With just over 600,000 cars sold in 2010, Malaysia is Southeast Asia’s largest car market, and production of cars and components is a crucial part of its industrial structure. But despite—or perhaps because of—its active industrial policy, Malaysia has so far failed to establish an internationally competitive car industry.

Recent privatization of Malaysia’s largest car company, Proton, previously a flagship state enterprise, could herald real change, but much more is needed to rejuvenate the country’s ailing automobile sector. Developing countries can learn many lessons from Malaysia’s experience as they seek to industrialize their economies.

Spare the Rod of Competition, Spoil the Industry

Malaysia’s car market is dominated by two manufacturers, Proton and Perodua, which together account for 57 percent of sales. The larger of the two, Proton, accounts for about 26 percent of sales and operates a virtual monopoly in the range of mid-size, mid-price cars. The rest of Malaysia’s automobile market is crowded with many assemblers of imported cars focused at the upper end of the price range and producing well below economic scale.

While Malaysia’s manufacturing sector is largely open to foreign investment and international competition, a number of policies are in place to protect Proton. True, import tariffs on assembled cars and car components from ASEAN countries have been reduced owing to Malaysia’s obligations under ASEAN’s Common Preferential Tariff Scheme. But hefty differential (effective) excise taxes levied on car manufacturers—ranging from 60 to 125 percent, depending on car size—continue to give the two large domestic manufacturers a decisive cost advantage.

Other ways in which Malaysia protects the two incumbent domestic manufacturers include high import tariffs on cars from non-ASEAN countries; investment licensing restrictions¹; an import ban on reconditioned parts and used vehicles more than five years old; and a variety of tax exemptions. Proton’s annual accounts, in addition, show that the company’s after-tax net income is higher than its before-tax net income, suggesting that it is a net recipient of government subsidies.

The most recent available estimate of the effective rate of protection for the automobile industry is 57 percent—for every dollar of value added at international prices, domestic manufacturers receive the equivalent of $1.57 in the domestic market. This makes the automobile sector the most protected within Malaysian manufacturing.² Not surprisingly, recent estimates indicate that Proton cars sold in the domestic market are significantly (in some cases, 50 percent) more expensive than the same cars sold in export markets where they have to compete head-to-head with global brands.

Despite the considerable financial and political support it enjoys from the government, Proton has been struggling to retain market share in recent years. Production has declined to about 45 percent of capacity, and over the last five years, the company has experienced a cumulative loss.

The main reasons for Proton’s poor performance include a protected domestic market in which it acquired a dominant share by the late 1980s; continued government backing; preferential treatment of Malays for component supplies, employment, and senior leadership positions in the company; and the struggle to keep up technologically with competitors.

Across the industry, these factors contribute to low-quality cars, low export levels, and relatively small production runs, resulting in high unit costs, which make it virtually impossible for Malaysia’s car companies to compete internationally without government support. Malaysia’s lagging automobile sector stands in sharp contrast to Thailand’s, which has emerged as the “Detroit of the East” through its open trade and investment policies and its welcoming stance toward multinationals.

The Privatization Decision

In January, Malaysia’s sovereign wealth fund, Khazanah, announced that it had sold its nearly 50 percent stake in Proton to DRB-Hicom, a large Malaysian conglomerate. The move was initially viewed as a reformist effort on the part of Prime Minister Najib Rezak, who is seeking to polish his record in advance of the upcoming elections. But there is reason to believe that Khazanah’s divestiture may not be a stepping stone to more fundamental changes.

The selection of DRB-Hicom’s bid was apparently influenced by the government’s desire to keep the company in Malaysian hands. The new owner agreed to pay 1.3 billion ringgits, or the equivalent of 5.5 ringgits per share—only slightly more than half of the company’s net asset value (9.7 ringgits per share)³—even though more lucrative foreign bids were received.

The decision to accept DRB-Hicom’s bid likely also had a political rationale. The conglomerate is controlled by Syed Mokhtar AlBukhary, Malaysia’s eighth-richest man, who has a net worth of $2.5 billion and is a significant contributor to Mr. Najib’s political party as well as a member of the prime minister’s inner circle.

Lessons for and from Malaysia

Privatizing Proton is, to be sure, a promising move toward improving the domestic car manufacturer’s efficiency. The door is now open to new partnerships with global brands, which could give Proton access to the latest technologies and breathe new life into the company’s products.

Yet, if Proton hopes to secure these partnerships, the company must be free to choose its suppliers and employees without outside interference. Moreover, Proton will have little reason to improve its technological capabilities and efficiency if the existing regulatory framework remains unchanged and the company continues to receive the same largesse from the state that it has enjoyed since it was established.

In short, in the long run, Proton’s divestment by itself will not make the company more competitive internationally.

Proton’s sale needs to be followed by measures allowing all car manufacturers, domestic and foreign, to attract the finest talent and source the best components from the most efficient and reliable suppliers, permitting competition on a level playing field. In addition to giving Proton access to attractive partnerships and boosting its international competitiveness, Malaysia’s entire automobile sector will be revitalized as it becomes more attractive to foreign investors and more capable of producing at economic scale. Malaysia could even become Southeast Asia’s automotive production hub. Nearby Thailand and India are prime examples of the benefits Malaysia could reap by liberalizing its automobile sector.

Malaysia’s experience with its automobile sector holds important lessons for middle-income developing countries considering industrial policy as a means of nurturing new globally competitive industries and firms. First, this is arguably a high-risk strategy; very few countries have implemented industrial policies successfully. Second, any protection should be signaled from its inception as being temporary, with a clear timetable for withdrawal. Third, industries, not firms, should be targeted for support. Fourth, firms should be encouraged to achieve economies of scale by exporting and should be given the freedom to access the talent and components they need. Finally, without policy reforms that promote competition, privatization merely transfers economic rents from the public to the private sector.

Proton’s example is emblematic of efforts by several developing countries that have used state ownership and protective policies to push industrial policy objectives. But when such “infant-industry” policies fail to deliver, privatization alone is not the answer. It must be accompanied by a broader commitment to dismantle protective policies and promote competition to ensure further development is internationally competitive and builds on the country’s comparative advantage.

Vikram Nehru is a senior associate in the Asia Program and Bakrie Chair in Southeast Asian Studies.

^{[1]. For example, all investors need to obtain approval permits, but the process for doing so lacks transparent guidelines, and the WTO has deemed it noncompliant with WTO requirements.}

^{[2]. The effective rate of protection for a product measures the effect of the entire structure of import tariffs, including the tariff equivalent of nontariff trade barriers, on the value added to a product in a domestic plant.}

^{[3]. The net asset value per share of the company was taken from its 2010 balance sheet and income statement.}