Realising Malaysia’s High-Income Aspiration: The Last Mile of Reforms

In 1991, then Prime Minister Mahathir Mohammad announced Malaysia’s Vision 2020 aspiration to become a fully developed country. In 2010, the New Economic Model articulated a more specific target of reaching World Bank’s high-income threshold by 2020. Although Malaysia missed the target, the country is currently about USD2000 away from crossing the threshold (Figure 1). Malaysia has become a classic example of the middle-income trap, however, having remained upper-middle income for 30 years. To finally breach the high-income bar and stay above, Malaysia needs a new generation of reforms and investments that will spur productivity growth and drive the next phase of services-based structural transformation.

Historically, most of Malaysia’s growth has come from factor accumulation, especially by increasing the quantity of capital. Productivity growth — output per unit of capital and output per worker — has played a relatively minor role. Going forward, productivity growth will need to make a greater contribution to circumvent the middle-income trap.

From the 1980s until the early 2000s, structural transformation was driven by rural-urban labour migration, mainly from agriculture to manufacturing (Figure 2). The quest for specialisation focused on reallocating physical, financial and human resources between rather than within sectors. This process is reaching its limit, as evidenced by the significant inflows of migrant workers to supplement domestic shortages of low-skilled workers in all sectors. Services started to expand from the early 2000s, driven by high-value services, while agriculture stabilised and manufacturing and other industry contracted, leading to concerns over premature deindustrialisation (Figures 2 and 3).

Future specialisation must take place within all these sectors if growth is to be productivity-led. This requires national reforms and investments that will facilitate: (i) upgrading within manufacturing supply chains towards higher value-added activities; (ii) diversification into high-value services; and (iii) greater processing of the output within resource-based industries and agriculture.

The 13th Malaysia Plan (2026–30) places great emphasis on developing high-value services. While its share in total services has been increasing, low-value services still dominate (Figure 3). Malaysia aims to become a key hub in the regional digital economy, focusing on AI data centres and cloud computing. The country is also one of the world’s largest issuers of sukuk finance  (Sharia-compliant financial arrangements). Future growth is expected to come from sustainable and green sukuk, simultaneously supporting Malaysia’s financial and green objectives. Other high-value service exports being promoted include healthcare, higher education and tourism, all with growing regional demand.

Within manufacturing, Malaysia has been trying to move up the value chain in the electrical and electronics (E&E) sector with mixed results. The New Industrial Master Plan 2030, launched in 2023, provides targeted fiscal support for front-end chip design, high-end packaging of AI chips and the like. It also aims to help local SMEs integrate into the supply chains of anchor technology firms and supply them with domestically produced parts and components, to increase domestic spillovers from multinational corporations (MNCs). 

In the resource-based and agriculture sector, the government is keen to increase local value-addition and processing of its raw materials and agricultural produce. Malaysia is already a regional standard-setter for halal industries and seeks to expand its footprint globally. As the world’s second-largest palm oil exporter, Malaysia seeks to increase downstream processing of high-value oleochemicals, specialised biomass derivatives and high-purity functional food ingredients. Malaysia hosts the world’s largest, rare earth extraction facility outside China and is one of the few countries that has the processing capacity in relation to certain critical minerals. Shifting geopolitics has placed a premium on reliable access to critical minerals, which Malaysia seeks to exploit. Tapping the premium markets in Europe, however, requires green credentials.

These types of products and activities, associated with specialisation within sectors, will promote productivity-led growth.

To achieve the necessary structural transformation, Malaysia must invest in human capital that reduce skills mismatches and deliver wide-ranging reforms that can level the playing field, reduce business costs and revitalise the private sector.

The World Bank estimates that 44 per cent of recent graduates work in positions below their skill level, resulting in loss of productivity and wage stagnation. Malaysian pupils recorded the sharpest overall score decline among major ASEAN countries in the latest cycle of the Programme for International Student Assessment (PISA) international standardised tests. There is an urgent need to improve the quality of education at all levels, starting with primary and secondary schooling, and to raise entry standards for teacher training colleges while also aligning teacher professional development with modern STEM requirements. Quality concerns also extend to technical and tertiary institutions, with Malaysia ranking 33rd out of 83 countries worldwide in a skills index that measures how well higher education systems prepare workforces for the evolving job market.

Malaysia must invest in human capital that reduce skills mismatches and deliver wide-ranging reforms that can level the playing field, reduce business costs and revitalise the private sector.

On the reform front, commitments to high-level Free Trade Agreements (FTA) such as the Comprehensive and Progressive Agreement for the Trans-Pacific Partnership (CPTPP), or the one under negotiation with the EU, can drive productivity-enhancing changes in difficult areas. These include government-linked corporations (GLCs), government procurement, digital trade and intellectual property rights protection. Given domestic vested interests, it is unlikely that Malaysia could pursue these reforms without the imperative of the CPTPP.

There is evidence that the widespread influence of GLCs is crowding out private investment, especially in the services sector where future growth is expected. The restrictive rules associated with government procurement further disadvantages the private sector, especially SMEs. Unless these constraints are relaxed, it is unlikely that the desired structural transformations can materialise. Such reforms can also help attract the kinds of high-quality, specialised Foreign Direct Investment (FDI) that Malaysia seeks.

The critical role that reforms can play in driving structural transformation is illustrated by the role that Special Economic Zones (SEZs) have played in the E&E sector, especially in Penang. The Bayan Lepas SEZ — the ‘Silicon Valley of the East’ — attracted MNCs by providing an enclave where all kinds of bureaucratic hurdles and policy distortions were removed. Looking ahead, the Johor-Singapore SEZ is serving as the platform for realising Malaysia’s ambition to become a hub for AI data centres, capitalising on rising costs in Singapore and potential positive spillovers.

The challenge facing SEZs, and indeed Malaysian policy makers, is to spread the reforms beyond the enclave, to get the rest of the economy to start resembling the conditions that prevail within the SEZ. This is exactly what the FTA-driven reforms should do, since they apply nation-wide.

Addressing the underlying causes of the skills mismatches and a program of wide-ranging national reforms may finally allow Malaysia to realise its high-income aspirations.

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