Can Economic Convergence be Predicted? This is a Case Study on Malaysia and New Zealand.

Introduction

Economic convergence is the process where poorer economies grow at a faster rate than richer economies in terms of income per capita. Economic convergence is predicted by the Solow Model, which analyses the changes in level of output determined by population growth, savings rate, and technological progress. However, the main limitation of this model is that it does not include elements that influence the GDP per capita growth in the long run (Barro, 1996). Intuitively there may be other factors that can affect the growth in income per capita which were not included in the Solow model, like education and healthcare.

Therefore, in this paper, I first seek to study the prevalence of economic convergence between two countries, New Zealand and Malaysia; in which New Zealand has a relatively higher income per capita. The reason New Zealand was chosen as the richer economy, instead of economies like the US and countries in the Euro Area, is because of its relatively closer geographical size and proximity to Malaysia. The GDP per capita will be used to measure income per capita of each country. Next, a detailed analysis was carried out on the relevance of the Solow Model to real-life data to see if the model fits today’s economy. Lastly, I attempt to identify and explain the different factors that the Solow Model lacks, such as the level of education, health and life expectancy, presence of corruption, and the ease of doing business that could affect the growth rate of GDP per capita.

This paper concludes that economic convergence is indeed prevalent between these two countries, just as the Solow Model predicted, in addition to other different factors that show positive correlation. Based on these findings, I analysed the key factors that are vital in developing the economy and put forward recommendations for the development of the poorer economy.

1.0 Economic Convergence is Observed

From 1981 to 2018, New Zealand had a higher GDP per capita than Malaysia (IMF Data, 2019). Although the GDP per capita has increased for both countries over the years, the gap between the two countries seems to be narrowing from 1997 onwards. When compared on a logarithmic scale, as shown in Figure 2, the shrinking gap between GDP per capita between both countries can be clearly seen, which implies that Malaysia is catching up to New Zealand in terms of GDP per capita.

2.0 Relevance of the Solow Model

The Solow Model states that a higher saving rate will result in higher investment, hence increasing the capital-labour ratio to a higher steady state. Malaysia consistently has a higher saving rate than New Zealand (World Bank, 2020), so we would expect the GDP per capita to grow faster for Malaysia than for New Zealand, heading for an economic convergence, thereby confirming the Solow Model.

However, only about 60% of cross-country variation in GDP per capita could be explained by the basic Solow Model (Nonneman & Vanhoudt, 1996). In fact, variables that are often excluded from growth models play a substantial role in determining GDP growth in the long run (Marattin and Salotti, 2011). For instance, a more stable macroeconomy, a more flexible microeconomy, and changing workforce characteristics, such as education participation, contributed to the economic growth in New Zealand (Carroll, 2012); yet they were not included in the Solow Model. Therefore, there is a need to study the different factors that might have a causal relationship with economic growth.

3.0 Other Factors that Affect the Growth Rate

3.1 Level of Education shows Positive Correlation with Growth Rate

Studies over the past two decades have shown that education is positively correlated with economic growth (Daren, 2007). Compared over 28 years from 1990 to 2018, Malaysia has shown a bigger percentage increase in its mean years of schooling, compared to New Zealand. This suggests that the quantity of education received by Malaysians has increased drastically, which is reflected in the higher growth rate.

 

Year

MalaysiaNew Zealand
MathematicsReadingScienceMathematicsReadingScience
2012421398420500512516
2018440415438494506508

 

Table 1 shows that New Zealand’s PISA test scores are consistently above Malaysia’s across all 3 categories (OECD, 2019). Upon further inspection, Malaysia’s test scores have improved since 2012, whereas New Zealand’s have worsened in each category. With that said, the quality of education is improving in Malaysia, whereas it is deteriorating in New Zealand.

Another measure for quality of education is the pupil-teacher ratio. The pupil-teacher ratio for secondary education in New Zealand in 2017 is 13.63, whereas it is 12.28 in Malaysia (UNESCO, 2019). This means that the average class size is smaller in Malaysia, which allows more teacher attention towards the students, signalling a higher quality of education. The country’s investment in education, especially in its teachers, has proved fruitful in producing better test performances.

3.2 Health and Life Expectancy Grows Faster in Malaysia

Bloom, Kuhn and Pretner (2018) suggested that there is a well-established positive correlation between health and economic growth. Improvements in health are shown to increase economic output through labour productivity and capital accumulation (Bloom, Canning & Sevilla, 2004).

Figure 5 shows that New Zealand persistently has had a higher life expectancy than Malaysia since 1981 (World Bank, 2020). However, the life expectancy of Malaysia is increasing and rated above the world average of 70.5 years (CIA, 2020), indicating a rise in the quality of health.

Another indicator for health is the percentage of the population that has access to basic sanitation services, which reduces the chances of contracting diseases linked to unhygienic environments. Since 2011, more than 99% of Malaysians use basic sanitation services (World Bank, 2020), demonstrating the high quality of health in the country, which contributes to its higher growth rate.

3.3 Malaysia Improved in Corruption and Ease of Doing Business Indexes

Corruption is said to reduce investments, hence slowing down growth (Mauro, 1995). Interestingly, political instability is the most important channel through which corruption affects economic growth (Mo, 2001). In 2018, New Zealand was ranked the 2nd least corrupt country with a score of 87/100, whereas Malaysia was ranked 61st with a score of 47/100 (Transparency International, 2019).

Besides, the ease of doing business in a country has a statistically significant effect on its economic growth (Adepoju, 2017). Although it is easier to do business in New Zealand, Malaysia’s score has improved tremendously from 2010 (Doing Business, 2018). With increasingly lower barriers to entry, Malaysia would be closer to achieving a perfect competition market which allows for allocative efficiency that maximizes social welfare and subsequently encourages economic growth.

4.0 Analysis and Recommendations

New Zealand is identified as a high-income country, whereas Malaysia is an upper-middle income country (World Bank, 2020). Evidently, Malaysia’s existing state of progression will be sufficient to catch up with New Zealand’s economy based on the narrowing gap between both countries as seen in Figure 1. The impressive improvement in Malaysia’s education sector is strong evidence that there will be economic convergence. This section will justify why education is the key factor in explaining the narrowing gap between each country’s GDP per capita, and how the level of corruption must be reduced to expedite the process.

Although technology is widely known as the main driver of economic growth, education is just as important, if not more, in developing a country. In fact, the positive effect of technological advancement on economic development might be caused by education level, a potential instrumental variable. To illustrate, I prepared a simple diagram as shown.

It is logical to propose that education affects the level of technological advancement in the country especially in thecreation, innovation, maintenance and operation of technology. Moreover, education has a direct impact on economic development through the improvement of human capital, thus increasing productivity of the workforce.  Hence, more emphasis must be placed into improving the level of education, which may involve initiatives such as increasing investments. Further, the investments in education must be done optimally to achieve maximum returns on education, propelling the economy forward. For instance, Malaysia could allocate funds into the correct channels to ensure that equal education rights are provided across different socio-economic status and racial backgrounds. In summary, the importance of education in stimulating economic growth should be recognised, and appropriate measures must be taken to address the issue.

Besides, the corruption indicator effectively explains the large gap between both countries. Although Malaysia’s GDP per capita is on track to reach a high-income nation status, its poor performance on the corruption perceptions index might hinder its progress. Economic initiatives will not be efficiently executed in this environment. For example, taxpayers’ money will not be fully utilised for the welfare of the country because a portion of it will be mishandled. Corruption also incentivises unnecessary infrastructure development, which will affect the country’s economic growth in the long term. Moreover, the presence of corruption inherently affects the political stability of the country which in turn impedes economic growth. Political instability in a country will cause the economy to slow down due to lower business activities, a drop in investments and poor market sentiment arising from uncertainties about the government and the policies implemented. Consequently, there is a risk of foreign capital flight away from Malaysia, as foreign investors are more likely to invest in a country with a more stable government.

Conclusion

This paper maintains an optimistic view of Malaysia’s goal of reaching the same level of economic development as New Zealand. The importance of education must first be acknowledged, and moving forward, a blueprint must be developed and executed to enhance the level of education exponentially. Also, the political maturity of the nation must improve to avoid supporting populist policies that might offer short term solutions, but ultimately detrimental to the economy in the long run

Writer: Lee, Yang Ler

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