Friday, June 5, 2009

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of China as the world's factory has created a formidable competitor in manufacturing, but even here China is being superseded by Vietnam and Mexico in low-cost production.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:

Total Consumption52.6%91.2%
Government Consumption9.1%21.3%
Private Consumption43.5%69.9%
Gross Fixed Capital Formation36.3%16.6%
Net Exports9.2%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.


  1. Bro

    I am glad to read your articulation on the elements of comparative advantage. On the matter of emphasising the services sector, I am inclined to agree with your caution.

    I very much agree that just because the BRIC countries, especially China, have become industrial powerhouses, does not and, should not, immediately mean that countries like Malaysia should shift 90% its resources towards its Services sector. That would be folly. Akin to shifting eggs from one basket to another instead of spreading the eggs around, so to speak.

    I remain a firm believer of basic, brick-and-mortar manufacturing, especially at the SME level. What I see is that these SMEs have been neglected for too long. There aren't enough tax-incentives to draw the SMEs towards a culture of R&D and innovation. Businesses operate and make decisions on the availability of tax-breaks. These tax incentives are tools for the policy-makers to channel the business behaviour of SMEs. This is one area that I hope to see the government put more emphasis on. Unfortunately, it is MITI and its agencies that are on record to support the SMEs. The MOF and IRB have been sagely silent. There is a need for a high level of ministerial and inter-departmental partnering to achieve Malaysia's economic goals. Otherwise it is only lip-service.

    I have taken too much of space, bro. Cheerio!

  2. tumpang lalu....just to merapu a wee bit :)

    how to move towards R&D and innovation when IP protection is weak?

    As for tax breaks why don't we do Buy Malaysia first with a tax break for local component (does this constitute as tariff ka?) on top of the agreed ASEAN multilateral agreements.


  3. Definitely agree with every country has its niche. I have written about the same subject here though as opposition to centrally-planned effort to reduce reliance on foreign labor ( I think ministers and their policy makers do not understand comparative advantage and are too focused on absolute advantage. The scary thing is that some of these ministers (like the Finance Minister II and even the PM) have been trained in economics.

    But the dependency on net exports and its contributions to growth as you have framed it requires context. It is far more meaningful to break net exports into its 2 components.

    Important to note that imports also form part of private and public consumption. The picture will be clearer if we inspect how portion of imports component contributes to growth. Subsequently, exports too. (Which also include private consumption because to do so, requires consumption input).

    The way it is placed in the table, the portion of imports and exports to “growth” has been gobbled up by the label private consumption and government consumption and even fixed capital.

    Also, it'd be interesting to note how many of these fixed capital is done for exporting purposes.


  4. de minimis,

    There's actually a lot of government support for SMEs and entrepreneurship development, not just in terms of finance but also training, marketing and packaging, as well as business development. Your point on tax incentives however is well put.

    One thing that does seem to be holding back SME development is that it is unfortunately still primarily race based, if you know what I mean. That means we are not full leveraging on the latent potential of the nation's people.


    Yo, long time no see!

    Actually, I think IP protection is adequate from a legal perspective. Enforcement is another matter.

    But whichever way you look at it, R&D spending in this country is horribly inadequate, even comparing with other emerging economies (I'll dig up the numbers if you like). And much of it is wasted because academic research is too out of line with industry requirements. That is the fault of both industry and academia - the former for not taking advantage of the available expertise, and the latter for not seeking out what industry really needs. This is more a cultural and informatonal problem, rather than a lack of resources.

    I've done some vetting of research proposals for a foundation, and I find that the proposals we get are depressingly predictable and generally out of touch with reality.

    As for local content requirements, the existing literature suggests that it has the opposite effect from what is intended. So I'd be against such a policy.


    I fully agree with your viewpoint regarding not restricting foreign workers. I'd actually go one step further and advocate assimilation rather than repatriation. It takes a deal of courage and willingness to take risks to uproot oneself and work and thrive in a foreign country and culture. We are foregoing a potential economic advantage in marginalising these people, not just from fulfilling our low-cost labour needs, but also over the long term in creating an environment of competition in the domestic labour market as well as harnessing the energy and entrepreneurship of immigrants. Not to mention enriching the cultural diversity of the country.

    Higher incomes should thus be a consequence not an instrument of economic policy, if you get my meaning.

    Regarding our ministers, I share your views. One thing I find from personal experience is that an undergraduate degree in economics makes one ill-prepared for real-world policy discussions and decisions. What you're given at that level is just too shallow.

    For the import-export breakdown, I'm as interested as you are. Unfortunately I don't have the time to wade through the detailed SITC breakdowns to make any good determination of what the impact might actually be, hence the aggregated table above.

    The Malaysian input-output tables should provide a clue, but it hasn't been updated since 2000 and the next survey isn't due until next year (which means we won't see it until 2011). There've been enough changes to export and import content that I can't rely on the old tables with any degree of confidence. When the new tables come out however, I fully intend to lay out an econometric model of the economy. That would really help in seeing the relationships between all the variables.

  5. Hi Hishamh,

    Some questions and opinions:
    1. On economic growth theory
    Is endogenous growth/new growth theory (by Paul Romer) less popular among economists ?
    I think this theory places more importance to innovation/entrepreneurship/education than Solow’s growth theory. I think it’s closer to Schumpeter’s view too (?).
    Wonder why..

    2. I think the essence of the problem is not whether it’s service or manufacturing.
    I think it’s the value added and its position in the value chain;
    There are also high value added industries even in agricultural and manufacturing sectors.

    High value added agricultural industry: high yield crops; premium cheese; premium chocolates; cuckoo clock;
    High value added traditional manufacturing industry: premium apparel; premium furnitures etc..
    (the element of design is important)

    I guess M’sia needs to move up the value chain..through innovation, entrepreneurship and education..

    3. There is this World Development Report 2009 that offers some great insights
    Europe’s Lisbon Strategy too:

  6. Hi WY,

    Growth theory really isn't my field - apart from learning the basics, like Solow. But reading that article link doesn't make me any more confident as to the conclusions.

    Also Schumpeter had two distinct phases in his thinking on growth, with an early period which really pushed the idea of the primacy of entrepreneurship (the famous creative destruction phase); his later work pulled back from this view somewhat, largely due to his recognition that much of innovation actually happened in large established firms.

    Why services instead of greater value-added manufacturing? Because the heart of the problem now is we have lost competitive advantage in the external sector, and the loss of America as consumer of last resort means slower global trade growth.

    The services sector by contrast is primarily domestic-oriented, even those subsectors earning foreign exchange like tourism. Second, adding value in this sector has a higher impact for the simple reason that there are even less imported inputs. A third reason is that since international wage arbitrage has also less impact on non-tradables, real incomes should rise faster under a services-oriented strategy.

    Moving up the value chain is still necessary, but I suspect it will only sustain what manufacturing capacity we have rather than be an engine for growth.

    Of course I could be wrong.

    3. Thanks for the links

  7. Thx Hishamh for your insights on Schumpeter’s two distinct phases..
    Need to read & think about it.. I prefer phase 1 explanation for now.

    Hope you can elaborate on “why services sector is primarily domestic-oriented”, “less imported inputs”.
    Take for example, tourism.. The infrastructure for tourism is domestic but the building materials and expertise can be foreign. Main “customer” is foreign.

    I hope M’sia can build on its strength of existing resources (domestic inputs)/strength, like:
    oil & gas -> refinery + O&G trading hub
    palm oil -> CPO trading hub + biofuel, carbon credit trading hub (maybe make it Syariah compliant too)
    flora & fauna resources -> new medicine, pharmaceutical research hub, IP hub
    Islamic -> Islamic finance hub + halal food hub etc…
    IT & semiconductor hub (since we have already some infrastructure/clusters on these)

    Need to have cluster development.
    Michael Porter’s website has some resources..
    There is this International Cluster Competitiveness Project inside.. Wonder whether M’sia is included.

    Haha, hope you all as economists can guide the country towards sustainable growth :-)

  8. To take your tourism example:

    1. Tourist arrives at KLCC having flown in by MAS (plane is imported but is a one-time lump sum import/capital good; but actual flying counts as services)
    2. Tourist books into 5-star hotel for one week stay (building a hotel is counts as construction, not services; room rental, f&b, using the fitness centre however is services)
    3. Tourist goes shopping, visits Petaling street, Low Yat and Suria KLCC (retailing, taxi fares, considered as services)
    4. Tourist makes day trip to Genting, does some gambling, takes in a show (all count as services)
    5. Tourist plays golf with local friends
    6. Tourist does full medical check-up at private hospital
    7. Tourist flys out

    The point of the above is that the net margin to local suppliers in many of these activities (which is what counts for GDP) is at least 25% and in some cases over 100%. The selling cost for instance of imported luxury goods would not count towards GDP, but the
    margin made by the retailer, the wholesaler, the transport from port to warehouse would.

    Compare that with much of the MNC-directed exports that we have.

  9. This comment has been removed by the author.

  10. Wow.. the margin is huge (25% - 100%).
    Hopefully the foreign demand for these services is big too.

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