Malaysia: From Economic Recovery to Sustained Economic Growth

Author(s): Marwan Abdul-Malik Thanoon, Ahmad Zubaidi Baharumshah and Abd. Aziz Abd.
Rahman
Reviewed work(s):
Source: Journal of Post Keynesian Economics, Vol. 28, No. 2 (Winter, 2005-2006), pp. 295-315
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296 JOURNAL OF POST KEYNESIANECONOMICS

investments.Hence, for the purposeof controllinginstabilityand of se-

quencing financial reform, the binding constraintson the growth pro-
cess must be identified.1The 1997 Asian financialcrisis and its effects
on the neighboringeconomies clearly illustratethis point. The growth
performanceof EastAsiancountries-namely, Malaysia,Thailand,South
Korea, Indonesia, and the Philippines-was severely affected by for-
eign capital withdrawalfollowing the 1997-98 crisis. Several authors
have arguedthat the sharpswing in the yen-dollar rate contributedto
the outbreakof the Asian crisis.2
Malaysia, setting out to transformits economy throughindustrializa-
tion to become a fully developed country by the year 2020 (VISION
2020), must provide for all of the resources requiredas efficiently as
possible. In formulatingpolicies to meet this vision, it will be necessary
to focus on the nature,magnitude,and evolution of the dominantcon-
straintsthatcan influencethe performanceof the economy throughtime.
An understandingof these majorrestrictionsmay serve as a guide for
policy makers in formulatingbetter policy options for the future.The
three-gapanalysis focuses on the majorimbalancesof the economy for
evaluatingpolicy choices facing Malaysia.It emphasizesboth domestic
and externalfactorsthatdetermineeconomic outcomes and welfare.
The presentpaperattemptsto (1) identifythe majorresourceconstraints
that may adversely affect a nation's growth performance;(2) provide
futureresourcerequirementsthatwould be needed to achieve the envis-
aged growthtarget;and (3) providepolicy options for Malaysiaas well
as other developing economies that may be facing difficulties in nar-
rowingthe resourcegap for attaininga moresustainedgrowth.The study
also attemptsto quantifythe relativeimportanceof externalborrowing
underalternativestructuraladjustmentpaths.The potentialgrowthrate
of the Malaysianeconomy moved to a lower plateauin the aftermathof
the East Asian financialcrisis. We thereforeintendto contributeto the
literatureby utilizing the three-gapmodel in identifyingthe majorcon-
straintsfaced by Malaysia and suggesting policy measuresin orderto
restoreits long-rungrowthpath set priorto the financialcrisis.

1 In the context of a
three-gapmodel, it means identifyingwhich of the three con-
straints-namely, saving, fiscal, or foreign exchange-is the least binding.
2 At the time this
paperwas written,the Malaysianeconomy had recoveredfrom
the 1997-98 financial crisis.
 FROM ECONOMICRECOVERYTO SUSTAINEDECONOMICGROWTH 297

Malaysia in the context of gap models

Malaysia,just priorto the crisis, was given a clean bill of healthin terms
of its macroeconomicfundamentals.During the period preceding the
crisis, Asian countrieshad severalyears of rapideconomic growth.Ma-
laysia,in particular,achieveda realgrossdomesticproduct(GDP)growth
of 8.5 percentbetween 1991 and 1997 with per capitaincome increasing
twofold in terms of U.S. dollarsby 1997, and the incidence of poverty
falling from 16.5 to 6.1 percent(Ministryof Finance, 2002). Gross na-
tional savings increasedfrom an average of 29.3 percent of gross na-
tionalproduct(GNP)in the 1980sto 34.6 percentoverthe 1990-96 period.
Standingat 39.4 and 40.4 percent in 1997 and 1998, respectively,this
was among the highest in the world. Gross investmentincreasedpro-
gressively from 16.7 percentduringthe FirstMalaysianPlan (1966-70)
to 40.8 percentin the Sixth MalaysianPlan (1990-96) andreached44.8
percentin 1997. The economy recordeda persistentdeficit in its current
accountbalancesfor most of the 1990s. The deficit amountedto M$21.6
billion (10.4 percentof GNP) in 1995, but declinedto M$12.2 billion in
1996 and M$14.2 billion in 1997 (5.4 percentof GNP). Political stabil-
ity was fundamentalin ensuring a business-friendlyenvironmentand
rapidgrowthin foreigninvestment,which increasedfromM$287.6 mil-
lion in 1970 to M$15 billion in 1996.
However,the performanceof the economy was adverselyaffectedby
the deflationaryimpactof the financialcrisis that hit the region in mid-
1997. In the aftermathof the crisis, real GNP growthin nominalterms
contractedby 4.8 percent in 1998. Per capita income declined by 1.8
percentto M$11,835 in 1998 comparedwith M$12,051 the yearbefore.
Foreigndirect investment(FDI) contractedmainly due to uncertainties
arisingfrom volatile exchange ratesfollowing the currencycrisis. Both
domestic and external demand declined sharply,creating problems in
excess capacity and a tight liquidity position since the onset of the fi-
nancialcrisis in July 1997. FDI declined from a high of M$15.3 billion
in 1997 to M$7.1 billion by the end of 1998. The overallfinancialposi-
tion of the governmentrecorded a deficit in 1998-primarily due to
lower tax revenue collection, which declined by 13.6 percentto M$55
million in 1998 (1997: M$70.2 million). The services account contin-
ued to recorda largedeficit amountingto M$19.5 billion in 1998 (1997:
M$21.8 billion). The deficit in the service accountwas due primarilyto
highernet outflow of investment(M$16.1 billion) andfreightand insur-
ance (M$9.7 billion).
298 JOURNALOF POSTKEYNESIAN
ECONOMICS

Theoreticalframeworkof the three-gapmodel

Inthisstudy,thethree-gapmodelis formulated andestimated.It is em-
ployed to further elaborateon the aforementioned sensitivityof theMa-
laysianeconomy. The mainfocus is on thestructural
adjustments needed
to
for an emergingeconomy achievealternative growthtargetsandde-
velopmentstrategieson thebasisof essentiallya conservativeexpecta-
tion withrespectto developmentsin theexternalsourceof capital.By
designinga scenariothatis morereflectiveof thecurrentsituation,we
hopethatthispaperwill enablepolicymakersto makemoreinformed
decisionson futurestructural reforms.
Severalsimplifying modifications weremadeto theBacha(1990;1992)
andTaylor(1993a;1993b;1994)three-gapmodelsin orderto enhance
theirapplicability andrelevanceinthecontextof theMalaysian economy.
Theseincludedomittingsome of its dependentvariablessuch as the
level of capitaloutflowandthesize of foreigncapitalinflowintopublic
andprivatesectorsdue to the nonavailability of reliabledatafor the
present work. Furthermore, omitting these variablesdoesnot appearto
affectourempiricalresultsin a significantway.Twotypesof equations
areusedto calculatethethree-gapmodel:(1) wheregovernment invest-
mentis factoredin, and(2) wherethe growthrateof GNPis incorpo-
ratedin themodel.Inaddition,twoalternative scenariosweresimulated
to understand howcapacityutilization,foreigncapital,andgovernment
borrowing have to be adjustedin orderto meeta 1 percentand2.5 per-
centannualincreasein capacitygrowth,withthe 1995growthratesetat
5.5 percent.As mentionedearlier,theseissuesareall important forthe
performance of theeconomy,whichis a smallopeneconomythatrelies
heavilyon the exportsectorfor economicgrowth(see Baharumshah
andRashid,1999;Ghataket al., 1997).Indeed,severalstudieshave
documented theimportance of foreigncapitalto theeconomicprogress
of Malaysiaforthepasttwodecadesor so. A recentarticleby Thanoon
andBaharumshah (2003a),for example,showeda positivecorrelation
betweenforeigncapitalandeconomicgrowthin Malaysia.
A setof simultaneous equationmodelsareemployedin theanalysisto
determinethe volumeof foreignresourcesthatwouldbe requiredto
fosterrapidgrowthin themediumterm.Forthispurpose,two scenarios
areconsidered.First,we considerthecasewheretheeconomyis totally
deprivedof anyshareof foreigncapitalinflows.Inotherwords,allforms
of investmentshaveto be sourceddomestically.Second,we relaxthe
firstassumptionby allowingthe economyto sourceall the capitalre-
quiredexternally.Thisis a morerealisticassumption, as it is wellknown
 FROM ECONOMICRECOVERYTO SUSTAINEDECONOMICGROWTH 299

thatMalaysiaactivelyseeksforeigncapitalfromtheUnitedStatesand
Japan.Together,the two scenariosallowus to showthe importance of
foreigncapitalto an emergingeconomy such as in
Malaysia achievinga
modestgrowthrateinthemediumterm.ThearticlebySepehriandLoxley
(1992),forinstance,evaluatedtheresourceconstraints facedby Uganda
basedon thethree-gapmodel.Resultsobtainedfromthisstudyshowed
a sharptrade-offbetweeninvestmentandcapacityutilizationunderfor-
eign exchangeconstraints. Specifically,theyshowedthattheeconomy
required about $545 million peryearto fill the foreignexchangegap
overthe 1988-92period.Thefindingsalsorevealedthatfiscalbalances
in Ugandacouldnot be restoredby 1993.Articlesby Taylor(1991a;
199lb) computedforeigncapitalrequirements to achievea targetgrowth
of 1 percentfor a groupof developedanddevelopingcountries,using
thethree-gapanalysis.Taylorfoundthatthetotalcapitalinflowrequired
for thesecountries(76 countries)to achievethe statedtargetis about
$35.31billionperyear.
Similarstudiesby theWorldBank(1994;1998)showedthatfor sub-
Saharan Africancountries, anincreaseof 1.5percentintheoutputgrowth
ratewouldrequireadditional inflowsof capitalestimatedat$4 billionin
the 1980s.In the year2000, a targetof 5 percentoutputgrowthrate
wouldrequirecapitalof no less than$19 billion.Inrelatedwork,Taylor
(1993a;1993b)estimatedthatthe totalforeigncapitalneededfor a 1
percentcapacitygrowthin 17 developingcountriesoverthe 1987-88
periodamounted to $15billion.ForthePhilippines, a studybyLim(1993)
foundthattheeconomywasboundby foreignexchangeandfiscalcon-
straintsto sustaina satisfactorygrowthrate.Basedon the 1988 eco-
nomicstructure of theeconomy,theanalysisfromthethree-gapmodel
revealedthatthePhilippineswouldneedabout$2.37 ($3.79)billionto
increaseits growthrateby 1 (2.5)percent.In anotherstudy,Vos (1994)
useda three-gapformtocomputea computable generalequilibrium (CGE)
modelforPakistanto simulate,amongotherthings,theeffectsof addi-
tionalforeignassistanceto Pakistan,andfoundthatthiswouldgenerate
"Dutchdisease"effectsandwould,therefore,be inconsistentwiththe
structuraladjustment programthatwas meantto strengthen the export
baseandtheproduction of tradedgoods.Inrelationto adjustment policy
variables,Vos alsofoundthatexchangeratedepreciation wouldproduce
mainlyinflationary pressure(cost-push),erosionof realincomes,anda
in
fall aggregatedemandin themediumrun.A cutin publicexpenditure
wouldseemless harmfulandwouldstimulatea shifttowardthetraded
goodssectors.Inaddition,it wouldallowforlowerinflationand"crowd-
ing-in"of privateinvestmentin Pakistan(see Iqbalet al., 2000).
300 JOURNAL OF POST KEYNESIANECONOMICS

Three-gapmodel
This section provides a brief accountof the three-gapmodel employed
in the analysis. A simple structuralgrowth model is specified in which
the economy is potentiallyconstrainedby domestic savings and exter-
nal andfiscal gaps.We utilizedthe three-gapmodel initially constructed
andrefinedby Bacha (1990; 1992), Taylor(1993a; 1993b), and Sepehri
and Loxley (1992), among others, to analyze growthprospectsin Ma-
laysia in the postcrisisera. Specifically,the model employedin this study
comprises22 variablesand 15 parametersandis boundby six identities.
In Table 1, we providea full accountof the behavioralequationsandthe
identitiesutilized in the three-gapanalysis.
A brief descriptionof the model formulationis as follows. Equation
(1) (see Table 1) hypothesizes that private investment(ip) is a linear
function of the level of governmentinvestment(ig) throughthe param-
eter a and throughan acceleratorterm,P. The privateinvestmentand
governmentinvestmentare complementary,implying that government
investmentin infrastructureand public utility are likely to crowd-inin-
vestmentin the privatesector.The parametersin Equation(1) indicate
how effectively the public sector (ig) can stimulatethe capacityexpan-
sion U. Low values for a and/ meanthatlargerforeign exchangetrans-
fers, more vigorous tax efforts, or a larger n is required for public
investmentto supporta given increase in the rate of capacity growth
(say, 1 percent).Equation(2) is the total investmentdemand(i), derived
after substitutingEquation(1) into (9).
Equation(3) suggests thatprivatesector savings (Sp)are a linearfunc-
tion of the activity variable.The parametera0 implicitly includes pri-
vate foreign interestpayments.The observedvalue of a0 may also shift
over time in response to capital outflow. The marginalsaving rate a1
implicitly includes the effects of transfersand taxes, and we assume
here thatprivatesaving increaseswith the rate of capacityutilizationas
indicatedby the al coefficient.
The fiscal effortvariable(Z) of governmentrevenuesis hypothesizedas
the linearfunctionof the level of economic activity(Equation(4)). Typi-
cally, Z1 is expected to be greaterthan zero as tax revenuesand public
enterpriseprofits rise with the level of economic activity.Equation(5)
states thatthe level of intermediateinputsMr is a linearfunctionof the
activityvariableU. Equation(6) maintainsthatonly a fractionof the level
of investment(i) is imported,whereasthe rest is sourceddomestically.
The importshare(1 - 0) in some circumstancesmay be elastic to invest-
ment itself: (1 - 0)i = V0+ VI x i is typically adopted in several studies.
 FROM ECONOMICRECOVERYTO SUSTAINEDECONOMICGROWTH 301

Table 1
Equations of the three-gap model
Behavioristicequations

ip =i +aig +PU > 0, io < or > 0, a< or > (1)

i = io + (1+ a)ig + PU (2)

Sp = a0 + U1U o0 < or >, o1 > 0 (3)

Z=Z +Z1U Z < or > 0,Z1 >0 (4)

Mr ao+a1U a < or >0, a1>0 (5)

Mk =(1-0)i= Vo+Vli 1>0>0 (6)
X = to + 1u to > 0, 1 < 0 > (7)

g =go + K X i K > 0, g < or > 0 (8)

Identitiesequations

= ip+ig (9)

s=Sg +Sp + Sf (10)

=Sg-ig (11)

Sg = Z - xj (12)

= Mr +Mk + Mo + -X (13)
i=s (14)
Notes:OLS constitutethe maintechniqueused for estimatingregressionparameters that
includea, /3,a, Z, a, ~, andK with capacityutilization,time trend,totalinvestment,and
governmentinvestmentas a ratioto potentialoutput.Followingthe conventionalpractice,
the statisticalcriterionemployedfor selectionof the model is basedon the coefficientof
determination (R2)to determinethe overallgoodnessof fit of the model,the t-valueto
ascertainthe significanceof the individualregressioncoefficients,the Durbin-Watson
statisticto detectautocorrelation,andthe Ramseyregressionspecificationerror(RESET)
test for overallspecificationof the model.

Equation(7) in Table 1 states that the level of exports (X) is a linear

function of the activity variable.Export sales seem to be cut back as
producersturnto the domestic marketwhen domestic activity(U) rises.
Equation(8) expresses the growthrateof potentialoutput(g) as a linear
functionof investmentnormalizedby the level of potentialoutputi, the
parameterK denotes the incrementalcapital-outputratio, and the pa-
rametergo representsboth the influenceof depreciationof capitalassets
302 JOURNAL OF POST KEYNESIANECONOMICS

in the economy and the underlyinggrowth prospects of the economy

underinvestigation.Finally, to close up the system, we used six identi-
ties (Equations(9)-(14)).
The variableson the left-handside of Equations(1)-(8) are the target
variables,and those on the right-handside are assumed to be policy-
drivenvariables.Oursimple model is, therefore,to assumethatthe vari-
ous parametersthatenterin Equations(1)-(8) are constant,from which
it follows that the targetvariablesare drivenby a set of log-linearrela-
tionships. Table 2 summarizesthe variables utilized in the three-gap
model.
We first calculatethe actualvalues of the endogenousvariables,using
1995 as the base yearandestimatedbased on a set of log-linearrelation-
ships using annual data from the 1965-95 period.3The ordinaryleast
square(OLS) estimatesof the parametersof the model are summarized
in Tables 3 and 4. They are generally satisfactoryin terms of the sign
and the overall fit as measuredby the coefficient of determination(R2).
In addition,the equationsappearto pass a batteryof diagnostictests.
In the second step, rearrangementsof the above parametersare for-
malized to identify the two sets of the gap. The growth version of the
model appearsas Equations(15)-(17), and the governmentinvestment
version appearsas Equations(18)-(21) (see Table5). Substitutingvari-
ablesappearingin Equations(1)-(13) intoEquation(8) yields threeequa-
tions that describe the growth constraintsfor the economy. Equation
(18) relatespublic sector investmentig to the capacityutilizationU and
a targetedgrowth rate g. This equation is obtainedby substitutingthe
totalinvestmentequationi (Equation(2)) intothe growthequation(Equa-
tion (8)) using privateinvestment,which is Equation(1).
The saving gap equation provides the maximum public investment
attainablefrom a given capacityutilization(U) thatsatisfiesthe saving-
investmentequilibriumcondition.This equation is derived from com-
bining Equations(1)-(13) and plugging them into Equation(14). The
foreign exchange gap is obtainedby substitutingEquations(5)-(7) into
foreign saving Equation(13). Finally,Equation(21) describesthe fiscal
gap, which is obtainedby substitutingEquations(11) and (4) into (12),
which is the governmentborrowing(public sector borrowingrequire-

3 This
paperexcluded the post-1996 period to avoid the statisticalproblemsassoci-
ated with the financialcrises. For a more detaileddiscussion on the East Asian crises,
see, for example, Radelet and Sachs (1998).
 FROM ECONOMICRECOVERYTO SUSTAINEDECONOMICGROWTH 303

Table 2
Specification variables of the three-gap model

Policy
Requirements Targets Exogenous Endogenous scenarios

AU U io, a, p
AF ix .7 Z ao, 71i
Atr i ip Zo Z,
Ag Sp 0 Sp ao, a
Zt /J S, Vol,v
Mr ux ' pg0, ~1
Mk J Q
g0, K1
X X

Table 3
Equilibrium of three-gap model (base year = 1995)
Value Ratio to
Variable (M$ million) potential

X 28,415.3
0 32,652.4
U
i 7,754.3 0.238
ig 2,775.4 0.085
tp 4,976.2 0.152
Sg 2,081.3 0.064
Sp 3,824.8 0.117
(, 1,848.0 0.0566
*j 901.2 0.028
# -0.880
M, 8,652.9 0.256
Mk 771.2 0.238
Mo 3,004.0 0.092
X 18,481.3 0.566
M+ * 20,329.5 0.620

ment; PSBR) equation.Notice that higher capacity utilizationpermits

an increasein governmentcapitalformationandhenceeconomicgrowth.
And higherforeigntransfers0 permitgreaterpublicinvestment,whereas
increasedinterestobligations(u x j*) have an adverseeffect on public
investment(ig). The total governmentinvestmentthatthe economy can
undertakeat any point in time will then be the smallest value provided
by the threegaps. In equilibrium,the three-gapequationsintersecteach
other,the saving gap (gs) equals the foreign gap (gf), which equals the
304 JOURNAL OF POST KEYNESIANECONOMICS

Table 4
Estimation parameters of three-gap model
Parameters Estimated value

go 0.002600
K 0.220000
io -0.022000
a 1.500000
Pf 0.054000
CFo -0.056500
oi 0.200000
Z4 -0.059000
Z1 0.169000
ao -0.213400
a1 0.620000
*
# j 0.024880
1- 0 0.600000
^o 0.548600
d1 0.020000
,n______ __0.021258

fiscal gap (gi), which equals the growth rate (g) or, equivalently,g =
gf= gi ==g

Three-gap analysis over the medium term

In this section, we address the following question: How can capacity
utilization(U), foreigntransfers(0), andgovernmentborrowing(PSBR)
adjust so as to meet a targetedincrease in capacity growth (g)? The
results reportedhere are based on two possible scenarios:one pegged
on a 6.5 percentgrowthrate and the other at a higher growthpath of 8
percent. The purpose here is to examine the sensitivity of our results
based on the two growthtargets.We solve the saving and externalcon-
straintequationssimultaneouslyfor changesin capacityutilization(AU)
and foreign transfers(A(), given that Ag = 0.01 and 0.025, and then
find the change in the PSBR or (Ar) that supports0.01 and 0.025 per-
cent growth from the fiscal gap. SubstitutingEquations(15) and (17)
into (14), we obtainedthe following relationships:

g+Ag=go +K[a0 +Z0 -j* +((+A()]

+ K(Z1+ o)(U+ AU) (22)
 FROM ECONOMICRECOVERYTO SUSTAINEDECONOMICGROWTH 305

Table 5
Two versions of the three-gap model

Model 1: three-gap equations for constraintgrowthrate (g)

Saving gap
gs = K[o + Z0 - j* + (]+ (Z1 + al)U+go (15)

gs = 0.22 (0.20 + 0.169)0.87 + 0.22[-0.059 - 0.024288 - 0.0565 + 0.0566] + 0.0026

gs = 0.081U - 0.015

Foreign gap
gf= -K/(1-0)[al + 1]U+[K/(1-0)][+ Jo - - -ao -Mo]+go (16)
-0.22
gf= 0.60 (0.62 + 0.02)(0.87)

+ 22[0.0566 + 0.5486 - 0.0267 + 0.2134 - 0.092] + 0.0026

0.60

gf = -0.234U + 0.259

Fiscal gap
gi =K[(1+ a)(Zo - , x j)]+ I[(1+ a)(n +Z1)+BP]U + go+ KXi (17)

gi = 0.22[(1+ 1.5)(0.021258 + 0.169 + 0.054)0.87

+ 0.22[(1 + 1.5)](-0.059 -
0.024288)] + 0.0026 + 0.22 * -0.022

gi = 0.117U - 0.047

Model 2: three-gap equations for constraintgovernment investment (ig)

Saving gap (igs)

(1-a)ig -(o1 +Z1-B)U =Zo +o

+o- xj* +~-io (18)

(1 + 1.5)ig - (0.20 + 0.169 - 0.054) U = -0.059 - 0.024288 - 0.0565 + 0.0566 + 0.022

igs = 0.126U - 0.024

Foreign gap (igf)

(1-0)(1+ a)ig[a + (1-0)P + 1]U = - M - --(1-0)io -ao + o (19)

(0.60)(2.5)ig + 0.62 + (0.60 * 0.054) + 0.02 =

0.0566 - 0.092 - 0.0276 + 0.60 * 0.022 + 0.2134 + 0.5485

(igf) = -0.448U + 0.47

(continues)
306 JOURNAL OF POST KEYNESIANECONOMICS

Table 5
(continued)
Fiscal gap (igi)
- ( + Z1)U = ZO- x j* (20)
ig
0.021258 + 0.169U = -0.059 - 0.0242
igi = 0.169U - 0.062

Government investment rate (ig)

- go)/K-(iQ
ig = (1/1+ a)(g + U) (21)

ig = (1/1 + 1.5)(0.055 - 0.0027/0.22 + 0.022 - 0.054 * U = 0.085)

Note: For a detailedderivationof the model,see ThanoonandBaharumshah

(2003b).

g+Ag=go+[K/1-0(DP+A()+o -j -ao-Mo]

-[K(a, +l1)/(1-)][ U+AU]. (23)

Next, we experimentedwith two other alternativepolicy scenarios.

The firstprovidesa situationin which foreign capitalinflows are absent
(capital immobility), and the requiredincrease in governmentinvest-
ment will requirea much highergovernmentdeficit. The second policy
scenario allows the governmentto source all the funds needed for in-
vestment from externalresources,reflecting more of the situationdur-
ing the precrisisperiod.An increasedpublic revenueeffort (AZo> 0) is
requiredto maintaina macrobalancewhen thereis fasterpotentialout-
put growthsupportedby higherpublic capitalformation.Thus, for sim-
plicity, we assume that governmentrevenue(Zo)increasesby the same
amountas (AO),andthis will reducethe governmentdeficit fromthatof
the base year.The following growth version of the fiscal gap has been
used to get the required(zr)in orderto close the fiscal gap broughtabout
by the change in the savings and foreign exchange equations.

g + Ag= go + Kio+ (1 + a)(Zo - *)

(24)
+ [Kc(1+ a)(J + Z1)+ fi](U + AU).

Empirical Results
Figure 1 (see also Table 5) illustratesthe three-gapmodel used in our
analysis for the Malaysian economy. It is worth noting that both the
 FROM ECONOMICRECOVERYTO SUSTAINEDECONOMICGROWTH 307

Figure 1 Foreignexchange,saving,andfiscalgaps
g

Fiscalgap

\, . Savinggap
Aroo /r~~ ^^

Growthrate(%)5.5

| sA '' Foreignexchangegap(E)

75 0 g 87 90 95 100
Capacityutilizationrate(%)

fiscalandsavinggapsarepositivelysloped,implyingthatanincreasein
capacityutilization(orlevelof economicactivity)wouldhavea positive
effectonpotentialoutput.Theoppositeis truefortheforeigngapsched-
ule.Theinversetrade-offbetweeneconomicactivitieslevelandgrowth
suggeststhatif one goes up, the otherhasto fall. Thiscurvewill shift
downwardat theonsetof a financialcrisisandmaymoveup if foreign
investorsgainconfidenceintheMalaysian economyandasforeigncapital
beginsto flow backintothe economy.Interestingly, the figuresreveal
thatthesavinggapequationis muchsteeperthantheforeigngapequa-
tionand,hence,supportsthattheformeris morebindingthanthelatter.
Hence,the objectiveof targetinghighergrowthrates(morethan5.5
percent)putsmorepressureon the fiscal ratherthanthe savingcon-
straintto financethedesiredinvestmentlevel.Thissituationclearlyre-
flectstheexperiencesof manyof thecrisis-affected EastAsiancountries
priorto thefall of theircurrencies.
The equilibriumpositionwith respectto the year 1995 (beforethe
crisis)is depictedin Figure1 as pointA, wherethethreeresourcegaps
(saving,fiscal, andexternalor foreign)intersecteach other.The ob-
servedequilibrium of 87 percentcapacityutilization,growthrateof 5.5
percent, governmentinvestmentof 8.5 percentof potentialoutput
and
is reproduced. Figure1 clearlyillustratesthetrade-offbetweengrowth
rateandcapacityutilizationundertheforeignexchangeconstraint, while
eitherthe savingor fiscalconstrainthasa positiveslope.Thus,growth
in 1995 was accompaniedby insufficientforeigncapitalinput;the
308 JOURNAL OF POST KEYNESIANECONOMICS

availableforeignfinancewouldonlybe atpointA as showninFigure1,

wherethe foreignexchangegap and fiscal gap will be binding.The
growthandcapacityutilizationarelowerat4.5 percentof potentialout-
put and83 percent,respectively.Thus,ourmodelrecognizedthe im-
portanceof foreigncapitalinflowandhow it can affectthe economic
progressin an emergingmarketeconomy.Historically,Malaysiahas
beensuccessfulin attractingforeigncapital,which,in turn,has led to
highdomesticgrowthrates.4

Projectionresults
Theanalysisis basedon two growthpaths,onepeggedon a 6.5 percent
growthrateandanotheron 8 percent.In addition,the economyis as-
sumedto achievefullcapacityutilization(thatis, U = 1) at 8 percentof
GNPgrowth.
Option 1: projected resourcesrequirementfora
I percent growth rate
Intryingto findouthowpotentialgrowthrate(g) canbe increasedby 1
percent,we allowedAg = 0.01 andAO andAU to be determinedby
solvingEquations(18) and(19) simultaneously. By solvingthesetwo
equationssimultaneously, we obtainedAU = 0.02 andA1>= 0.041.This
findingsuggests thatto achieve an additional1 percentgrowthratein
potentialoutput,foreigncapital to increaseby 4.1 percentof poten-
has
tial output(orM$1.35billion),andcapacityutilizationhasto increase
by 2 percentannually.Meanwhile,the percentagechangerequiredin
totalgovernment andprivateinvestmentsto achievethestatedtargeted
growthrateis estimatedat 0.043 and0.018,respectively,andas a per-
centageof totaloutput,is 0.280and0.103,respectively.Theexpansion-
aryeffectsof foreigncapitalinflowsalsoconfirmedthefindingof Iqbal
(1994),Papanek(1973),andThanoonandBaharumshah (2003a),among
others.All of these studiesdiscoveredthatforeigncapitalcontribute
positivelyto thegrowthprocessof thedevelopingeconomies.
Next, resultsbasedon two alternativescenariosare presented.The
firstscenariois wherethegovernment doesnotget anyincreasein for-
eign capitalinflows to financeits spending.Givena AU thatbringsa

4 Foreigncapital inflows soaredin the Association of SoutheastAsian Nations

(ASEAN) markedlyin the 1990s, and they were closely relatedto the period when
Malaysia's economy was growing rapidly.FDI as a fractionof currentaccountstood
at around90-100 percentover the 1992-95 period.
 FROM ECONOMICRECOVERYTO SUSTAINEDECONOMICGROWTH 309

capacityutilizationof 0.89, this substantiallyhigh governmentborrow-

ing ratio (PSBR) will definitely create an inflationarypressurein the
domestic economy. The change in Ar requiredto cover the increase in
governmentinvestment(ig) andeconomic growth(g) is: Ar = 0.014742
(or 7 = 0.036).
The second scenario is where the governmentis able to source all of
the fundsfrom an externalsource.Then we can assumethatZ0increases
by ADI= 0.041, so that Equation(20) yields At = -0.005455 (or Jr=
0.01585). This means that the increased capital inflow is more than
enough to finance the increased government investment required to
achieve a higher growth rate. This option has the advantageof some-
what alleviatingthe inflationarypressurebroughtaboutby tryingto in-
crease the growth rate of potential outputthroughforeign borrowing.
Thus,the availabilityof foreigncapitalallows Malaysiato grow at higher
rates.
It is worthpointingout here thatusing Equations(18) and (19) would
achieve similar results if we reduce interestpaymentson foreign debt
(j*). This can be achievedeitherby writingoff partof the foreigndebtor
by decreasingthe interestratepaid on the foreign debt (j*) by 0.041 of
potentialoutput(roundingoff makes it equal to the A(I derivedearlier)
in orderto achieve a 1 percentgrowthrate in potentialcapacity.
Therefore,it appearsthat the most efficient way to generatean addi-
tional 1 percentgrowthin capacityis to attracta higherlevel of foreign
investmentand to managethe fiscal budget.The most likely approach,
however, should consist of a mixtureof new resourcestogetherwith a
reductionin foreign debt interestpaymentthroughreformsin fiscal and
monetarypolicies, and an improvementin the external sector by im-
proving exports, implementingimportsubstitution,and managingfor-
eign debt and FDI inflows.
Option2: projectedresourcerequirementsfor a
2.5 percent growthrate
We now turn to the issue of foreign capital and allow the economy to
operateat full capacity,a situationmore like the booming periodsprior
to the financialcrisis. Underthis scenario,it is assumedthatthe growth
rate is targeted at potential output set at 8 percent, and full capacity
utilization(U = 1) is allowed. Assuming U = 1 and Ag = 0.025 in Equa-
tions (22) and (23), we solve for (( + A(D).Accordingly, the percent-
age change of foreign saving requiredto achieve an 8 percentgrowth
rateis A(I = 0.0558 of potentialoutput(which is equivalentto M$3.152
billion). The requiredA() is subsequentlyinserted into Equation(24)
310 JOURNAL OF POST KEYNESIANECONOMICS

togetherwith U = 1, to derivethe additionalfiscal effortZ0neededto

ensurethatthe savingequationwill achieve8 percentgrowth.There-
sults we obtainedare as follows:AD = 0.0558, AZ0= -0.048. Even
withthis increasein AZ0,Equation(20) revealsthatthe additional2.5
percentgrowthwill increasegovernment borrowing PSBRtoz7= 0.042,
ATr= 0.0208.
If we assumethattheA( goesdirectlyintofiscalrevenue,thegovern-
mentwill reduceits borrowingPSBRratios(AIr&lt; 0), ortherecouldbe
a budgetsurplusequalto n = -0.0245. In thiscase,evenpublicinvest-
mentneeds to increaseto raiseoverallcapitalformation.Othercon-
tributoryfactorsto the fiscal improvement includeincreasedcapacity
use, whichgeneratesmorenet governmentrevenueand an expected
increasein publicsaving,AZ0.
As summarized in Table6, a sustainable growthof 6.5 percentwould
requirean investmentratioof 28 percent,whereasan 8 percentgrowth
ratewouldrequirean investmentratioof 35 percent.By comparison, a
sustainable growthrateof 6.5 percent would a
require public investment
ratioof 10.3percent,whereasan 8 percentgrowthwouldrequirea 12.8
percentsharein publicinvestment. Withno changein theratioof inter-
est paymentto potentialoutput,5.58 percentof foreignsaving(around
M$5billion)peryearwouldbe required foran8 percentgrowth.Also,a
4.1 percent(aroundM$3.2billion)peryearof foreignsavingswouldbe
requiredfora 6.5 percentgrowth.A similarresultwouldbe obtainedif
foreigninterestpaymentis reducedby thesameamount.Further, foran
8 percentgrowthrate,an additionalincreasein fiscaleffort,or an in-
creasein Z0,amountingto 0.11 percentof potentialoutput,wouldbe
needed.
TheMalaysianeconomycanachieveits targetof growthandreduce
the burdenof foreigncapitalandthenclose the resourcesgapsby em-
ployingothertoolsandpoliciessuchas:
1.Encourageprivatization. If the responsiveness of privateinvest-
mentto publicinvestmentcanincreaseas theinvestmentclimate
improves,privatization can be acceleratedto furtherreducethe
size andfinancialburdenof thepublicsector.
2. Increasecomplementarity betweenprivateandgovernment invest-
ment.This can be done throughacceleratorterm/3, whichwill
processandprogresseconomicdevelopment (i, g) andreducethe
capitaloutputratioK, increase the investmentefficiency,income,
and capital accumulation,which will lead to increasedtotal
saving(s).
 RECOVERY
FROMECONOMIC TO SUSTAINED GROWTH311
ECONOMIC

Table 6
Simulations of growth paths for the Malaysian economy in the medium
term
Base year Growthpathscenario

Projections 5.5 percent 6.5 percent 8 percent

Potentialoutput Q 32,652.40 44,736.70

Realizedoutput X 28,415.30 39,853.90
Capacityutilization U 0.87 0.89 1.00
Annualchange AU -0.02 0.11
As percentageof potentialoutput
Governmentinvestment ig 0.085 0.102 0.128
Annualchange Aig 0.017 0.043
Privateinvestment ip 0.152 0.178 0.223
Annualchange Aip - 0.026 0.071
Totalinvestment i 0.237 0.280 0.351
Percentagechange Ai 0.043 0.071
Governmentsaving sg 0.064 0.067 0.086
Foreignsaving (D 0.057 0.098 0.154
Percentagechange A - 0.041 0.056
(o)Government borrowing ;r 0.021 0.036 0.042
requirement (PSBR)
Annualchange Ar
(.) Government borrowing n 0.016
requirement (PSBR) - -0.005* -0.025
Annualchange A.
Totalnet foreigncapital
inflowrequirement (M$billion) 1.848 3.2 5.0
Notes:Thebase yearis 1995;the symbol(o) refersto the firstscenarioand(.) refersto the
secondscenario;* theminussignrefersto surplusin governmentrevenue.

3. Reform fiscal and monetary policies. Government expenditure can

be reduced or its revenue increased or both by increasing taxes on
luxury goods, which can save a considerable amount of foreign
currency.
4. Enhance fiscal or export and import substitution efforts. For ex-
ample, if A0o > 0 or Aao &lt;
0 and import share (1 -0) is small, such
efforts can reduce external requirements, the services deficit in
current account, and hold down government borrowing (PSBR).
5. Repatriation of foreign capital. This can easily be incorporated in
the model as A(D > 0 due to reduced siphoning off of excessive
profits and dividends earned by FDI; a reduction in interest pay-
ment can create new resources through negotiations for long-term
debts.
312 JOURNAL OF POST KEYNESIANECONOMICS

6. Increasethe efficiency of privateinvestment(a) and enhancethe

privatesaving al. These will lead to an increasein ipand improve
the investmentclimate andreducethe financialburdenof the pub-
lic sector (governmentborrowingrequirement).

Conclusion and policy implications

The objective of maintainingreal economic growth at about 8 percent

over the next few years will dependnot only on the continuedprogress
of adjustmentsundertakenby the global economy butalso, moreimpor-
tantly, on the responsivenessand ability of the economy to adjustthe
domestic structureof productionto changingglobal marketdemandand
the opportunitiesthat may arise with it. At the same time, progress in
industrydeepening and diversifyingthe productionbase will certainly
increase the resilience of the economy to insulate itself from external
shocks, such as the recentAsian financialcrisis.
The main advantageof three-gapanalysis is to providepolicy options
for policy makersto choose. But which policy will be effective depends
on which gap is more binding to the growthprocess. The result of the
three-gapequationsdemonstratesa sharptrade-offbetween growthrate
and capacity utilizationunderthe foreign exchange constraint.And the
fiscal constraintis much steeperthan the saving constraint,indicating
that the formeris more binding than the latter,as more foreign capital
becomes availablein the host country.
The three-gapmodel is consideredto be particularlyuseful for explor-
ing andanalyzingthe differentpolicy optionsfacedby anyopeneconomy.
The empiricalresultsreveal severalinterestingpolicy insights.First,the
Malaysianeconomy cannotdependentirelyon the externalsectoralone.
The countrymust shift fromgrowththatis solely based on exportto one
that is domestic-led.As such, the privatesector must resume its role as
the engine of economic growth.
Second, the results of the relationshipbetween foreign capital, GDP
growthrate,and investmentindicatethatthe tradegap becomes a major
bindingconstraintwhen the governmentsets the outputand investment
at high levels (e.g., 8 percent).Given a high initial debt of M$68.8 bil-
lion in 1995, it would be difficultto raise the entirefunds in the form of
debt financing, because this would imply a growthrate of foreign debt
at 7.3 percent per year for an economy growing at 8 percent.Alterna-
tively, foreign debt could grow at 4.7 percentper year,andthis could be
achieved by targetinga lower growthrate. The findings suggest that it
 FROM ECONOMICRECOVERYTO SUSTAINEDECONOMICGROWTH 313

may not be feasible to achieve the 8 percentgrowthratetargetas docu-

mentedin the currentfive-year plan of the country.
Third,againstthis backdrop,the government,over the next few years,
shouldattemptto introduceadditionalmeasuresto stronglyimprovethe
country'sbalance-of-paymentsposition. These measuresshould aim at
enhancing the competitiveness of Malaysia's exports, reducing inter-
mediate and some consumption good imports, and strengtheningthe
services tradeaccount.Traderegulationcan contributeto the accelera-
tion of growthby promotingthe competitivenessof domestic producers
and speeding up Malaysia's integrationinto the global economy. The
analyses point to the need for exportsto grow by more than 23 percent
in orderto achieve an 8 percentgrowth rate. The challenge will be for
Malaysiato sustainits highexportgrowthrate.Thiswouldrequire,among
other things, a set of coherent and consistent export promotionpolicy
efforts. This has to be achieved in orderto convince investorsthat the
domestic marketdoes and can providevast opportunitiesfor theircapi-
tal investmentin exportindustries.In this respect,the pricingpolicy and
exchangeratepolicy must be aligned in orderto provideproducerswith
the right incentiveto exporttheirproducts.Malaysianeeds to diversify
its tradingpartner.
Fourth,an integratedinvestmentpolicy is requiredto bring about a
more balancedcapital formationas well as outputand demandexpan-
sion thatcan bringaboutdecreasingaveragecosts in the entireeconomy.
Malaysianproducersmust be bold in undertakingventuresto produce
high-qualityproductson a large scale for the world market.This can
only be achieved throughincreasingproductivity,reducingthe cost of
doing business, acquiringtechnology,andbeing more innovative.In or-
der to ensure that developmentexpenditureallocations could provide
maximum stimulus to economic growth, investmentprojectsto be se-
lected shouldbe those thathave strongstructuralandtechnologicallink-
ages with the domestic industries.Several selection criterianeed to be
used in considering these projects; priority should be given to those
projects that can generate greateruse of local inputs, create employ-
ment and export earnings,induce high local value-addedcontent, save
foreign exchange, have shortergestationperiods,and enhancethe over-
all efficiency of the economy.
Fifth, a significantpotential exists for raising tax receipts througha
broadertax base, improvementin tax administration,rationalizationof
the tax system, and the curbing of unproductiveoutlays. Such budget
reformswould allow an increasein governmentrevenueandreducegov-
ernmentborrowing.
314 JOURNAL OF POST KEYNESIANECONOMICS

Finally,improvingthe economicperformance requiresnot only do-

mesticreformsbut also skilledgovernmentmanagementof external
funds.Whilemoreexternalfinanceis essentialin makingsucha strat-
egy feasible,the governmentwill, at the sametime,haveto pay more
attentionto stimulatingnationalsaving,expandingtradecreditcreation
of newfinancialinstruments, reducingnetinterestoutflows,enhancing
effortsto limitfuturefinancingneeds,anddeepeninganddiversifying
the productionbase to help increasethe resilienceof the economyto
insulateitself againstexternaleconomicshocks.New andnovel ideas
haveto be found,evaluated,andimplemented. New strategicalliances
in trade,finance,andtechnologywithotherneighboringcountriesand
new international corporations shouldbe probed.Malaysia'sdevelop-
mentstrategyin thenextdecadeshould,therefore,be basedon a com-
promise between growth, on one hand, and increased resource
mobilization andimprovedefficiency,ontheotherhand.Thisimportant
researchareaprovidesvastpotentialfor rewardingwork,bothfor im-
mediateandlong-termbenefitsto Malaysia.Whilesomeprogresshas
been madein this areain recentyears,thereis a furtherneed now to
acceleratetherestructuring of publicenterprises
andprivatization in or-
derto reducetheirrelianceon budgetarysubsidiesandtransfers,andin
orderto promotetheiroveralleconomicefficiency.

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