Phase II: The New Economic Policy Period, 1970 to 1987

The Malay political leaders, who were the dominant group in the ruling coalition, decided that the ground rules for governance had to be changed. When parliamentary government was restored in February 1971, the constitution was amended to make seditious public discussion of constitutional provisions for language, citizenship, and the special position of Malays and the status of the Sultans (Malay rulers). In the economic sphere, there was a clear shift from planning and policymaking based purely on economic considerations, towards an affirmative action policy based on ethnicity. This policy shift was formalized in the New Economic Policy (NEP), which was introduced in the Second Malaysia Plan (1971-75).

The overriding objective of the NEP was to maintain national unity through the pursuance of two objectives: eradication of poverty among the entire population and restructuring of society with a view to eliminating the identification of race with economic function. For the first objective, the overall development strategy was reformulated with emphasis on exportoriented industrialization, and an ambitious rural and urban development program. For the second objective, long-term targets were established for the Malay ownership of share capital in limited companies, and the proportion of Malays employed in manufacturing and installed in managerial positions. The NEP aimed to increase the Malay share in corporate assets from 2% in 1970 to 30% in 1990, and to have employment patterns in the urban sector reflect the racial composition of the country.

Malay participation in business was promoted in two ways: (i) through the expansion of the public sector where Malays held most of the key positions, and (ii) by providing Malays with privileged access to share ownership and business opportunities in the private sector. The Industrial Coordination Act (ICA) was enacted in 1975 to strengthen measures to implement NEP norms on Bumiputra participation at the enterprise level. Under the ICA, the conduct of medium- and large-scale enterprises was subject to licensing with the aim of improving the relative position of the Malays in the modern sector of the economy.

As part of the NEP, Malaysia moved into the promotion of heavy industries over the term of its Fourth Five-Year Plan (1981-85). The Heavy Industries Corporation of Malaysia (HICOM), a public-sector holding company, was formed in 1980 to go into partnership with foreign companies in setting up industries in areas such as petrochemicals; iron and steel; cement; paper and paper products; machinery and equipment; general engineering; transport equipment; and building materials. These industries were expected to “strengthen the foundation of the manufacturing sector ... [by providing] strong forward and backward linkages for the development of other industries” (Government of Malaysia, 1993). Even though the new selective industrialization push was often rationalized as an attempt to emulate Japan and Korea (hence the “look East” policy, a term coined by Prime Minister Mahathir in 1981), in practice the selection of new projects was based largely on traditional import-substitution criteria. These projects were supported with subsidized credit, government procurement provisions and heavy tariff protection, without subjecting them to market-based performance norms.

Despite all this, there is little evidence that either the government leadership in industrial policy in general, or the heavy industrialization push in the early 1980s in particular, affected the export-led industrialization process. The structure of industry that evolved was still much in line with what one would have expected, given the nature of Malaysia’s comparative advantage and changing factor endowments (Athukorala and Menon, 1999). Most of the industries set up under HICOM were “born losers” artificially spawned with subsidies. By the late 1980s, HICOM had invested over RM42 billion in various projects that generated less than 5,000 jobs directly (an average RM400,000 per job), and exports from these industries were negligible (Chee, 1994, Table 10.5). Although some employment, technical and managerial skills, and scale economies were generated (see Lall, 1995), these have come at a considerable price.

According to a detailed analysis of productivity performance of Malaysian manufacturing during the period 1979-89, most of the 3-digit industries dominated by state enterprises recorded negative or zero total factor productivity (TFP) growth (Alavi, 1996, Chapter 5). A more recent analysis that separates domestic from foreign firms by Menon (1998) confirms this finding. Interestingly, the industries that topped the list in terms of TFP growth were private-sector dominated, labor-intensive industries which received little direct government support. These industries included textiles, clothing and footwear, and “other” manufacturing, such as toys and sports goods. Apart from the direct economic cost, the heavy industry push burdened downstream industries, which were forced to pay higher prices for the protected products (Lim, 1992), and worsened the macroeconomic situation.

The blow-out in public expenditure as a result of massive government investment programs under the new industrialization drive was reflected in widening budget and current account deficits between 1981 and 1986 (Table 1 [ PDF 14.3KB | 1 page ]). The scale of fiscal expansion during this period, especially in 1981 and 1982, was unprecedented. The macro imbalance was compounded by the terms of trade decline in the early 1980s and the subsequent world recession in the mid-1980s (Corden, 1996). Between 1981 and 1983, the terms of trade declined by about 20% (Ariff, 1991, Table 2.13), shaving off about 4.5% of national income. Continued pump priming propped up growth at 6.3% and 7.8% in 1983 and 1984 respectively, but the situation with the twin deficits was reaching a critical point. As a share of GNP, the current account deficit had increased beyond 5%, while the overall public sector deficit amounted to almost 14%.

The collapse of the prices of all major export commodities in 1985 was the final straw. The ensuing 1.1% contraction in GDP was the worst performance ever recorded. The required cuts in government expenditure, in light of ballooning deficits, had further contractionary effects on the domestic economy. At the same time, the uncertainty in the policy environment dampened both local and foreign private investments.

On the monetary front, the ringgit was floated in 1973. Since the floating, Malaysia’s capital account has been progressively liberalized. There remain, however, a number of restrictions that, from time to time, have been increased to serve so-called national objectives. Some of the more important capital account regulations and restrictions, leading up to the 1997 crisis, are discussed in Appendix 1. Unlike fiscal policy, the monetary policy stance throughout this period has been relatively conservative, with BNM rarely employing it in a counter-cyclical manner. But there was an episode in the mid-1970s and another during the downturn in the mid-1980s that marked departures from the general hands-off approach. Monetary policy became quite interventionist in the mid-1970s, when Malaysia was faced with double-digit inflation. The money supply was squeezed, pushing up interest rates sharply, in order to quell inflationary pressures. Monetary policy for most of the first half of the 1980s continued to remain restrictive, in order to contain inflation and further deterioration in the current account. To support the currency during the economic downturn in the mid-1980s, the BNM implicitly imposed controls on capital outflows. Temporary restrictions on exchange markets were imposed in 1986.

These factors combined to bring the economic advances of the 1970s to a halt, and created an environment in which race relations became increasingly tense. This volatile climate paved the way for a series of policy reforms that placed greater emphasis on the role of the private sector and strengthened the conditions for export-oriented industrialization.

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