Jurnal

EKONOMI
PEMBANGUNAN
Kajian Ekonomi Negara Berkembang
Hal: 1 – 11

LINKAGES BETWEEN FOREIGN DIRECT INVESTMENT

AND ITS DETERMINANTS IN MALAYSIA
Zunaidah Sulong
Department of Finance and Accounting, University Putra Malaysia

D. Agus Harjito
Economic Faculty of Indonesia Islamic University,

Abstract

This paper addresses the relationship between Foreign Direct Investment (FDI) and
its determinants in Malaysia. The annual data for the period of 1970 to 1999 were employed
in this study. The OLS regression is used to determine the relationship between FDI and its
independent variables. The variables are estimated in the full model (Model I) and different
sub-models (Model II, Model III and Model IV). Generally, the results indicate that there are
at least four factors that may be used to predict the level of FDI in Malaysia. These variables
are inflation rate, gross domestic product (GDP), import, and export are among the main
determinants of FDI in Malaysia.

Keywords: foreign direct investment, inflation rate, GDP, import, and export

INTRODUCTION growth. Second, the success of the “Four

The definition of Foreign Direct In- Asian Tigers” or Newly Industrialized
vestment (henceforth, FDI), which is de- Economies (NIEs)2 in achieving rapid
rived from The Departments of Statistics1 of growth and improving the distribution of
Malaysia as “foreign-controlled” companies, income through export-led-industrialization.
in which fifty percent or more of the equity Third, Foreign Direct Investment (FDI),
share capital is held by non residents. The which has a remarkable growth of export,
FDI inflows are then defined to comprise especially in the manufacturing sector which
branches’ liabilities to Head Office and had become a very important impetus from
other foreign liabilities plus subsidiaries’ structural transformation of the Malaysia
share capital, undistributed profits as well as industry.
other liabilities to the parent companies. The Malaysian New Economic Pol-
In Malaysia, the transition from im- icy was introduced in 1971. It brought forth
port substitution to export orientation ini- a new policy to alter the economic and sec-
tially started in the early 1957. There are toral structures as well as to eradicate pov-
three factors that led to export-oriented in- erty. Industrial development was acceler-
dustries, as derived by Ariff (1985). Firstly, ated in order to achieve both a high eco-
a poor record of import substitution, which nomic growth rate plus an ethnic-
earlier policies failed to generate sustained distribution objective. Malaysia welcomed
manufacturing output and employment FDI inflows after 1970, but it was not so

1 2
Quarterly Balance of Payments Report 2000, Depart- NIEs represented by Hong Kong, South Korea, Tai-
ment of Statistics, Malaysia wan and Singapore

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 Jurnal Ekonomi Pembangunan Vol. 10 No. 1, April 2005 Hal: 1 – 11

strong in doing so. However, due to a global investment in Malaysia. The specific pur-
recession in 1980, high interest rate led to poses are as follows:
costly holding of inventories plus a drastic a. To investigate the relationship between
reduction in domestic demand. The govern- FDI and its determinants.
ment then increased in public expenditure, b. To derive some policy alternatives re-
which was then accompanied by a high pub- lated to FDI in manufacturing sector.
lic sector debt. Hence, the urgent need for
non-debt creation in addition to increased The major bulk of FDI flows to
job opportunities and export promotion at- China, which is now the largest recipient in
tracted more FDI to the country (Phang, developing countries and the second largest
1998). FDI recipient in the world (Chen, 1997).
The Industrial Master Plan (IMP)3 China has a competitive advantage in terms
1986-1995 was introduced to provide direc- of cheap labor of production and availability
tion for industrialization and export manu- for domestic demand. Due to the increase of
facturing. Foreign Direct Investment (FDI) the competitiveness, Malaysia has to take
benefited significantly from this program the opportunity to shift from labor-intensive
since the government was keen to attract product to capital and technology intensive.
foreign Multinational Companies (MNCs) Thus, this paper would examine empirically
that provide capital, technology and foreign the factors that determine the FDI flows in
market access. The share of FDI in manufac- Malaysia, specifically in manufacturing sec-
turing exports increased continuously. To tor.
encourage exports, Malaysia passed the This paper is organized as follows:
Promotion of Investment Act 1986 which section II presents the literature review on
contains major tax incentives for exports the relationship between export and growth,
including the provision of abatement by us- FDI and growth, FDI and productivity, tech-
ing local material for manufactured products nology spillover, and other determinants of
for export (Ismail, 1990). FDI. Section III presents the methodology
However, attracting FDI is going to used in this paper, including OLS and the
be more difficult now as compared to be- construction of the models. Section IV pro-
fore. Foreign investors have more options vides empirical results and discussions. Fi-
now as more and more countries open up nally, summary of the main findings and
their economies to foreign equity participa- policy implication as well as recommenda-
tion. Liberalization in China and India, in tion for further studies are presented in sec-
particular, is likely to cause FDI to bypass tion V.
Southeast Asia. Now, Korea is also actively
seeking foreign equity after facing trauma in LITERATURE REVIEW
financial crisis. A large portion FDI was Foreign Direct Investment (FDI) has
diverted into China after Chinese Yen was become one of the most important means to
devalued in 1994 (Chen, 1997). integrate the economy of a country. FDI
The general purpose of this study is enables the investing firm to utilize their
to identify the determinants of foreign direct specific assets such as technologies and
managerial know-how. Thus, FDI brings
3
IMP was designed to maintain robust export perform- benefits in various aspects, which are source
ance by improving Malaysia’s competitiveness plus of funds in term of capital stock; increase in
accelerating the growth and diversification of the indus- employment, income and growth, as well as
trial export base. It is reviewed every 5 years to pro-
vide a coherent industrial program
in skills and technology.

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Linkages Between Foreign Direct Investment and Its Determinant … (Zunaidah Sulong & D. Agus Harjito)

For developing countries, FDI has by examining the correlation between the
been a very important source of funding variables, which represent the magnitude of
especially during the debt crisis. Numerous economic performance. Tyler (1981) found
empirical studies have been conducted to a positive relationship between GDP growth
investigate the main factor that can attract and export growth, also between GDP and
FDI to the host countries. Chen (1997) ana- manufacturing export growth.
lyzed China’s manufacturing industry by Baharumshah and Rashid (1999) nar-
using the OLS cross-sectional regression rowed down the studies to Malaysia. They
and found that the inward FDI stocks of conducted further empirical tests on the
eleven industries are positively related to causal relationship between export growth
China’s abundant labor resource endow- and output growth. They employed the Vec-
ment, market size and growth rate of indus- tor Error Regression method (VER) in estab-
tries. lishing the relationship between export and
Balasubramanyam et al (1999) used economic growth; and it was found that bi-
cross sectional annual data averaged over directional relationship existed between
the period 1970 – 1985 for a sample of 46 them. Al-Marhubi (2000) presented empiri-
developing countries. They found that the cal evidence in testing the link between
size of the domestic market, the companies growth and export diversification by using
climate in relation to local producer and simple regression model. He found that the
interaction between FDI and human capital export diversification is associated with
have an important influence upon growth faster growth both directly and indirectly
performance. Their analysis indicates that with the stimulation of the accumulation of
FDI is more productive in countries that capital.
have pursued export promotion rather than Noland (1997) suggested that success
import substitution. in developing Asia’s export growth was fu-
Noorbahksh and Ali (2001) examined elled by a combination of mutually suppor-
the importance of human capital as a re- tive events-industrialization, a reduction in
source that can attract FDI into the host trade barrier, a more integrated global envi-
countries. They also tested on other vari- ronment and a growth in FDI. Meanwhile,
ables which were equally important such as Lensink and Morrissey (2001) studied the
the growth rate of the labor force, the effect of FDI flow and volatility of FDI
growth of domestic markets, the availability flows on growth. They found that FDI flows
of energy, a stable macroeconomic envi- have positive effect on growth; where as
ronment are significant for FDI inflows. volatility of FDI has a negative effect. The
They concluded that the countries that rely suggested that economies with high level of
on low-cost, low skill labor or natural re- uncertain economic growth rates, appear less
sources to attract FDI will face difficulty in attractive to foreign investors.
inducing FDI into high value-added indus- Chamarbagwala, et. al (2000)
tries and may suffer slower economic strongly suggested that investment in human
growth. capital and technology embodied in foreign
Many researchers have conducted capital play a significant role in determining
empirical studies on the relationship be- manufacturing productivity. Furthermore,
tween export growth and economic growth Baldwin et al (1999) presents a theoretical
by using different method on different coun- growth model where MNCs directly affect
tries. Michaely (1977) tested on the relation- the endogenous long-run growth via techno-
ship between export and economic growth logical spillovers. They found that FDI leads

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to knowledge spillovers, which appear to Numerous studies (see Michaely,

promote growth by promoting technology 1977; Balassa, 1978; Tyler, 1981; Kavossi,
transfer. 1984 and Islam, 1998) have done on export
According to Noorbahksh and Ali led growth strategy which indicate positive
(2001), FDI has become a very important relationship between export and growth.
agenda which is not only a source of finance Evidence also had suggested that export
and employment but also can be a medium have proven positively associated with FDI
for acquiring skills, technology, organiza- (see Pfaffermayr, 1994; and Dowling &
tional and managerial practices and access to Cheang, 2000). Hence, it is important to
markets. Dowling and Cheang (2000) also include export and economic growth in the
stressed that computers and electronics are model.
embedded in most production processes, For the purpose of the study, some
consumer and capital goods, which are very important variables such as technology and
important to determine industrial competi- exchange rate are used to examine whether
tiveness. In fact, they are key enabling tech- this elements would be relevant determinant
nologies in the communications and infor- in Malaysia. Other variables include market
mation revolution of modern knowledge size, current account deficit, gross domestic
economy. in manufacturing sector, domestic inflation
rate and export in manufacturing sector.
METHODOLOGY The above-mentioned factors argua-
Based on previous studies, there are bly are expected to be the most important
many internal and external factors that de- determinant of FDI. However, other factors,
termine FDI inflows into the host country. which has been studied by many researchers
Therefore, several hypotheses can be devel- such as resource endowment, political stabil-
oped regarding some potential determinants ity, trade barriers, investment incentives,
attracting FDI into Malaysia, particularly in legal framework also has some influence on
the manufacturing sector. The determinants FDI but would not be tested due to data
which would be studied in this paper are limitations and the difficulties in quantifying
market size (gross national product), current some of the variables.
account balance, Gross Domestic Product
(GDP) in manufacturing sector, macroeco- Dependent Variable
nomic stability (inflation rate), export manu- The dependent variable for FDI cov-
facturing, the level of technology, exchange ers a period of thirty years (from 1970 to
rate. 1999). The data on net flow of FDI is only
The above-mentioned factors are ex- available from 1974 onwards. Since this
pected to be the most important determi- study will focus more on FDI in manufactur-
nants of FDI. Other factors, such as resource ing sector. Data on FDI inflow in manufac-
endowment, trade barriers; political stability turing is used as dependent variable. How-
and investment incentives are equally im- ever, due to lack of data on the actual vol-
portant but will not be examined in this ume of FDI for Malaysia, approved FDI4 in
study. This is mainly because of data limita- manufacturing is used as proxy.
tions and the difficulties in quantifying some
of the variables. All the variables are ex- 4
Bank Negara Malaysia defines as foreign equity plus
pected to have positive relationship with foreign retained earnings / reserves plus loan attributed
FDI except inflation rate. to foreign interest (loan attributed to foreign interest is
apportioned from the total loan according to the per-
centage of the foreign share in the equity of each pro-

4
Linkages Between Foreign Direct Investment and Its Determinant … (Zunaidah Sulong & D. Agus Harjito)

Independent Variable FDI. Otherwise, if it is positive, current

The variables that would be used account surplus would be a determinant
cover both internal as well as external fac- to attract FDI.
tors, which are expected to be the determi- 3. Gross domestic product (GDP) at cur-
nants of FDI in Malaysia. All independent rent price in manufacturing sector
variables, which are selected for this study Theoretically, the higher portion of
are justified by following explanation: manufacturing output reflects the coun-
1. Market size (GNP) try’s serious involvement in manufac-
In this study, Gross National Prod- turing sector that attract more foreign
uct (GNP) at current price will be used investors, particularly from export-
as a proxy for market size. GNP is se- oriented multinational and transnational
lected instead of Gross Domestic Prod- companies. Hanson (2001) found that
uct (GDP) because it is more accurate to some multinationals are attracted to
reflect the economic performance con- higher productivity countries and to
sidering the net factor income from high productivity industries within these
abroad. Empirical studies examined FDI countries. Hence, it is expected to have
and market size found that their effects a positive relationship between manu-
to be statistically significant (see Chen, facturing output and FDI.
1997; Billington, 1999 and Noorbakhsh 4. Domestic inflation rate (the annual rate
et al 2001). There, the market size is of inflation, as measured by CPI5)
expected to have positive relationship Macroeconomic stability is a neces-
with FDI. sary precondition for financial liberali-
2. Current account balance zation. Successful inflation stabilization
The position of the current account is associated with sound fiscal adjust-
transaction in balance of payments in- ment and an increase private sector’s
volves trade of goods, services and in- share of domestic credit (Noorbakhsh
vestment income (Batiz, second edi- and Ali, 2001). Therefore, inflation rate
tion). However, the current account bal- can be used as proxy for macroeco-
ance also can be defined as the differ- nomic stability. A viable upward swing
ence of domestic saving and domestic in the inflation rate is expected to re-
investment (Higgins and Klitgaard, duce FDI flows in the host country, as
1998). In addition, the deterioration in higher price would decrease real return
the current account balances also driven in investment. Thus, obviously the rela-
by an increase in domestic investment tionship between the inflation rate and
and a fall in savings (Higgins and Klit- FDI is expected to be negative.
gaard, 1998), leads to less confident in 5. Export in manufacturing
foreign investors. Export has been proved by many re-
Considering the importance of cur- searchers such that Tyler (1981), Pfaf-
rent account balances in influencing fermayr (1994), Islam (1998), Baha-
foreign investor’s decisions, this vari- rumshah et al (1999) and Al-Marhubi
able is considered in this study. If the (2000); as a very important tool to ex-
result is negative, a deficit current ac- pand economic growth. Therefore, ex-
count is said to be a factor to determine
5
CPI are the most frequently used indicators of infla-
ject). (Monthly Statistical Bulletin, June 2003, Bank tion and reflect changes in the cost of acquiring a fixed
Negara Malaysia) basket of goods and services by the average consumer.

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port has become a very important inde- Following on the above explanation,
pendent variable. Considering the case FDI can be modeled in the form of
of export-oriented FDI like Malaysia, in equation as below:
this study export in manufacturing will FDIt = β0 + β1XCHGt + β2CPIt +
be used as one of the determinant of β3GDP%t + β4GNPt +
FDI and expected to have a positive β5GDPt + β6XPOTt +
sign. β7MPOTt + β8CAt + t ...... (1)
6. Technology Where;
FDI is always associated with tech- FDIt = foreign direct investment
nology transfer. However, recently, at- XCHGt = exchange rate
tracting FDI has become more challeng- CPIt = domestic in inflation rate
ing. Some MNEs tend to locate the (proxy for macroeconomic
businesses to the country, which have stability)
already better infrastructure, modern GDP%t = percentage of gross domestic
communication and modern machinery. product (in manufacturing)
The data for technology is very difficult GNPt = gross national product
to measure. Jorg (2001) used the GDP (proxy for market size)
ratio of machinery import and Coe et al GDPt = gross domestic product (in
(1997) used import on machinery and manufacturing)
transport equipment to measure tech- XPOTt = export (in manufacturing)
nology. MPOTt = import (in manufacturing –
Due to lack of data on technology, proxy for the level of tech-
import on machinery specifically in nology)
capital good6 would be used as a proxy CAt = current account (deficit)
for the level of technology. Therefore, Tt = the level of technology
in this study the level of technology be-
comes an independent variable, which is Note that β4, β3, β5, β6 and β7 are ex-
expected to have a positive relationship pected to have positive relationship,
with FDI. while β2 is expected to be negative. β1,
7. Exchange Rate β5 and β8 are unpredictable.
FDI flows are greatly influenced by
a mix of micro and macroeconomic Sources of Data
policies and other market factors. Tas- Data for net FDI flow and Gross Na-
neem and Zakariah (2002) mentioned tional Product (GNP) are available in Inter-
that government policies towards trade, national Financial Statistic Yearbook, how-
regulations, taxation, subsidy, entry ever the data for FDI is available from 1974
rules, foreign exchange etc. are impor- onward. The approved FDI in manufacturing
tant determinants of FDI flows. In this is used as a proxy for this study. Since this
study, exchange rates need to be tested study specifically focusing in manufacturing
and evaluated to see if it is related sig- sector, therefore the use of approved FDI in
nificantly in predicting the level of FDI manufacturing should be reliable.
in Malaysia. The data for Gross Domestic Product
(GDP) in manufacturing, export in manufac-
turing, import machinery and domestic infla-
6
tion rate are collected from Monthly Statisti-
import machinery such as electrical machine, scien-
tific and computer cal Bulletin, Bank Negara Malaysia in vari-

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Linkages Between Foreign Direct Investment and Its Determinant … (Zunaidah Sulong & D. Agus Harjito)

ous issues. The annual data for Current Ac- tics and correlations between variables are
count and Consumer Price Index are also reported in Table 1.
collected from International Financial Statis- The results from Table 1 indicate that
tics Yearbook and International Monetary FDI is related significantly to all variables
Fund. tested except for exchange rate and percent-
age of GDP. The FDI is also related posi-
EMPIRICAL RESULTS AND DISCUS- tively to all variables, except for balance of
SIONS current account (CA). For the three meas-
In this section, the estimates in the ures of income; percentage of GDP, GDP in
equation (1) are obtained by ordinary least value, and GNP, the correlations show that
squares estimation (OLS) of regression. The GDP(%) and GDP is positively but not sig-
McKinnon critical value at the 5% level of nificantly correlated so that the inclusion of
significance becomes the basis for rejecting these variables is not likely to impose col-
or not rejecting the null hypotheses. If the linearity problem. However, it can be no-
reported t-test statistics are less than the ticed that the GNP and GDP are positively
given critical value, the null hypotheses can perfectly correlated such that one of the
be rejected. The results of descriptive statis- variable is sufficient to represent the vari-
able being tested.

Table 1. Results on the descriptive statistics and correlations between variables

Mean Std Dev FDI XCHG CPI GDP% GNP GDP XPOT MPOT CA

FDI 4955.07 6221.19 1

XCHG 2.66 0.45 0.271 1
CPI 71.10 23.86 0.657** 0.483** 1
GDP% 6.85 4.07 0.301 -0.324 -0.202 1
GNP 98304.17 84139.20 0.652** 0.649** 0.945** -0.161 1
GDP 103769.37 88991.03 0.649** 0.654** 0.945** -0.165 1.000** 1
XPOT 75725.95 86795.93 0.569** 0.726** 0.889** -0.220 0.977** 0.978** 1
MPOT 68825.73 77408.60 0.640** 0.680** 0.901** -0.141 0.991** 0.991** 0.986** 1
CA -2540.23 8081.90 -0.422** 0.264 -0.168 -0.466** -0.153 -0.146 -0.004 -0.157 1
Notes: ** and * denote significant at 1% and 5% level, respectively. See text for variable
definitions and sources.

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Table 2 reports the results of the OLS variables examined in the study. However,
of FDI on the independent variables. The on the individual variable the results suggest
results shown also have been estimated in that only four factors are significant in pre-
the full model (Model I) and different sub- dicting the FDI level in Malaysia, namely
models (Model II, Model III and Model IV). CPI, GDP%, Import and Export. FDI seems
Based on the results in Table 2, the GDP in to increase with increases in CPI, GDP%,
value is removed from the full model (model and import but decreases as export in-
I) as suggested in the SPSS output. Since creases.
GDP and GNP measures are perfectly corre-
lated, the inclusion of GNP in the equation Model II
should be adequate. Thus, the results for By taking out the insignificant factors
each model can be explained as follow: from Model I generate a sub-model, Model
II. The simplifying the equation obvious
Model I reduces the predictive power of the relation-
The results obtained from running ship (R2) and causing two more variables to
this model indicate 71.5 percent of the varia- be insignificant (import and export).
tion in FDI level is explained by all the 7

Table 2: Results of the OLS or regressions of FDI on the independent variables

Model I Model II Model III Model IV

Constant -28118.5 -10047.6 -13647.2 -7220.4
(-2.238)** (-2.297)** (-4.770)*** (-2.595)**
CPI 443.8 146.3 195.0 171.245
(2.304)** (2.058)** (6.231)*** (4.607)***
GDP% 646.246 519.4 691.1
(2.987)*** (2.486)** (3.763)***
XPOT -0.306 -0.090
(-2.199)** (-1.567)
MPOT 0.515 0.114
(2.200)** (1.676)
XCHG 3249.1
(1.094)
GNP -0.232
(-1.457)
CA 0.395
(1.517)
R2 0.715 0.665 0.627 0.431
F-value 7.903 12.388 22.684 21.226
Sig-value .000 .000 .000 .000
Notes: ***, **, and * indicate significance at 1, 5, and 10 percent level, respectively. See text
for variable definitions and sources.

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Linkages Between Foreign Direct Investment and Its Determinant … (Zunaidah Sulong & D. Agus Harjito)

Model III and IV resources and labors open the market to all
By simplying further the equation the countries in the world. Therefore, it is
yields even lower R2 as only 62.7 percent suggested that the Malaysian government
and 43.2 percent of the variation in FDI are need to prepare high quality skilled labor
produced in Model III and IV, respectively. and supporting research and development
However, the reduced models reveal that the activities. It is a challenge to Malaysia to
remaining variable(s) in these equations are improve on human capital stock through
the more important factors in determining skilled labor. Skilled labor is required for
FDI compared to import and export. Overall, absorbing, using and improving the technol-
the results indicate that there are at least four ogy. Thus, educational competences, par-
factors that may be used to predict the level ticularly in technical and managerial areas,
of FDI in Malaysia. These variables are CPI, are gaining importance. In this case, Malay-
GDP%, import, and export. sia needs to emphasize the upgrading of the
level of education by increasing the number
CONCLUSIONS, LIMITATIONS AND of universities, center for technical training,
FUTURE RESEARCH center of research and development, and
Numerous studies support the impor- distance learning.
tance of foreign capital in expanding the FDI can be a vehicle for the adoption
economic growth. In this study, some vari- of new technology. Therefore, the workforce
ables are chosen to determine factors influ- should be prepared to work with these new
encing FDI in Malaysia. Gross national technologies. This suggests that there might
product (GNP) used as a proxy of the market be an effect of FDI on human capital accu-
size, gross domestic product (GDP) in mulation (Bernstein et al, 1998). Empirical
manufacturing sector is chosen as a proxy studies done by Yeaple (1999) found that for
for the degree of industrialization. Other more skill-intensive industry, affiliate sales
equally important factors are inflation rate, are positively correlated with average educa-
manufacturing export, current account bal- tion attainment in host country. Dowling et
ance, the level of technology and human al (2000) define technologies capabilities for
capital. Malaysia has many advantages to foreign investor as skills, education and re-
attract more FDI, in terms of maintaining the search and development.
inflation rate, expanding the market size Moreover, Hanson (2001) states that
domestically and internationally. In addition, countries with large supplies of human capi-
Malaysia is making successful efforts to tal are more likely to attract FDI especially
upgrade the level of infrastructure and the in sectors, which are relatively intensive in
development of telecommunication, which the use of skilled labor. In addition, Malay-
are very important elements in attracting sia also must be able to take a greater advan-
more foreign investors. tage of the access to scientific and technical
Overall, the results suggest that there information that exists within the global
are at least four factors that may be used to information infrastructure. Enabling tech-
predict the level of FDI in Malaysia. These nology in information and communication
variables are inflation rate, gross domestic (ICT) is a need for modern knowledge and
product (GDP), import, and export are economy (Dowling, 2000).
among the main determinants of FDI in Ma- In this study, some important vari-
laysia. However, attracting FDI is not easy ables are left out due to insufficient data
in the new era of globalization, which has such as wages or labor cost, research and
seen China with huge domestic demand, development, the ability of energy, tax in-

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centives, political stability and policy liber- be used to improve the accuracy of the
alization. Therefore, it is suggested that the model’s estimation. Furthermore, the rela-
future research should take them into ac- tively small sample may require the applica-
count. tion of non-parametric methods that is sup-
Since the annual data are used in this ported by the results of normality distribu-
study that covers from a period of 1970 to tion test. Further studies should be done by
1999, it is recommended that quarterly data extending to more countries.

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