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The Effects of Foreign Direct Investment on Economic Growth in Malaysia

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In this chapter, the background, problem statement, objectives and justification of the study are discussed. The general and specific objectives are listed and the scopes of the study are described.

1.1Background of the Study
1.1.1 Malaysia Economic Growth

Malaysian economy was consistently reached a GDP growth of more than 7% followed by the low inflation rate in the 1980s and 1990s. The economy went on to an extensive diversification and continued economic growth averaging 9% per annum in the period of 1988-1997. During the year of 1996-1997, on average, the economy had grown at annual rate of 8.7% whereas inflation averaged 3.8% and the unemployment rate was low, averaging around 2.5% per annum. Manufacturing sector grew from 13.9% of GDP in 1970 to roughly about 30% in 1999, whereas agriculture and mining sectors together was 42.7% of GDP in 1970 and falls to 9.3% and 7.3%, respectively in 1999 (Marial and Ngee, 2009).

Malaysia’s economic growth is growing rapidly and is a relatively open economy. In the year of 2007, the Malaysia economy was rank 29th largest economy in the world by purchasing power parity with gross domestic product for 2007 was estimated to be approximately $357.9 billion (World Bank, 2007). It has been recorded that, Malaysia experienced a stable and consistence record of economic growth in GDP which averaging an annual rate of around 7 percent over the period between 1970 until 2005.

Due to Malaysian open economy, from the externalities, it will create a major impact as well as the oil crises of the 1970s, the decline in the electronics industry in the mid 1980s and particularly the Asian financial crisis in 1997. In terms of the economic performance, the Malaysian economy experienced sluggish growth in 2001 with 0.3 percent, but rebounded strongly in 2002 with 4.1 percent. As the time goes by, the Malaysian economy however had strongly expanded in the year of 2004 increased by 7.1 percent and a stable growth was being marked in the year 2005 and 2006 by 5.3 percent and 5.9 percent respectively (figure 1).

Figure 1: Gross Domestic Product of Malaysia, 2001-2011, (RM Millions)
Note: 2011 is an estimate data based on Bank Negara Malaysia 2010 Annual Report Source: Economic Planning Unit, Malaysia

Moreover, the Malaysian economy had contracted by 6.2 percent in first quarter of 2009 (Q4 2008: 0.1%), it was the first contraction since the third quarter of 2001. It was mainly due to a significant declining in external demand in which the economy has been affected by the spillover of deepening recession in several advanced economies as well as slower growth in the regional economies. Besides, it was also due to contracted of domestic demand mainly because of weaker investment and private consumptionh activities.

However, Malaysian economy regained the growth momentum by 4.5% in fourth quarter by the contribution in strengthening domestic and external demand. After the downturn in 2009, Malaysian economy experienced a strong growth in 2010 at 7.2% which mainly driven by healthy domestic demand and with strong expansion in private sector activity, whereas in 2011, Bank Negara Malaysia estimated that Malaysian economic growth will grow at 5.0% which is likely to improve where private investment is expected to remain strong and also accompanied with the government initiative under the ETP. FDI are also expected to increase given the positive economic outlook, increasing business confidence, enhancing global FDI flows, better corporate earnings and also government’s extensive economic transformation projects.

1.1.2Trends and Patterns of FDI Flows in Malaysia

Foreign Direct Investment (FDI) has been the underlying key vehicle that drives the strong growth performance experienced by the Malaysian economy. The reformation of policy which consist of the introduction of the Investment Incentives Act 1968, the establishment of free trade zones in the early 1970s and the stipulation of export incentives together with the acceleration of open policy in the 1980s, led to a surge of FDI in the late 1980s. Liberal incentives including allowing a larger percentage of foreign equity ownership in enterprise under the Promotion of Investment Act, 1986 has been introduced by the government to attract a larger inflow of FDI in which resulted in a large amount inflow of FDI after 1987 which grew at an annual average rate of 38.7 percent between 1986 until 1996 (Kew W.C., 1999).

Furthermore, macroeconomic management, maintained economic growth and the existence of a well performance and functions of financial system have made Malaysia an attractive prospect for FDI. Investment activities that have been made by the foreign companies are in the major areas of sectors such as electronics and electrical products, chemicals and chemical products, basic metal products, non metallic mineral products, food manufacturing, plastic products and scientific and measuring equipment (Ministry of Finance, 2001).

Figure 2: GDP (RM millions) and FDI (millions dollar) inflows to Malaysia 1970-2002
Source: Malaysia Economic Report, Ministry of Finance

Based on figure 2, it shows the trend of GDP and FDI inflow to Malaysia, during 1970 until 2004. We can observe that Malaysia’s economy grew concurrently with the growth of FDI. Malaysia was receiving a lot of FDI for the past two decades in which FDI stocks starts to grow up slowly by 1970s and FDI inflows had increased almost twenty fold during 1970s ($94 million dollar) to 1990s ($2.6 billion dollar) although some fluctuations had occurred during the years.

However, albeit FDI was increased over the year, there have been a several phases of slowdown since the early 1990s in which in 1993, there is a slowdown in investment activities for Malaysia from two main sources which is Japan and Taiwan that led to a rapidly drop of FDI and one of the reasons for this is because of the rise in wage rates in Malaysia compare to other countries (China, Vietnam, Indonesia). FDI flows in Malaysia were at peaked in 1996 when it achieved $7.3 billion dollar (Ministry of Finance, 2002).

In addition, with the impact of Asian Financial Crisis in 1997 which affected by most of the Southeast Asia country and the rise of China and India as a major open economies that compete with Malaysia over FDI inflows into developing countries can be the reason of slowdown of FDI flow into Malaysia. The FDI flows in Malaysia tend to be randomly fluctuating and unstable, though it also reaches an average inflow of US$3 billion per year.

(Oti-Prempeh, 2003) identified that, there are three factors that influence the attraction of FDI in Malaysia which is its undervalued currency, degree of openness, low cost of labour moderately low inflation rate. According to (Kuzo and Shujiro, 2004), depreciation of host country’s currency will attract FDI whereas exchange rate with high volatility will discouraged FDI. If there is an appreciation in exchange rate, in the foreign exchange market, it would result in a depreciation of domestic currency against US dollar.

Usually, trading activities in Malaysia normally in their transaction, it uses the term of US dollar. Thus, FDI is theorise to increase with the respond to the depreciation in Malaysian Ringgit. Based on (Nakamura and Oyama, 2001), recommend that the exchange rate will reflects the choices for MNCs to select FDI destination. Low cost of labour and low inflation will determine the attraction of FDI in which countries will definitely invest in a country with low cost of production and stability in economy.

The contributions of FDI to the economic growth in Malaysia is also because of the country good environment. With the good conditions will make the investors face with less problems because in order to make more profit with life safety, all investors would probably want to run their business conveniently. The most important factors for foreign direct investment shall include political stability, economic stability, lower wages and easy accessibility to raw material, special rights and person safety (Har Wai Mun, Teo Kai Lin, Yee Kar Man, 2008).

1.2Problem Statement

In Malaysia, Foreign direct investment (FDI) has been strongly encouraged in order for the country to achieve sustainable economic growth, improvement in the conditions of employment, accelerating modernization in industrialization and increase the standard of living among the society. The economic growth in Malaysia has been affected due to the Asian financial crisis in 1997-1998 in which the gross domestic product (GDP) rate has declined from 7.4% in 1997 to -7.4% in 1998 but the growth had recover to 5.3% in 1999.

Furthermore, there is a major increase in FDI between 2005 and 2008 which is from $4.1 billion to $8.1 billion whereas in the same year GDP had also increase from 2.6% to 3.8% (EPU, 2008). It shows that as FDI increases, GDP also increases. Hence Malaysia is known as the fastest growing economy in the Southeast region. Many questions have risen on what makes the economic growth in Malaysia recovered. Was it the effects from FDI that makes the Malaysia economy return to a steady rate? What are the factors influence the FDI? Does FDI is the one that cause economic growth in Malaysia?

There’s seems to be variety of variables included in finding the effects of foreign direct investment (FDI) on Malaysian economic growth. From the previous studies, effects from FDI such as physical capital, labour force, human capital and absorptive capacity have shown many different results. Some studies had suggest that, the effects of FDI on economic growth can come from the technology and productivity spillover, more skilled labour will be hired, accumulation of capital and from the role of MNEs. This paper will focus on the major effects of foreign direct investment (FDI) that influence Malaysian economic growth (GDP).

Therefore the research questions are:

1.Does foreign direct investment (FDI) cause economic growth (GDP) in Malaysia?

2.Which are the effects (physical capital, labour force, human capital and absorptive capacity) from foreign direct investment (FDI) that influence the economic growth of Malaysia?

1.3Objective of the Study

The general objective of this study is to examine the relationship between economic growth and foreign direct investment (FDI). The specific objectives of this study:

1.To examine the causal relationship between foreign direct investment (FDI) and economic growth in Malaysia; and

2.To identify the elements of FDI which include physical capital, labour force, human capital and absorptive capacity (spillover effect) that contributes to the growth in Malaysian economic growth.

1.4Justification of the Study

The effects of foreign direct investment on Malaysian economic growth is an important aspect of research because atleast it gives a brief explanation and benefit to different types of individual and organization including the government, small and big companies, the Multinational Companies (MNE) , the employees and the country itself.

Firstly, this research can bring benefits to the government as it allows them to efficiently formulate a policy of foreign direct investment by analysing the determinants and effect of FDI, which it may ease the government to invent new economic strategy which eventually promote growth. The effective policy on FDI and also on the country itself may helps to gain the attraction and confidence level of foreign investors to invest in Malaysia. Besides, if the government really construct an analysis on the benefits of FDI, it may becomes a way to fill the gap between the required funds for growth and the internal savings capacity of a country.

Secondly, companies in Malaysia may also obtain a benefits from this research in terms of productivity in producing product and services. As more competition brought in by FDI, it be likely to become more productive in an effective way to counteract the threat of the competitor from abroad.

The companies must know what are the effects of FDI on Malaysian economy as it will somehow affect their organization in terms of productions in which one of the effects is technological spillovers. They have to be prepare to adapt to the new changes and exposure. This will lead to contribution of economic growth in the aspect of the company in Malaysia to grow to become bigger companies and goes internationally.

Thirdly, it may be benefit the employers and employees. As the they will exposed to the effects of foreign direct investment on Malaysia, the advantage is that, they can use this research to analyse the important components of it and prepare themselves in facing such aspects. For an instance, for the employer, when the FDI tend to increase in Malaysia, the competitiveness will be increasing. Thus, the changes in technological aspect will occur and the employer have to organize the position of managing the employees, so that they will always be prepared and easily adapt and also it will lead to lower unemployment. Need more explanation

In this chapter, related theoretical and empirical framework will be discussed based on the previous researchers studies in order to have a clear perspective regarding the topic. 2.1Theoretical Framework

2.2Empirical / Methodological Framework

In this chapter, data sources, conceptual framework, empirical/ statistical analysis, hypothesis and limitations of the study are discussed.

3.1Data Sources
The data collection that is use in this research is by using the secondary data. Secondary data is data that is neither collected directly by the user nor specifically for the user, often under conditions not known to the user. It may be available from internal sources, or may have been collected and published by another organization.

Table 1: Definition of variable and Sources of Data
1999 – 2008Department of Statistics
PhyCapitalgross capital formation as a share of GDP
1999 – 2008Department of Statistics
LabourLabour force growth (thousand)
1999 – 2008Department of Statistics
FDIInflows of FDI (RM million)
1999 – 2008Department of Statistics
SchoolPrimary schooling enrollment is use as proxy for human capital
1999 – 2008Department of Statistics
FDI*SchoolInteraction variable. Included in order to take into account the absorptive capacity in Malaysia1999 – 2008Department of Statistics FDI*PhyCapitalTo take into account the interaction between FDI and physical capital to have an impact on growth1999 – 2008Department of Statistics FDI*labourTo take into account the interaction between FDI and employment1999 – 2008Department of Statistics

3.2Conceptual Framework

Figure? : The relationship between the interaction variable with foreign direct investment (FDI) and Malaysian economic growth (GDP).

3.2.1Explanation of Framework

Based on the conceptual framework above, focuses on how FDI inflows have an effect on Malaysia economic growth. The variable of capital and labour is introduced in order to observe the effects on economic growth by taking into account the stocks of physical capital and labour. As the data for stocks of physical capital is said to be difficult to put up, gross capital formation as a share of GDP for the quarterly period of 1999 to 2008 is being employ as a proxy for the influence of physical capital in which also similarly being done by (Olofsdotter, 1998). Labour is measured as the labour force during the quarterly period of 1999 to 2008. The variable GDP would be the dependent variable in which to observe the economic growth in Malaysia.

Moreover, referring to the approach used by (Sala-i-Martin et al, 2004), the effects of FDI in determining the economic growth in which the powerful indication that was found is the primary schooling, the price of investment and the initial level of GDP per capita. By following those indicators, I shall include the average years of schooling enrollment in which it can be for the purpose both in measuring the human capital and a rough proxy for the absorptive capacity of Malaysia.

Since most of the studies had found that FDI alone might not have an impact on economic growth, the joint effect is introduced in this studies which according to the earlier research (Borensztein et al., 1998), in order to discover the joint effect of FDI and schooling enrollment, FDI and labour force and FDI and physical capital, the interaction variable is introduced which is the FDI*SCHOOL, FDI*LABOUR FORCE and FDI*PHYSICAL CAPITAL. The FDI*SCHOOL interaction is introduced to examine the effect of the absorptive capacity in Malaysia on the potential of FDI to have an effect on economic growth.

The independent variables such as FDI must have shown a positive effect on economic growth. The level of GDP is used in growth regressions to examine the existence of convergence in GDP levels which is the dependent variable. FDI*SCHOOL is projected to have a significant effect on economic growth since a higher absorptive capacity would imply that technology spillovers become more important as well as FDI*LABOUR FORCE and FDI*PHYSICAL CAPITAL. Since the schooling enrollment variable act as a proxy for human capital, it is predicted to have a positive effect on economic growth (Andreas, 2005).

Based on the study done by (Andreas, 2005), for the baseline specification, the interaction variable of FDI*SCHOOL, FDI*PHYSICAL CAPITAL and FDI*LABOUR FORCE are used as explanatory variables. The study attempts to fill the gaps by developing this equation:

GDP = α + β1 FDI + β2 FDI*PHYCAP + β3 FDI*SCH +β4 FDI*LABOUR + ɛ Where for Malaysia in quarterly period of 1999 to 2008, the output is quarterly real GDP and the inputs are FDI and gross capital formation as a share of GDP FDI*CAPITAL, FDI and number of labour force FDI*LABOUR, FDI and the school enrollment, FDI*SCHOOL represent as the proxies of human capital and absorptive capacity.

FDI:Foreign Direct Investment in
FDI*PHYCAP:Interaction variable between FDI and physical capital (gross capital formation as a share of GDP FDI*SCH:Interaction variable between FDI and human capital (absorptive capacity) FDI*LABOUR:Interaction variable between FDI and labour force (number of employed person)

3.3Empirical/ Statistical Analysis

In order to test the causality between foreign direct investment (FDI) and economic growth (GDP) in the case of Malaysia, three steps will be performed. Firstly, I will test for the order of integration in the GDP and FDI time series. The technique of unit root will be used for the estimation of individual time series with the intention to provide evidence about when the variables are integrated.

Secondly, after establishes the order of integration in the series, it is followed by the Ordinary Least Square regression test in order to know whether one variable is dependent on another variable. Lastly, the Granger causality test is used to assess the short run cointegration in which to observe the direction of causality between the two variables. 3.3.1 Single Equation-Based Unit Root Tests

In carrying out the cointegration analysis between the variables, the first step is required to implement the unit root test for each variable using the testing principle of Augmented (Dicky and Fuller, 1979) on the following regression: 4.0 (1)

The ADF regression tests for the existence of unit root of Xt, namely in the logarithm of all model variables at time t. The variable ΔX t-ᵢ expresses the first differences with k lags and final ut is the variable that alters the errors of autocorrelation. The coefficients δ0, δ1, δ2 and αi are being estimated. The null and the alternative hypothesis for the existence of unit root in variable Xt is: H0: δ2 = 0 Hɛ: δ2 < 0

The minimum values of the Akaike (Akaike, 1973) (AIC) and Schwartz (SC) statistics have provided the better structure of ADF equations as well as the relative numbers of time lags, under the indication “Lag”. As far as the autocorrelation disturbance term test is concerned, the Lagrange Multiplier (LM) test has been used.

3.3.2 Ordinary Least Square (OLS) Regression

The method of Ordinary least Square is a method generally used for regressions analysis, which is developed by Carl Friedrich Gauss (1821). It is concerned in the study of the relationship between one variable called the explained or dependable variable and one or more other variables called independent or explanatory variables. This is to observe whether one variable is dependent on another or a combination of other variables. It involve in establishing the coefficients of regression for a sample and then making a conclusion on the population (Oscar Kiiza, 2007). The linear regression equation for this model is: Yi = αi + β1i + β2i + β3i + β4i + εi

Where, Yi represent the dependent variable at a particular time respectively while the coefficient of regression, β1i, β2i, β3i, β4i explain how a unit change in the independent variable affects the dependent variable. The αi and βi indicates the slope and coefficient of regression. The εi represents the error term in which it included in the equation to provide for other factors that may influence the dependent variable. Furthermore, the coefficient of determination (r2) measures the proportion of the dependent variable that is explained by the regression model.

3.3.3 Granger Causality Test
In determining the test for direct causality between FDI and economic growth, Granger causality test using equations (1) and (2) was performed: (1) (2) in which and are stationary time series sequences, and are the intercepts respectively, and are white noise error terms, and k is the maximum lag length which will be use in each time series. By using the (Hsiao’s, 1981) sequential procedure, the most possible lag length can be identified which according to Granger’s definition of causality and Akaike’s (1969, 1970) minimum final prediction error criterion. If in equation (1) is significantly different from zero, then the conclusion is that FDI Granger causes GDP. On the other hand, if in equation (2) is significantly different from zero, then the conclusion is that GDP Granger causes FDI. There is a definite possibility that Granger causality can be in both directions (Dharmendra, Saif and Kamal, 2007). 3.3.4 Estimation Procedure

First model

Identify the potential effects of foreign direct investment (FDI) which is physical capital, labour force, human capital and absorptive capacity that influence economic growth (GDP) of Malaysia. Second model

Determine the causal direction between foreign direct investment (FDI) and economic growth (GDP) of Malaysia.


There are three effects of foreign direct investment (FDI) that influence Malaysian economic growth (GDP). Hypothesis is a statement that explains the association between various variables, which concerned in the study. The statements that have been made are based on the finding from previous research. By testing the hypothesis and confirming the conjectured relationships, it is expected that the solutions can be found to correct the problem encountered. Therefore, the hypotheses that will be tested are as below:

H1: Foreign direct investment (FDI) is significantly associated with economic growth H2: Absorptive capacity which determine the spillover effect is significantly associated with economic growth

H3: Physical Capital accumulation is significantly associated with economic growth through FDI

H4: Labour force is significantly associated with economic growth through FDI

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