Foreign direct investment and economic growth in malaysia

1.1 Introduction

Foreign direct investment (FDI) has been recognised as the key indicator of economic growth in Malaysia for the past thirty years. As a developing country, Malaysia has worked hand in hand with private sectors to accelerate the pace of industrialisation marking successful economic development. Among the ASEAN (Association of Southeast Asian Nations) countries, Malaysia has been regularly listed among the twenty five top destinations for foreign investment. The real mechanism driving Malaysia’s decision to welcome foreign investors and reliance on FDI is solely market power. Malaysia is not the first in this region to welcome foreign investors and has applied the strategy only after witnessing successful implementation of this policy in neighbouring countries.

Policy reform has contributed to the success story of rapid economic development in Malaysia starting with the introduction of Investment Incentives Policy 1968, followed by the free trade zones in the early 70s and next, the provision of export incentives together with the introduction of open policy in the 80s. The annual average FDI in Malaysia between 1985 and 1995 was close to $ 3 billion totalling to an average of 14.5% of the nation’s annual gross capital fixed capital formation and in 1996, the FDI achieved was above $ 7 billion (UNCTAD 2002). However, the annual average FDI recorded was $ 2.7 billion (UNCTAD 2002) falling over 57% from 1997. This is mainly due to the disinvestment during the Asian Financial Crisis. Malaysia’s recovery was sharp and in 1999, the annual average FDI recorded was $3.8 billion. The worldwide contraction of foreign investment in 2001 has caused annual average FDI fell to $554 million. The main investment sources in Malaysia are the United States, Japan, Germany, Taiwan, Singapore and Korea.

1.2 Problem statement

In this globalization age, FDI inflow becomes one of the major key solutions to reduce development gaps among the nations. Most of ASEAN countries have focused their economic growth on global economy. Changes in ASEAN economy system have brought to international capital flows and transactions in goods and services and also transfer of the technologies. The increasing in FDI inflow in ASEAN economy can be seems through their countries’ gross domestic production (GDP).

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However, Khine (2008) state that, FDI inflows into developing countries show a decreasing trend after the Asian financial crisis in year 1997, the economic slowdown in US and Europe and the recession in Japan. The FDI inflow into South-East Asia decreased from US$34,307 million in year 1997 to US$22,276 million in year 1998. Although there was an increase in year 1999 (US$ 28,766 million), FDI inflows into ASEAN region was decreased again to US$ 18,024 million in year 2002, (Sources: ASEAN Statistical Yearbook, 2006). These crises had weakened the ASEAN countries monetary system and leads to huge capital outflow in ASEAN. These huge capital outflow and the poor monetary system lead the currency weakening, decreasing in the export and import that also affect the decreasing and insufficient of the production.

Many investors pulled out their investment in ASEAN suddenly due to these crises and had caused many multinational enterprises in the ASEAN countries bankrupt and increased the unemployment rate because they mostly depended on FDI inflows sources countries. Economic growth in ASEAN countries especially in Malaysia was affected. This is because FDI is the main stimulator in these countries economic growth. Decreasing in FDI will also decrease their gross domestic product (GDP) and weakened these countries economic growth.

Therefore, the persistent decline in FDI together with the inability to sustain reasonable FDI inflows in Malaysia has become a major concern among Malaysian economist. The understanding of what determines FDI in Malaysia is lacking thus it is crucial to investigate the key forces that stimulates FDI inflows in Malaysia.

1.3 Objective of the study

Generally, this study aims to determine the significant determinants of foreign direct investment (FDI) inflow into Malaysia. FDI inflows play an important role to the strong and faster growth for Malaysian economy. The specific objectives for this study are:

To determine whether there exist a long run relationship among the FDI, market size, openness to trade, interest rate and exchange rate.

To examine the causal relationship between FDI inflows and the explanatory variables in Malaysia whether it is unidirectional or bi-directional.

1.4 Significant of study

Evidence from the past studies suggests that FDI inflow is very important to a developing country such as Malaysia. It can help the country to achieve the globalization and liberalization of its economy. It also can help to reduce the production costs such as gain the different skill levels of labor, primary commodities, intermediate goods or access to the externalities of knowledge spillovers, (Shatz and Venables, 2000).

According to Lim (2001), there is a growing view in recent year that FDI inflow is positively correlated with growth. This view has been supported by the recent development in growth theory which had highlighted the importance of improvements in technology, efficiency and productivity in motivating the growth. Through FDI inflow, it will increase the transferring of advanced technology from developed countries. This shows that it is important to identify the significant determinant which will influence FDI inflows into Malaysia.

It is believed that this study will enable Malaysia’s policy makers to determine the significant determinant which will influence the (FDI) inflows as well as facilitating the FDI inflows. Hence, policy that promotes or encourage FDI can be introduced. In addition, this study will also help to create awareness on the importance of foreign direct investment to a country and to avoid and prevent the shortage or decreasing of FDI inflows when financial crises occur in Malaysia.

1.5 Scope of study

This study will focus on Malaysia only. Malaysia is categorized as upper-middle income within ASEAN region country with $3848 GDP per capita in year 2000, (Fukase and Winters, 2003). The independent variables in this study are market size; openness to trade, exchange rate and interest rate while the dependent variable is FDI inflows into Malaysia. This study will expand the John Dunning Eclectic theory (OLI Paradigm) which is different from the research by Ang (2008) which used the adequate dynamics model. The secondary data from year 1976 to 2009 will be used to run the ADF Unit Root Test, Johansen-Juselius Co-integration test and Granger Causality Test. Besides that, Vector Error Correction Method (VECM) also will include in the test. All the facts and data are from the economic journal’s web site such as Emerald Database and ASEAN Economic Bulletin, world Investment report, UNCTAD and International Monetary Fund.

Chapter 2: Literature Review

2.1 Determinants of FDI Inflows

Many countries are actively seeking ways to attract FDI due to the attractive effect on income generation from capital inflows, technology enhancement, management skills and market know how. FDI has become an important element in global economic development and every economist has been constantly investigating important determinants and factors of FDI based on the theories of international investment. Generally, there are many determinants of the foreign direct investment (FDI). According to Dunning (1981) study on the factors to attract FDI inflows revealed that the determinants of FDI inflow are ownership advantage, internalization advantage and the location advantage. He was the first person to provide more comprehensive analysis based on ownership, location, and the advantages of internalization. A firm or a country can only engage in FDI with these advantages.

Another analysis undertaken by Singh and Jun (1995) on developing countries indicated that political risk, business operation conditions and exports are also the significant determinants influence a home country to receive high FDI. The research on United Stated (US) by Brainard (1997) had determined the determinant of FDI inflows such as the transportation costs; tariff barrier in host countries, GDP per capita; trade measurement and openness of the market in FDI inflows. According to research done by Gastanaga et al. (1998), using Pooled cross-section and time-series data for 49 less-developed countries (LDCs) shows that host country policies can influence FDI inflows mostly through their influence on the advantages of location in the host country.

Bende−Nabende (2002) used the Johansen-Juselius Co integration analysis, vector auto-regression, Granger causality test and unit roots showed that most dominant long run determinants of FDI inflows in Sub Sahara Africa are market growth, export orientation policy and FDI liberalization. These are followed by real exchange rates, market size and openness. From the study, the results for real wage rates and human capital are uncertain. In a study by Yusof and Ismail (2002) on the human capital and FDI inflow in ASEAN, they have divided the determinants of FDI inflow into three aspects which are economic factors, host countries policies and transnational corporate strategies. For economic factors there are three factors namely market, resources and competition. In host countries government policies, there are macro policies, private sector, industry and trade, and FDI policies. In transnational corporate strategies, there are risks perceptions and integration of location and resources.

2.1.1 Market size

Hypothetically, FDI level is positively related to the absolute size of a foreign market, (Dunning, 1993) and both market size together with growth variables have significant positive effects on FDI with the market size weight more, (Clegg, 1999). Numerous research have been undertaken to examine the market size as one of significant determinant of FDI inflows. Bevan (2004) had examined the determinants of FDI from western country particularly the European Union using a panel data set of bilateral flows of FDI from 1994 to 2000. The results of the study are found to be consistent with transaction cost analysis of FDI where inflows are attracted between relatively large economies. The findings show that investment has been both market and efficiency oriented.

In a hypothesis testing to the factor influence the inflows of FDI in United States (US) by Scaperlanda and Mauer (1969) and Barrel and Pain (1996) also show that FDI inflows has positive feedback to the market size and it will lead to the economic scale and will have the efficiency in using the resources. According to Barrel and Pain (1996), 1% increase in GNP will lead to increase of 0.83% in real investment stock market in US. Bende-Nabende et al. (2001) also found that market size is the factor influence most in FDI inflow in ASEAN countries. Erdal and Tatoglu, (2002) based on Turkey by using Co-integration analysis and time series analysis also show that host country market size had a positive effect to influence the FDI inflows. Bigger market size will attract more FDI inflows for a country to able support the high demand of the goods and services.

A more recent study undertaken by Gast (2008) also reports similar findings. The authors aimed to identify the determinants which led to the increase in worldwide FDI during the 1990s as well as investigating whether these factors influenced exports differently by using panel data from the 22 OECD countries over a period of 11 years (1991-2001), simple regressions such as random effects specification and cross section estimation were carried out. The authors highlighted that a change in market size is an important factor that leads to both FDI and exports in the same direction.

Agiomirgianakis, et al. (2006) examines panel data evidence concerning empirical relevance between FDI attraction and its determinative effects. The sample data used are from 20 OECD countries over a period of 23 years (1975-1977). The paper focused on assessing the relative significance of the factors that may attract FDI utilizing panel data regression analysis on the sample data. The results of the study shows that the level of development and market size along with openness to trade are important to enhance the attractiveness of the host countries as it represents additional growth dynamic.

Another research done by Tiwari et al. (2003) concerning the pattern of Japanese manufacturing industry in ASEAN countries, the factors influence the most FDI inflows is the market size. A country which has a bigger population or higher level of income per capita will have more FDI inflow. Tsen (2005) studied on the determinants of FDI inflows in ASEAN from year 1972 to 2002 found that the market size is the factors which give the positive effect to the FDI inflows in Indonesia, Malaysia and Singapore.

At the Malaysian context, Ang (2008) examines the determinants of FDI for Malaysia to inform analytical and policy debates. The author used annual time series data for the period 1960-2005 and simple regression methodology was undertaken. The paper suggests that increased size of domestic market attracts more FDI inflows due to the benefits of economic scale. Evidence from previous studies suggests that market size is one of the important variables to influence FDI inflows.

2.1.2 Openness of trade

Trade Openness is an important explanatory factor in FDI inflow. Trade Openness will attract more FDI inflow and led to economic growth, (Albert, et. al, 2004). Londan Economics (2009) by using panel data analysis has determined that Trade Openness and market Capitalization have statistically significant impact on FDI inflow to EU-27 (27 Member States of the European Union). In Nigeria case, Olusegun et. al. (2009) research to determine the empirical econometric evidence of both causal & long run interrelationship among FDI, trade openness and economy’s growth in the period 1970-2006 by using time series data found that foreign direct investment and trade openness are positively significant in explaining the output growth. The authors concluded that more trade openness will have more inflow of FDI for output growth in Nigeria.

Recent study undertaken by Nicholas et al. (2006) found dynamic nature of the possible causal effect between FDI and domestic investment in 30 countries America, Europe, Asia (Australia and New Zealand) and Africa between years 1992-2002. Agim (2007) study on 10 transition economies used the panel data between periods 1990-2001 showed that FDI varies directly with the level of country’s openness. Volume of trade will directly relate with regime of taxes and tariff adopted in the country. He also suggest that trade liberalization is important in order to attract FDI, by the reason less restriction on export goods will reduce the cost of moving part from home country to a host country.

Sader (1993) in his econometric analysis using cross sectional data mean value toward 21 developing economy from 1988-1992 indicate that the degree of openness of trade or economy is a significant factor for the inflow of FDI per capita. Chung-Suk and Jung-Soo (1998) in their research on the factors influence FDI inflows in ASEAN and China also found that the openness of economy system is an important factor to influence the FDI inflows. Openness of trade will expose the country’s economy more to the international trade such as import and export.

In Lord (1999) study, Southeast Asia has been changed to export oriented industries commenced with Singapore at the end of year 1960s and followed by Malaysia at year 1970s. Export oriented industries will expand the countries economics market and encourage the increase of FDI inflows through technology transfer. Increasing in FDI inflows will increase the international trade and capital will also expand extremely especially for Malaysia.

However, although there are many previous study found the trade openness have positive relationship with FDI, in Micah and Thula (2009) study on Swaziland used time series analysis in the period 1980-2001 found that concentrate only in trade openness is not sufficient to attract foreign investor. They argue that better infrastructure was important in order to attract FDI.

2.1.3 Interest rate and Exchange rate

Interest rate and exchange rate plays an important role in the decision making for firms in their international activities such as investment. Both of variables are the measurement to the investment costs and benefit. A higher interest rate will lead to higher costs in borrowing and increasing in exchange rate will also decrease the inflow of FDI. The relation between FDI inflows with interest rate and exchange rate is expected to be negative. High interest rate and exchange rate will lead to low borrowing and investment and vice versa.

According to Larrain and Vergara (1993) in their research on Korea, Singapore, Thailand and Malaysia, they found that high interest rate will increase the costs of the production and decrease in investment. Borrowing of money for investment will also decrease due to high interest rate because it will increase the cost for borrowing. People would prefer to increase their saving to gain the interest rate. High fiscal deficit will increase the interest rate to the private sector and consequently this will decrease the private investment. In order to expand private investment, government should decrease the fiscal deficit, (Kuehlwein and Samalapa, 1999).

Exchange rate is important in the decision making for the firms in the international activities. Love and Lage-Hidalgo (2000) in their analysis of the determinants of US direct investment in Mexico indicated that the exchange rate movements will affect the investment decision. In a research on exchange rate and FDI inflows done by Froot and Stein (1991), FDI inflow will increase if the real value of the domestic money is low because the declining in the domestic money price will rise up profit for foreign investment. On the other hand, rising in the currency of home country will decrease the FDI inflow. Lucas (1993) which investigated the factors influence FDI inflows in seven Asian countries from 1961-1987 has shows the important of exchange rate in the economy and financial stabilization. Investors will not invest in the countries which have unstable exchange rate. Unstable exchange rate has high negative correlation relation with the FDI inflow to certain countries.

The study on the relationships among trade, inflows of FDI and the real exchange rate by Goldberg and Klein (1997) also stated that FDI is significantly affected by bilateral real exchange rates. Relationship between the real exchange rate and FDI inflows; and FDI inflows and trade had supported that the real exchange rate will affects trade. Decreasing in currency will encourage more FDI inflow. According to past researches, multinational firms consider the changes of exchange rate as exogenous. Unstable exchange rate will rise up or decrease the FDI inflows (Russ, 2004).

Economic growth and Political condition

Mottaleb (2007) empirically demonstrates the relationship between economic growth and FDI inflows and had found that the countries with larger GDP and high GDP growth rate and maintain business friendly environment with abundant modern infrastructural facilities can successfully attract FDI inflows. Khaliq and Noy (2007) study on the impact of FDI inflows on economic growth in Indonesia with different economic sectors found a positive effect of inflow of FDI on economic growth in aggregate level.

A country policies and growth will influence the FDI inflow, (Aqeel and Nishat, 2004). Their study shows that different variables or indicators reflecting trade, fiscal and financial sector liberalization has different attraction of FDI inflows. Mansor, et al. (2008) in their panel data analysis to identify how Japanese multinational corporations (MNCs) allocate their investments found that there is a significant relationship between Japanese FDI and political condition in the home countries. The inflows of Japanese investment have negative relationship with the political risk. It means that Japanese MNCs tend to allocate more investments into the countries with better political condition.