Malaysia’s politic is more and more perfect and stable International economic integration has a positive impact on the improvement

of the legal framework The internal legal system is constantly being amended along with international customs toward a more transparent business environment, ensuring equality for economic sectors and stabilization between domestic and foreign enterprises

It could be generally concluded that Malaysia is a country of stable politics The nation has been managed by a democratically-elected coalition which always sticks closely with development plan of its economy A lot of appropriate measures, particularly the Economic Transformation Program (ETP), have been designed for the Government pledge implement the suitable policies and provide enough support for the establishment of an ideal environment for investment and business This is to guarantee the investors that Malaysian government firm yet flexible enough to address their needs

2.1.6 Population age distributions

With a population just over 30 million6, Malaysia is a heterogeneous nation made

up of 61,8 percent ethnic Malay (Bumiputera), 22,5 percent Chinese, and 6,7 percent Indians

Malaysia’s rapid boost in population over the years has resulted in a demographic shift Malaysia’s fertility rate has fallen from 4,737 in 1971 to 3,275 in 1996, and down

to 1,944 in 2014 This has contributed to a structural shift to an older population In terms

of mortality, the death rate has rapidly declined from 41,7 percent in 1971 to 6,9 percent

in 2014 This has resulted in an increased life expectancy increasing from 64,876 to 74,718 in the same period (Table 2.7)

6 “The World Factbook”

Table 2 7 Fertility rate, Life expectation and mortality in Malaysia

Fertility

rate (%)

Mortality rate (%)

Life expectation

Fertility rate (%)

Mortality rate (%)

Life expectation

Source: UIS Statistic

In other words, population ageing rises with the increasing life expectancy and declining lower fertility rate This phenomenon is depicted in Malaysia’s demographic