Assessing the economic impact of public investment in Malaysia: a case study on MyRapid Transit project using a dynamic computable general equilibrium model

The central focus of this thesis is the question of whether public investment in transport infrastructure contributes positively to Malaysia’s economic growth and welfare. Although there are strong analytical reasons to believe that public investment spending is one of the important variables that influence growth, there remains significant uncertainty about its actual degree of influence. In Malaysia, whenever there is a collapse in domestic demand, government spending becomes an important management tool for stimulating economic growth. Therefore understanding and quantifying the effects of public investment remains important from a policy perspective, particularly in view of the fact that Malaysia’s economic growth remains well below what it was during the pre-Asian Financial Crisis, despite a high level of public spending. Furthermore, the government’s fiscal deficit has been widening and the current account is heading into deficit at an alarming rate. Motivated by these developments, this thesis investigates the implications of a large public investment in an urban infrastructure project costed at 15 billion ringgit. This project is MyRapid Transit (MRT), which involves the construction of a rail-based public transport network serving the Greater Kuala Lumpur/Klang Valley region, a region which currently has more than a fifth of Malaysia's total population and which contributes approximately 30 per cent of the nation’s gross domestic product (GDP). The project began in 2011 and is expected to be completed by 2017. Being the largest infrastructure project ever, the MRT is expected not only to enhance mobility in Klang Valley, but also to be an economic catalyst under the Economic Transformation Program for the region and for the economy as a whole. The goal of this thesis is to understand better, at the empirical level, how large public investments in a transport infrastructure project contribute to Malaysia’s economic growth and welfare. It attempts to answer three specific questions: (i) What are the impacts of an increase in investment in the transport industry during the construction phase, as well as when the transport project becomes operational; (ii) What are the impacts on the economy if the government chooses to increase personal income tax, instead of debt, to finance the transport project; and (iii) What are the conditions under which public investment has a strong and long-lasting impact on economic growth? These questions were investigated in relation to the period 2011-2025 using MyAGE, a dynamic computable general equilibrium (CGE) model of the Malaysian economy. This analytical framework was chosen because the effect of public funds is expected to stimulate domestic demand, and the study of this needs a multi-sector model that is capable of capturing the interactions of all agents in the economy (producers, investors, households, government and the export sector). Furthermore, a dynamic model was needed that could trace the long-run evolution of the economy, because investment takes time to come into effect – six years, for example, in this MRT project. To the best of my knowledge, this is the first time the impact of a publically financed infrastructure project in Malaysia is assessed using a general equilibrium model. Assessing what role public investment spending has played in a short-and long-run economic growth context may also be relevant to other sectors and other countries. In CGE analysis, the impact of a policy is assessed against a business-as-usual baseline, which means the forecast for the development of the economy without application of the policy under consideration. An important part of this thesis is the construction of a plausible forecast for the Malaysian economy for the period 2011-2025. To that end, I first conducted a historical analysis of the economy during the period 2006-2011. Through the historical simulation unobservable structural changes, such as changes in technology and consumer preferences, are uncovered by observed changes in economic variables. Results from the historical analysis are used to inform the forecast for the period 2012-2025, alongside other independent forecasts for the economy. After constructing the baseline, I conducted three policy simulations to investigate the aforementioned research questions. Key results from the analysis are as follows. First, in the short run, the most dominant impact of public investment in the MRT project is higher employment, generated mainly by demand from construction-related industries. This results in an average deviation from real GDP of 0.015 per cent above the baseline per annum for the period 2011-2013. However, the increase in investment demand causes a real appreciation of the Malaysian ringgit, which has an adverse impact on the export sector. Toward the later part of the construction phase (or in the medium term) the real GDP contracts due to lower capital stock in the economy, which is mainly due to the deterioration of the export sectors that are capital intensive. Once the MRT project comes into operation, the economy starts to deviate positively as a result of an increase in capital stock, as the additional investments in transport industry are now transformed into effective capital. However, with no positive externalities, the positive impact of public investment on economic growth will diminish over time, mainly due to the trending down of labour and capital towards the baseline in the long run. Second, the way through which the government chooses to finance public investment (borrowing or taxes) will have different influences on economic growth and welfare. If we assume that public investment is financed via debts, then the large investment spending in the infrastructure project causes excessive strain on the federal government budget, resulting in expansion of the fiscal deficit. In addition, the current account faces deficit due to deterioration in the trade account, as well as high debt service payments. As a result, throughout the simulation period of 2011-2025, the Malaysian economy will face twin deficits; that is, (i) a fiscal account deficit, and (ii) a current account deficit. If the government decides to raise personal income tax to pay for the project to ensure that the fiscal position remains unchanged during the period under study, then there are likely to be improvements in the trade account, as most of the nation’s outputs are exported. The increase in exports would be due to lower domestic consumption resulting from the lower level of household disposable income. Consequently, part of the net foreign liabilities would be eliminated. Nevertheless, an increase in the personal income tax rate would have a diminishing effect on household disposable income by causing the post-tax real wage to fall. Therefore, taxation on income would narrow the deficit in the fiscal account and reduce the accumulated net foreign liabilities, but have a diminishing effect on household disposable income and consumption. Third, if there are positive externalities with the implementation of the new transport project, such as an improvement in productivity via external economies of scale from spatial concentration in economic activities, then public investment would contribute significantly to economic growth in the long run. In this case, public spending on the MRT project would contribute to economic growth not only through its direct impact by increasing investment demand and capital stock, but also through indirect impact by creating a positive spillover effect. With the improvement in productivity, GDP expands significantly and net foreign liabilities are eliminated by large trade surpluses and large increases in national savings. The government fiscal position would also improve with a higher collection of revenue as the economy expands significantly and as interest payments on government debt are reduced. This indicates that if there are positive externalities induced by public investment, then there would be no need for government to use taxes to pay for the project. Simulation results show that the net present value of real GNP, at a 5 per cent discount rate for the duration of the 15 years from 2011-2025, would be about 6 trillion ringgit for the scenario with productivity improvement. In contrast, if the project does not bring about productivity improvement, the real GNP would be -0.2 trillion ringgit when the project is financed by debts and 0.1 trillion ringgit when it is financed by labour income tax. In summary, the results show that public investment would have a permanent positive effect on economic growth and welfare if it induces positive externalities such as productivity improvement. Otherwise, it would only act as a pump-priming tool to promote economic growth in the short run by creating higher employment. It was estimated that with positive externalities, the investment in the MRT project, which cost about 2 per cent of GDP in 2011, is expected to contribute about 1 percentage point per annum to the real output growth during the period 2018-2025. Furthermore, the debt incurred to finance the project would be eliminated naturally with large trade surpluses. Therefore the existence of positive externalities is essential in determining if a public investment is worthwhile.