Sustained rapid and inclusive economic growth for half a century has brought Malaysia close to the threshold of high-income status.

The economy has achieved an impressive average yearly growth of over 6% since the 1960s. Malaysia has been ahead of regional peers in terms of per capita incomes and has been able to consolidate this lead (Figure 1). While incomes were only one-third of the World Bank’s threshold for high-income countries in 1989, it is set to surpass that threshold by 2028.

Significant policy reforms in the 1980s allowed Malaysia to attract large inflows of foreign direct investment, turning it into a global chips and electronics manufacturer. Growth and productivity could be strengthened further by easing restrictive regulations and creating a more level playing field between state-owned enterprises and private firms. This would bring particular benefits for services and for small and medium enterprises.

With higher incomes, however, surging demands for better public services require different policies from those that were successful in the past. The public sector will have to deliver more and become more effective, which calls for improved economic governance.

Filling the substantial gaps in the current social protection requires increased expenditure. Population ageing will add to these pressures, as an increasing share of the population will be unable to provide for their own basic needs. The transition to a greener and more sustainable economy also calls for large investments. Providing solid financing for these spending needs by mobilising additional tax revenues is likely to be one of the major challenges in coming years, and an area where visible progress has yet to materialise.

Growth is accelerating, mostly driven by expanding domestic demand. Exports are set to rebound amid stronger external demand. Inflation has fallen below historical averages and but is expected to rise as energy subsidies are withdrawn.

The economy has shown resilience in the face of shocks, including the pandemic, supply chain bottlenecks and the economic implications of Russia’s war of aggression against Ukraine. Amid weaker export demand in 2023, growth has been driven by domestic consumption, supported by low unemployment (Table 1).

Both headline and core inflation fell below 2% in the latter part of 2023 following an acceleration in 2021-22. Inflation is expected to remain moderate amid easing global supply constraints and commodity prices, despite the necessary withdrawal of energy subsidies.

Growth is projected to reach 4.9% in 2024 and then 4.7% in 2025. Buoyant domestic demand and new opportunities in technology-intensive sectors and the expected rebound in exports will encourage private investment despite higher financing costs. Export developments are subject to geopolitical risks, which could affect Malaysia’s economy given its strong exposure to foreign markets.

Monetary policy tightening has led to a broadly neutral policy stance. Monetary authorities started a tightening cycle in 2022 as inflation approached 5%, driven by global energy prices and currency depreciation. With inflation near its 2% long-term average, the current monetary policy stance seems adequate and provides room to accommodate a temporary increase in inflation as energy subsidies are withdrawn. At the same time, monetary authorities should stand ready to raise rates to counter possible second-round effects from higher energy prices.

The new fiscal framework provides a good basis for the needed fiscal consolidation, but rising spending needs require mobilising additional tax revenues.

Fiscal policy started to consolidate as growth recovered from the pandemic shock (Figure 2). However, one obstacle to more decisive progress has been a threefold rise in subsidies to 3.5% of GDP in 2023. While government spending has risen, tax revenues remain low at around 12% of GDP. Spending needs could be most efficiently financed by raising additional revenues through a well-designed value added tax, a broader personal income tax base and improvements in tax administration.

The 2023 fiscal framework is a major step towards stronger fiscal accounts, maintaining a prudent debt level and more effective fiscal risk management. The underlying institutional framework, however, could be made stronger by expanding the fiscal framework to cover the consolidated public sector and contingent liabilities.

Improving the targeting of social protection while raising social assistance coverage and benefit levels would allow stronger reductions of poverty and inequality. Better access to childcare and a better alignment of tertiary education curriculums with labour market needs would allow more workers, including women, to participate in the labour market and find jobs that match their skills.

Strong growth has propelled impressive social progress over recent decades. But public policies could do more to provide better opportunities for all. The impact of taxes, transfers and subsidies on inequality is less than in peer economies (Figure 3). Benefit levels are often too low to make a real difference for the livelihoods of vulnerable households.

Social assistance is fragmented and poorly targeted. Different programmes are managed by multiple agencies at different levels of government, leading to benefit duplication. Subsidies are particularly ineffective as a social policy tool, as more affluent households receive a larger share of the subsidies than those at the bottom of the income distribution. Shifting social spending from subsidies to well-targeted and unified social assistance benefits would support improvements in social inclusion.

Pension coverage is narrow and inadequate. More than 60% of the population are not covered by any pension scheme, and those who are often fail to receive a decent pension. Rapid population ageing will reinforce the need for stronger and more sustainable pensions. Non-contributory social assistance pensions could help fill current coverage gaps in the future, but they currently have low coverage and low benefit levels.

Labour market reforms could improve job quality and strengthen productivity. Many people, particularly recent tertiary graduates, work in occupations that do not match their skills. Better alignment of tertiary education with labour market needs, a reorganisation of vocational education and training and more investment into adult education could help to reduce skills mismatches. Strengthening collective wage bargaining institutions may help to give workers and employers a more equal voice in negotiations and accelerate slow wage growth.

Informality affects more than one in four workers in Malaysia, particularly older and less educated ones. Stronger enforcement could be coupled with improved incentives, such as less rigid labour market regulations and exempting low-wage workers from mandatory contributions to contributory old-age pensions.

The gender employment gap is high. Improving access to affordable childcare facilities would allow more women to work. Women outperform men in tertiary enrolment, but remain underrepresented in management positions, despite some encouraging recent trends among listed companies.

Addressing climate change requires phasing out fossil fuel subsidies and a stronger role for carbon pricing, complemented by stricter regulations. Better disaster risk financing and insurance could bolster adaptation efforts.

Mitigation efforts should rely on both carbon pricing and regulation. Malaysia currently has no mandatory carbon pricing measures or fuel tax. Instead, subsidies have encouraged energy consumption and promoted rising emissions (Figure 4). A gradual introduction of carbon pricing through taxes or emission trading systems could be complemented by more stringent regulations, while targeted transfers could cushion their social impact and facilitate political support.

The energy sector remains the largest source of emissions. Electrification and renewable energy sources will need to be expanded.

Malaysia faces significant climate risks including floods, heat waves and storms. Developing a strategy for disaster risk financing and insurance could strengthen resilience.

Average productivity in micro, small and medium enterprises is low. Changes in regulations, finance and digitalisation can help, while current policy support for MSMEs is fragmented and often narrowly focused.

Malaysia has hundreds of programmes to support MSMEs, many of which are targeted based on sectors, location or ownership. Scaling up MSMEs is a key to increase their productivity, but it is difficult to determine which firms will be able to achieve high-growth episodes. Risks associated with policy mistakes would be minimised by shifting the focus towards creating framework conditions that enable a wide range of firms to achieve stronger growth.

The ability to harness digitalisation is a distinctive feature of firms that scale up. For MSMEs, digitalisation is a game-changer, allowing them to compete on a more even footing with larger firms. Stronger competition in telecommunications could improve the limited take-up of digital solutions among MSMEs.

MSMEs lag behind with respect to innovation and technology. Only 6% of small firms and 20% of medium-sized firms invest in R&D. Better access to government research institutes and tax incentives could promote R&D among MSMEs.

Successful export activities are often a good predictor of MSMEs’ ability to scale up. Relative to regional peers, fewer of Malaysia’s small firms manage to export (Figure 5). The potential benefits of recent trade agreements for MSME exports could be maximised by reducing remaining trade restrictions in telecommunications, computer and digital services to improve access to competitively priced services inputs.

Obtaining financing is usually more complicated for MSMEs than for larger firms, reflecting limited collateral and credit histories. Malaysia uses direct lending and credit guarantees to alleviate financing constraints for MSMEs. Despite their merits, these may create incentives for over-reliance on public financing options and may delay the exit or restructuring of nonviable MSMEs, thus limiting the scope for the entry of new firms and the expansion of innovative firms. Fostering venture capital and equity crowdfunding would help MSMEs grow.

Burdensome regulations can limit MSMEs’ ability to scale up and challenge larger incumbents. Compliance costs with licenses and permits, estimated at 2.3% of GDP, fall disproportionally on smaller firms and can be an obstacle to formalisation. Malaysia’s product market regulations are more restrictive than in peers, limiting competition and entry. Further regulatory reforms to ease these barriers would strengthen competition, especially in services such as retail trade.

A large state-owned enterprise (SOE) sector remains an obstacle to competition, particularly for MSMEs. Preferential treatment and subsidies can crowd out private investment, especially in industries where SOEs are dominant. Fear of state expropriation may prevent some firms from scaling up. Levelling the playing field between SOEs and private firms would support growth prospects for MSMEs.