Malaysia’s potential growth rate has declined over the last two decades from 7 per cent in the late 1980s to 5.5 per cent now, with labour-intensive exports losing their competitiveness to newly emerging economies such as China and Vietnam.

Malaysia needs to reinvent its economy and search for new sources of growth, not only to move up the value chain towards higher value-added production, but also to lift the entire chain vertically upward so that value can be added at every point in the supply chain through increased productivity.

In the new model, the role of manufacturing will diminish while that of services will rise, and the production of goods and services will become more sophisticated, moving away from unskilled labour-intensive assembly activities towards technology, skill and knowledge-intensive processes.

But Malaysia must remain an open economy, with liberal trade and investment policies, as it cannot afford to look inward, given the small size of its domestic sector. The services sector could replace the manufacturing sector as the main engine of growth only if it can become internationally competitive. To accomplish this, the services sector needs to emulate the manufacturing sector through liberalisation measures.

Manufacturing will remain an important sector, but its profile will have to change dramatically, such that there is more domestic content and hence more domestic value-added in every unit of exports.
The relative importance of electrical and electronic exports will decline, while that of resource-based manufacturing will rise. This will enable exports to contribute more to gross domestic product, so that the multiplier effect of every dollar’s worth of exports will be considerably larger.

In short, Malaysia’s economic growth will remain essentially export-driven, notwithstanding major changes in export composition or export destination.
The domestic economy will no doubt expand in size over time, which will make the economy more resilient, but it cannot be the main growth driver or a substitute for the lucrative global market.

Trade and investment are interlinked, one reinforcing the other. It is no coincidence that Malaysia’s major trading partners are also the major sources of foreign direct investment.
Although capital exports can substitute exports of goods through outward investment for the home country, investment itself tends to generate two-way trade flows, with imports of intermediate products and exports of final goods in the host country.

Malaysia has been creating economic space in other domains through outward investment that has generated not only profit remittances but also exports and imports. The potential is huge, as more and more countries actively seek foreign direct investment. Such investments may more than compensate for any slackening in export earnings.

Malaysia needs to revisit its strategy of forging numerous bilateral free trade agreements (FTAs) – these make some sense in certain cases but not all. Bilateral trade agreements take time and resources to negotiate and implement, but it is not clear that the outcomes will justify such efforts.

For one thing, bilateral trade agreements cause costly trade distortions, given the discriminatory nature of trade pacts. For another, the rules of origin, which vary from agreement to agreement, tend to act as dampeners, causing problems not only for Customs but also for manufacturers at a loss on which rules to follow. But it appears that the utilisation rate of FTA concessions is low, as most manufacturers take the World Trade Organization (WTO) route to obviate the need for Customs verification of the various rules of origin, especially where the preferential margin is rather small.

It would be more rewarding for Malaysia to focus on the WTO multilateral trade negotiations instead of dissipating its energy on dubious FTAs.

For international trade and investment to flourish, the removal of trade and investment barriers is necessary but not sufficient. Barriers exist not only at the border but also behind the border – hence the need for domestic reforms. ‘Behind the border’ reforms relate to good governance, best practices, civil liberty, independent judiciary and institutional integrity. These matters are not resolved through trade agreements. Malaysia must proactively bring about such reforms at home without foreigners asking, because they are in the nation’s interests. In the absence of such reforms, trade liberalisation would come to naught.

The so-called ‘new model’ is not about reorienting the Malaysian economy away from exports to domestic consumption, as Malaysia is too small an economy. It is, therefore, in Malaysia’s interests to stay trade-dependent, although the composition of its exports of goods and services will need to undergo major changes through export substitution and transformation.

Likewise, Malaysia needs to diversify its export market, though not at the expense of its current major trading partners. The linkage calls for a simultaneous liberalisation of regulations that directly affect trade and investment flows. Equally important are domestic institutional reforms to reduce the cost and enhance the ease of doing business in the country, increasing international competitiveness. Malaysia cannot integrate with the global economy fully as long as reforms are piecemeal; hence, the merit of a holistic approach, even if gradual, with a clear time frame.

This piece was first published here at the New Straits Times.

Mohamed Ariff is a Distinguished Fellow at the Malaysian Institute of Economic Research and Professor Emeritus at the Faculty of Economics and Administration, University of Malaya.