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* Vote on Malaysia's prospects sees "brain drain"
* Malaysia sets very ambitious investment targets
* Affirmative action policy prompts talent exodus
* Policy reform needed, but will be political risk
By Bill Tarrant
PUTRAJAYA, Malaysia, July 7 (Reuters) - Dr. Mahathir Mohamad sits at a vast desk cluttered with work, hands clasped before him and looking at his visitors with a slight smile.
Dr. M, as he is popularly known, was prime minister of Malaysia from 1981 to 2003, the first commoner to ever hold the post in a land with nine sultans. His demeanor suggests the country physician he once was, ready with a frank diagnosis -- and in his first interview with the foreign media in five years, he doles out prescriptions for what ails his nation.
The man who made Malaysia part of the "East Asia Miracle" with a massive inflow of foreign direct investment doesn't think much of it today. The former miracle economy, now a muddle, needs a new policy direction, he says in his office in Putrajaya, the administrative capital he built on old plantation land in the 1990s.
"We should not be too dependent on FDI anymore," says Mahathir. "We've come to the stage when locals can invest. They have now the capital. They have the technology. They know the market. And I think they can manage big industries."
His thinking is at odds with government policy. But it gets to the heart of a debate over the future of Malaysia, a former emerging market star now in danger of becoming an also-ran, stuck in the dreaded "middle income trap."
Foreign investment has been dwindling since the onset of the 1997-1998 Asian financial crisis. Capital outflows have even exceeded inflows in four of the past five years. This has been accompanied by an alarming "brain drain" of emigres voting with their feet against Malaysia's prospects.
Malaysia is counting on foreign investment to provide a quarter of the investments needed to fund projects under its "Economic Transformation Programme," which aims to turn the country of 28 million into a fully developed nation by 2020.
That comes to an average of more than $11 billion a year, compared with an average of $3.1 billion since 1997 -- by any measure an ambitious target.
The challenge is vastly more complicated by the exodus of talent that hits directly at Malaysia's aspiration to become a high-income nation focused on knowledge-based industries.
"For Malaysia to stand success in its journey to high income, it will need to develop, attract and retain talent," the World Bank said in a March report. "Brain drain does not appear to square with this objective: Malaysia needs talent, but talent seems to be leaving."
The rise of China and India in the region has overshadowed the export-dependent "Tiger Cub" economies of Southeast Asia, all struggling with their own reforms. Thailand has been at a dangerous political impasse for six years. Indonesia is consistently ranked as among the world's most corrupt countries. The Philippines is battling long-running insurgencies.
Yet Malaysia does not compare well with its peers in the eyes of investors. A March report by Bank of America Merrill Lynch ranked Malaysia the second least popular market after Colombia among global emerging market fund managers and tied with India for least favourite among Asia-Pacific managers.
A chief difficulty is the nation's balky affirmative action programme.
Ethnic Chinese account for most of the brain drain. The reason 60 percent of them gave for why they moved out of the motherland was "social injustice", a World Bank survey says.
They are referring to the "Bumiputra" (sons of the soil) policy that discriminates against Chinese and Indians, who account for a third of the population, in favour of majority Malays for all kinds of things -- places in universities, jobs, shares in companies, home mortgages, government contracts.
The government acknowledges the policy has been widely abused, with Malay front men offering their names to Chinese businesses to obtain government contracts, an arrangement known as "Ali Baba", after the character in Arabian Nights who gains entrance to the treasure cave of the 40 thieves with the magic words "Open Sesame".
Prime Minister Najib Razak has launched a new edition of the policy called the New Economic Model that is meant to correct the inequities, mainly by making preferences need-based and not race-based. But as the World Bank report noted, "limited headway has been made on this front."
It is certainly not popular with the rank and file Malays in Najib's UMNO party.
Making significant reforms to the system is crucial to Malaysia's aspirations, but any rollback of privileges for the majority is a big political risk for any government that tries it.
It is the Malaysian dilemma.
Idris Jala, the minister in charge of greatly boosting investment and wooing back emigres under the Economic Transformation Programme (ETP), calls it the impossible game.
He is an unlikely character in the Malaysian Cabinet, a Christian from the Kelabit tribe in Sarawak on Malaysian Borneo who spent most of his career running companies, including the Malaysian unit of Royal Dutch Shell RSDs.L and Malaysia Airlines .
"I am a true believer that real transformation goes hand in hand with the game of the impossible," Idris says in an e-mail interview. He sets impossible targets, is "very directive" and pushes his team constantly "to do the right things, but differently" until they are finally "one step ahead of you".
"When you do transformation, you cannot achieve big results by democracy," he notes.
The ETP aims to attract 1.4 trillion ringgit ($466 billion) by 2020 in a dozen broad industries. Only 8 percent of that will come from the government, which has long dominated the economy, either directly or through government-linked firms. Idris disclosed to Reuters that foreign investment will account for 27 percent of the total.
He wants to climb the value ladder in the targeted industries.
Take birds' nests, for example. Nests made with the saliva of swifts have been collected for centuries from huge limestone caves in Idris' home state of Sarawak to make the most expensive soup on earth. Processing them would give Malaysia a bigger chunk of a global market worth $3.3 billion, he said.
Foreign investment will also provide many of the 3.3 million jobs that will be created under the ETP, whose over-arching goal is to raise per capita income to $15,000 from $6,700 in 2009.
A challenge will be to upgrade skills in a labour force long geared to basic manufacturing and plantations, attract foreign talent, and try to reverse some of the "brain drain." About 700,000 Malaysians work abroad.
A new agency called "Talent Corporation" has been given this task, offering tax breaks for Malaysians to return home and easing visa restrictions for foreigners.
But the shift from low-cost manufacturing and plantations to more knowledge intensive work needs to take place in an environment where creativity and freedom of inquiry can flourish to draw talent and investment. The Malaysian model of ethnic preferences has not been conducive to that.
Mahathir remains a towering figure. In public forums and in his blog, he is a scourge to the government of the day, influential, for instance, in forcing the early retirement of his anointed successor, Abdullah Badawi. But while he's a critic of his successors, he is a strong defender of the Malaysian system he built.
Mahathir came to office as the foremost champion of Malay privileges. Under his administration, the "Bumiputra rules" led to a mingling of politics and business that largely benefited a coterie of Malay and Chinese businessmen.
Huge government building projects kept the contracts flowing and