KUALA LUMPUR, Oct 9 (Reuters) Spoilt by a diet of state spending and protection, Malaysia's economy has lost its sparkle, but reforms to revive growth and cut public debt may mean dumping affirmative-action policies that underpin government support.
State intervention has helped transform Malaysia from an agrarian backwater into a manufacturing hub, but growth has faltered this decade and some economists urge market-based reforms, with less protection for majority ethnic Malays.
''The current leadership has yet to embrace ideas of reform,'' said Bridget Welsh, a Southeast Asia specialist at Johns Hopkins University in the United States.
''The government is not willing to engage in the reforms that would work for the overall interest of domestic capital, increasing competitiveness, due to political insecurity and the mistaken impression that government spending is needed for the Malay community.'' As part of efforts to narrow the wealth gap with ethnic Chinese, Malays have enjoyed preference in jobs, education and business for over 30 years, a policy that has underpinned support for the ruling party of Prime Minister Abdullah Ahmad Badawi.
Many Malay businesses have relied on state contracts to succeed, putting pressure on the government to keep spending.
But economists say a rethink may be needed.
Annual economic growth was about 10 percent in the middle of the 1990s, powered by an industrialisation drive, but it has slowed to around 5 percent since the Asian economic crisis of 1997/98, and other Asian countries are now more competitive.
Malaysia is expected to draw an average .8 billion a year in foreign direct investment in 2007-2011, which is more than Indonesia and Vietnam but less than Hong Kong, Singapore and Thailand, the Economist Intelligence unit estimates.
Efforts to build up its Islamic finance sector -- its Islamic bond sector has been a notable success -- may require loosening restrictions on foreign investors.
Three Middle Eastern banks -- Kuwait Finance House
<1120.SE> and Asian Finance Bank -- operate in Malaysia.
Foreigners are keen to have a bigger slice of the market but they are only allowed to own 49 percent of an Islamic bank and the central bank has indicated it wants to encourage strategic alliances rather than give out more licences.
A recent relaxation of capital controls was applauded by investors, especially from the Middle East, but was not enough.
''For Islamic finance investors, the banking side offers them very limited opportunities and organic growth is quite costly and time-consuming,'' said Rafe Haneef, Citigroup Asia's head of Islamic banking.
The government has relaxed the affirmative action policy for foreign firms investing in a 5 billion development zone in southern Johor state, exempting them from a ruling requiring a Malay partner, but again investors want more.
''Inevitably it must stifle private sector activity,'' said Vishnu Varathan, an economist with Forecast Pte Ltd. ''Whatever the sentiments behind it, how it would be viewed from a business perspective is just protectionism.'' One aspect of the affirmative-action policy -- Malay-owned firms have priority on government contracts -- has proved to be a stumbling block in negotiations between Malaysia and the United States on a free trade deal.
DEFICIT PROBLEMS Budgetary problems also argue for a new approach.
State spending has helped cut the number of people living in poverty in Malaysia to just 5.7 percent of the population from more than 50 percent in the 1950s.
But, after a decade of heavy spending, Malaysia's fiscal deficit as a percentage of GDP is the highest in Southeast Asia.
It hit 5.5 percent in 2000 and even if the government expects it to fall to 3.1 percent in 2008 from 3.2 percent this year, it is making no promises on when it will balance the budget, saying a sharp reduction in public spending could hurt economic growth.
''Government spending was quite important in the early part of this decade when the economy went through a bad patch,'' said Manu Bhaskaran, head of economic research at Centennial Group.
High oil prices have helped -- a major non-OPEC exporter, Malaysia gets a third of state revenue from oil -- but have also allowed Malaysia to get away without structural reforms.
In the 1980s, long-time Prime Minister Mahathir Mohamad launched a privatisation drive involving the telecommunications, shipping and media industries to trim public spending, but the 1997 Asian financial crisis threw a spanner in the works.
Early in his four-year-old administration, Abdullah tried to wean the economy off government spending, asking the private sector to lead growth and slashing public expenditure on big infrastructure projects.
But as building jobs dried up, grumbling from Malay contractors threatened to split the ruling party and the prime minister recanted, announcing multi-billion-dollar development plans, led by state money.
Kuala Lumpur keeps a tight hold on the corporate sector -- state-linked firms account for a third of the 6 billion stock market -- and this reduces incentives for entrepreneurs.
''Government-linked companies are competing with the private sector for projects,'' said Mohamed Ariff, who heads the Malaysian Institute of Economic Research, an independent think tank. ''They tend to crowd out private investment.'' REUTERS SR RAI1147