Services, Services, Services

There's been a lot of talk in the press about a new economic model for Malaysia, and it isn't just a reaction to the present economic downturn we are facing. On a subjective level, the emergence of China as the world's factory has created a formidable competitor in manufacturing, but even here China is being superseded by Vietnam and Mexico in low-cost production. So there's been a lot of changes internationally in the last decade that put's into question Malaysia's development strategy. There's been an obvious impact in terms of trade and manufacturing numbers that help outline these trends.

Also while the share of total trade to GDP has been rising to a truly astounding level (+200%) the direct contribution of trade to growth has been negligible. I haven't fully worked out the indirect impact however, which ought to be substantial given the reaction of the economy to the deterioration of global trade this last 9 months. Nevertheless its interesting to note the evolving contributions to growth on the expenditure side:

	1987-2000	2000-2008
Total Consumption	52.6%	91.2%
Government Consumption	9.1%	21.3%
Private Consumption	43.5%	69.9%
Gross Fixed Capital Formation	36.3%	16.6%
Net Exports	9.2%	1.4%

Between 1987 and 2000, the economy grew 159.7%, even with the recession of 1997-98. Out of that growth, just over half came from public and private consumption, while a further third came from investment. In contrast, the growth contribution of consumption for the period 2000-2008 exceeded 90% even if the share of consumption (<52%) is below the average for industrial economies, and the economy only grew 48.4%. In both cases, the direct growth contribution from trade was relatively minor.

So what's next, if manufacturing (on the supply side) and trade (on the demand side) are no longer the key drivers for growth? Quah Boon Huat of MIER outlines my own particular viewpoint of how the Malaysian economy ought to evolve:

“This change in policy focus on the services sector is not an unreasonable strategy shift considering that Malaysia will have trouble maintaining its growth momentum, going forward, if it were to continue relying on an export-led growth strategy that is primarily dependent on manufacturing. The strategy is after all already well past its sell-by date for Malaysia. This is because rising competition from regional powerhouses, China and India, countries that have significant competitive advantages in manufacturing, will see to that. “

I've been preaching a strategy shift to services sector growth for a few years now, but there is in fact little empirical backing for such a move. In fact the debate is still open when it comes to the determinants of economic growth. You could say that the warring camps on the appropriate policies and timing of development is really an argument on the level of theology rather than science – it takes a leap of faith.

There have been many alternative suggestions to getting Malaysia over the middle-income hurdle from a strong Ringgit policy, to raising real incomes, to promoting a consumption based economy.

The problem from an economic planning perspective is that there's very little in terms of solid guidance on what would constitute the right way forward. Every country's capabilities and resources are different; legal and judicial frameworks differ; culture, education and institutions don't work exactly alike. What works for one country may not necessarily work for another. Initial conditions matter in terms of reaching a particular level of development, and so does the timing of institutional development and reform. The social, political and economic chaos attendant to Eastern Europe's (and particularly Russia's) shift from centrally planned economies to market economies provides a strong counter argument against going cold turkey.

The literature on economic growth also provides little comfort, at least to my mind. Solow's seminal attempt at quantifying economic growth (after accounting for labour and capital inputs) resulted in the conclusion that technological progress was the key driver of growth. But empirical evidence in support has been largely contradictory and isn't a great deal of help in formulating a development strategy.

Looking at past history, using the experience of other countries as 'natural experiments', leads to the structural view of development. This viewpoint suggests that economic development on the supply side follows a defined path: exploitation of natural resources->processing->heavy industry->services-based development. On the demand side, the equivalent path is net exports->investment->consumption. The reality is more nuanced than that of course, but I find this useful as shorthand in explaining economic development.

I'll forbear from discussing all the possible pitfalls of implementing services based development – education, culture, etc. These have been discussed ad nauseum elsewhere and in better detail. What I would like to mention is some of the possible ramifications of services-led growth. First is that since wages in the services sector are less subject to international arbitrage than in the tradable sector, real incomes would tend to rise under this strategy. This in turn implies a greater share of consumption in GDP, as well as a stronger exchange rate. Services-led growth therefore rather neatly encompasses quite a few of the alternative strategies I mentioned.

One issue that does worry me though is that the services is a catch-all label for a number of very different industries, from government to finance to tourism, to everything in between; development policy as a result would have to be necessarily fragmented. And Quah's concern about neglect of other sectors is very real and.pertinent. Investment in services should not come at the expense of maintaining our competitive position in other sectors, particularly agriculture and manufacturing.

Why should we bother if China is so far ahead in manufacturing and India in services? Because the principle of comparative advantage suggests that even if we cannot compete on price, scarcity of resources and specialisation of production means that there will always be a niche to be filled. On that basis, we should not over-pursue development in any one particular sector – while a simplistic, focused strategy is probably easier to sell to the public and to implement, it does not make economic sense in terms of maximising welfare.