What matters is economic growth that can be sustained

TheEdge Online | What matters is economic growth that can be sustained               
Written by Chan Huan Chiang   
Monday, 14 February 2011 11:22

Penang’s excitement about topping, for the first time, Malaysian Investment Development Authority’s (MIDA) investment list by getting RM12 billion out of the total RM47 billion of investment the country received in 2010 is only natural. Penang has only 6% of Malaysia’s population but produces 8% of its GDP. To capture a quarter of total investments is indeed an achievement.

Still, at the end of the day, it all boils down to GDP. If the GDP does not perform as well, such high scores are less meaningful.

The issue at hand is that over time, rising per capita income depends on population growth, capital accumulation and technical progress. Population grows and for living standards to rise, output levels must rise even faster.

Excitement over investment numbers is caused by the connection between capital inputs and production outputs. Sir Roy Harrod in 1939 and Evsey Domar in 1946 came out with a model that says economic growth is simply investment inputs divided by the capital to output ratio (for the moment ignoring depreciation, for convenience).

Over the last decade in Malaysia, the capital-to-output ratio averaged around two — two units of capital input for one unit of output. Malaysia’s GDP today in current prices is about RM600 billion. The nation invests 22% of this money which amounts to some RM132 billion of incremental capital each year. This figure multiplied by the incremental capital-to-output ratio (ICOR) of two will thus mean an expected production output increment of about RM66 billion over the RM600 billion or nominal GDP growth of 11%. We say nominal because these figures are based on current prices as investment figures are reported this way.

The above simple reasoning to figure out GDP growth from investment numbers preoccupied economists until Robert Solow published A Contribution to the Theory of Economic Growth in 1956. Doing things differently with inputs to make output, as economists call this production function, reveals huge departures in the relationship between capital and output.

For instance, Alwyn Young in his A Tale of Two Cities: Factor Accumulation and Technical Change in Hong Kong and Singapore, compared the two. Both had similar histories: former British island colonies starting out as trading ports that went on to make textiles, then clothes, and progressed to electronics before ending up in banking and finance. In 1960, per capita GDP of Hong Kong was US$1,737 (RM5,298) and Singapore’s was US$1,580. Over the next three decades, Hong Kong grew 6.3% annually on average while Singapore grew at 7.2%. Between the two economies, however, Hong Kong puts back 20% of its GDP as investments, but Singapore needed nearly double the investment monies to milk out each dollar of GDP growth.

Output is not merely pouring inputs at the top of a device and dishing out outputs at the bottom at a fixed ratio between them. Many things can actually happen along the way. Figuratively speaking, one can shake, tap or even bang the device. Better still, use a different device altogether.

Solow looked at labour and capital data and how these relate to output, and found that not only the ratios of inputs to output vary but also the proportion of capital and labour inputs. To solve the model, an additional parameter that has nothing to do with inputs had to be added. This parameter represents the state of technology that economists today call total factor productivity or TFP.

The impact from this work gave rise to prospects of technological progress as well as potential for substituting inputs — tweaking the production process in search of optimum use of resources. For this, Solow was awarded the Nobel Prize in 1987.

Unfortunately, investment data routinely gathered and officially reported through the years by MIDA are not amenable to the above analysis. Projects that make up the RM47 billion that MIDA approved in 2010 are to be phased over different time scales. The data thus have nothing to do with the RM115 billion worth of actual investments made over the first three quarters of 2010 reported by Bank Negara (fourth quarter 2010 numbers have yet to come out). Remember, the figure for the year should be around RM132 billion.

Without growth, living standards will fall but for growth to be sustained, stability is also important. For Penang to produce 8% of the nation’s economy, it must receive at least 8% of the investments whenever they are made. This means MIDA’s data are best smoothed out over many years, such as Penang’s 25% share in 2010. If we do this and still find Penang to generally outpace 8% of total investments, it means Penang is more like capital-intensive Singapore rather than TFP Hong Kong.

What will really make regional economic news exciting is when Penang dips far below or rises well above 8% of the national GDP share. For decades, it has not happened.

Dr Chan Huan Chiang is a SERI fellow and an associate research fellow with the Malaysian Institute of Economic Research. He was an associate professor at the Centre for Policy Research, Universiti Sains Malaysia where he taught finance, econometrics and public sector economics in the School of Social Sciences.

This article appeared in The Edge Financial Daily, February 14, 2011.