This article first appeared in Forum, The Edge Malaysia Weekly on December 24, 2018 - December 30, 2018

Malaysia is in transition to an innovation-driven, high-income economy. At this stage, efficiency in manufacturing becomes a nation’s dominant source of competitive advantage. The products may be sophisticated and there is much reliance on imported technology and designs. Technology is accessed through foreign direct investment (FDI), licensing, joint ventures and imitation at this stage of economic development.

After independence, Malaysia started out as a primary commodities producer and exporter. Around the mid-1980s, manufacturing overtook agriculture as the main contributor to gross domestic product. The rapid expansion of the export-oriented manufacturing sector, made possible by high inflows ofFDI, helped the country break away from its overdependence on commodities. Apart from that, the growth of the sector helped solve the problem of unemployment. By the early 1990s, the economy had virtually reached full employment. The manufacturing sector also helped reduce the incidence of poverty and increased overall living standards.

As manufacturing has long been recognised for its role as an engine of growth, considering the major role it plays in economic development, its continued strategic importance cannot be overstated.

More recently however, the manufacturing sector appears to be losing its shine, and deindustrialisation seems to be on the cards for Malaysia. Deindustrialisation is defined as a phenomenon whereby there is a steady decline in the manufacturing sector’s share of employment. This has been experienced by almost all the rich countries of The Organisation for Economic Co-operation and Development (OECD) and caused considerable concern in the affected countries, especially in the US during the early 1980s, and later in Europe, leading to vigorous debate about its causes.

Deindustrialisation can be viewed as the norm in successful economic growth. As per capita income rises during the course of economic development, the share of employment in manufacturing rises at the expense of agriculture until a relatively higher level of development is achieved. Beyond a certain threshold of per capita income, however, the share of services in employment starts to rise at the expense of manufacturing.

This takes place for two reasons: higher productivity growth rates in the manufacturing sector relative to the services sector, and systematic change in consumption patterns. This form of deindustrialisation is considered “positive” because it is associated with rising real incomes and full employment, not because of a failure of the manufacturing sector.

A second form of deindustrialisation, negative deindustrialisation, can be caused by the failure or inability of firms to respond to changing market conditions. The loss of jobs in the manufacturing sector is typically made up by employment in less productive service sectors and informal employment, among others.

It results in a slowdown in manufacturing output and productivity and prevents nations from achieving their full economic potential. Given the performance of the economy, jobs lost due to negative deindustrialisation are not balanced out by jobs created in the services sector. Negative deindustrialisation is thus associated with falling productivity and rising inequality due to the disparity of labour productivity among sectors.

If deindustrialisation is indeed on the cards for Malaysia, it cannot be positive deindustrialisation. The manufacturing sector is being affected by, among other things, rising production costs arising from a tightening labour market, and cheap exports from, for example, China and Vietnam. The sector has also failed to make the transition to higher-value-added activities.

The problems the manufacturing sector faces currently can be traced to a lack of industrial deepening because of misguided institutional change during the 1990s. What needs to be done now is not the creation of more organisations, but effective implementation of an appraisal, reward and penalty system to improve coordination of activities among the relevant institutions to ensure industrial deepening.

However, Malaysia aspires to become a high-income economy by 2020. Thus, the manufacturing sector would no doubt continue to play a pivotal role. In fact, based on Economic Planning Unit estimates, the manufacturing sector would contribute about a quarter of GDP in 2020. In order for this to happen, we cannot continue to rely on low-skill, labour-intensive industries and instead, shift to high-value added sectors, which will invariably result in increased total factor productivity (TFP).

It is imperative for us from now on to prepare for enhancing TFP, which dictates structural and technological changes in the economy for the remaining years of this decade. One way is by creating strong technical linkages among the agricultural, manufacturing and service sectors. In economic jargon, this is said to be “neat complementary” and causes industrial deepening.

In the case of the palm oil industry, accelerate the shift of activities from upstream to downstream, investing in food-based as well as non-food-based components. The growth of downstream activities is to be driven by a strong focus on finished components that generate high value, such as oleo derivatives and selected food and health-based products, and viable and sustainable output such as biofuels.

In the case of the electronics and electrical sector, one of the four sub-sectors that will augment our capabilities across the value chain, especially in higher-value-added upstream activities, is semiconductors. The obvious strategies are to upgrade from lower-value-added activities such as test and assembly to the more mature areas of technology fabrication, expand into advanced packaging and design of integrated circuits and support the growth of substrate manufacturers. So, in more ways than one, this sector can be revitalised.

In the final analysis the manufacturing sector should continue to play a crucial role, even though we may have progressed to become a high-income economy by the end of this decade. There is one caveat though: At that point in time, the manufacturing sector should have developed synergies (strong technical linkages) with other sectors and be characterised by a marked increase in TFP. Time is of the essence and we must make the necessary structural and technological changes now.

Samirul Ariff Othman is an analyst with local think tank Malaysian Institute of Economic Research. He completed his graduate studies at Macquarie University, Australia. The opinions in this article are his own.

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.