Determinants of FDI Inflows in Malaysia

CHAPTER 1

1.0 INTRODUCTION

Foreign Direct Investment (FDI) nowadays is very important elements that are needed in order to improve the economic situation especially among the developing countries. The expansion and rapid growth of technologies, telecommunications, infrastructure and transportation for instance has encouraged more Multinational Corporation (MNCs) to take the opportunities to expand their businesses. The investments can be either locally or cross borders. Developed countries for instance have increased their FDI activities by investing more and find new opportunities in other countries especially among developing countries such as ASEAN. ASEAN countries which consist of Malaysia, Brunei, Singapore, Philippines, Thailand and Indonesia are among the favourable destinations of FDI by investors all over the world. The presence of FDI in ASEAN region started in 1980s and now become one of the important factors of economic growth among member countries.

The decision why more investors seeking for new investment in Asia countries is due to the countries advantages in terms of supply of labor force at lower cost and rich of natural resources that can be exploited. The increasing trends of FDI among these countries will encourage more competition in order to secure FDIs in their countries. It will also help the SMEs create new businesses with joint venture and sharing partner with the MNCs to expand the businesses (T.Khine, 2008).

Global foreign direct investment (FDI) flows have been risen steadily over the past 30 years with some declines in the early 1980s, 1990s and 2000s. For the year 2006, global FDI inflows rose for the third consecutive year in order to reach at &1.306 trillion. The increment and growth of FDI occurred in all regions and was driven by increasing corporate profits worldwide and resulting higher stock prices that raised the value of cross-border mergers and acquisition (M&As) (UNCTAD, 2008).

1.1 FDI IN EAST ASIA

The effect from the global growth on FDI also can be seen in the foreign direct investment (FDI) in East Asia which has increased significantly since 1990s. It is reported that the rose is almost over 6 times from US$21 billion in 1990 to US$156 billion in 2005 notwithstanding some large falls during and after the 1997-1998 Asian financial crisis. China for instance is the largest recipient of FDI flows in Asia with inward FDI flows rising by 22 times from merely USD3.5 billion in 1990 to USD79.1 billion in 2005 which accounting half of the total inward FDI flows in Asia (Liu, Chow and Li, 2006).

However, if we look at the trends of FDI inflows to developing Asia countries especially in ASEAN countries, in 1995 it is recorded FDI inflow to ASEAN is amounting USD28,164.3 million and keep on increasing until the year 1997. However, due to financial crisis in 1997 the figure has fall until the year 2002.

The year 1997-1998 are the year where the world economy have facing a financial crisis or some economies called it as modern – styled capital account crisis which characterized by a boom of international capital inflows followed by a sudden withdrawal of funds due to the loss of confidence by investors all over the world in the country’s currency (Anthukorala, 2003). Several countries, Malaysia, Thailand, Indonesia, the Republic of Korea and the Philippines, were hit directly while others such as Taiwan Province of China, Singapore and especially Hong Kong, China were badly affected. The speculative attack on the Thai baht in July 1997 was quickly spread out to the other countries. Over a three-month period between July and October 1997, the baht fell nearly 40 per cent, the Malaysian ringgit and Philippine peso by about 27 per cent, the Indonesian rupiah by about 40 per cent and the Korean won approximately 35 per cent against the United States dollar (Ismath Bacha, 2004).

However, after the financial crisis, the investors are more confidence to invest in ASEAN. The FDI inflows in ASEAN countries started back by showing in increasing trend until 2008 (ASEAN Statistical Yearbook, 2008). Besides that, according to World Investment Report 2008, it is reported that FDI flows to ASEAN sub region which consist of Malaysia, Singapore, Indonesia, Thailand, Brunei, Philippines, Vietnam has increased by 18% in 2007 which amounting to USD$61 billion compared to 2006. The largest recipients of FDI countries are from Singapore, Thailand, Malaysia, Indonesia and Vietnam. However, the newer ASEAN member’s countries such as Myanmar, Vietnam, Cambodia and the Lao People’s Democratic Republic recorded the strongest FDI growth exceeding 70%.

FDI inflows among ASEAN countries are unequally distributed. From the graph below, it showed that Singapore is the largest recipient of FDI among ASEAN countries since 1995 until to date. It is followed by Thailand, Malaysia, Philippines and Indonesia. However, the figure has showed a decreasing trend in 2008.

Source: ASEAN Statistical Yearbook, 2008

Singapore are still remained as the most attractive country in the region for FDIs by gaining US$22.8 billion in 2008 which is much lower than the US$31.6 billion in year 2007. It is followed by Thailand which took the second position with US$9.83 billion and Malaysia which earned US$8.053 billion compared to US$8.4 billion in 2007. For Indonesia, they only received US$7.9 billion in 2008, the Philippines US$1.5 million and Brunei US$239.2 million. However, in 2008 it is reported that FDI flows to newly member of ASEAN such as Vietnam is US$8.05 billion, Laos received just US$227.8 million, Myanmar US$714.8 million and Cambodia US$815.2 million.

Most of the FDI flows in Asian countries come from developed countries where the major investors are from European Union (27.3%), Japan (14.1%) and United States (10.2%) for the period from the year 2000 – 2008. It is shown in the graph below. It is the same situation of main investors to Asian countries for the period 1990-2002. The largest investors in the Asian countries particularly in Singapore and Taiwan are come from United States. In contrast, Japan is the largest developed country investors in ASEAN (excluding Singapore) especially in Thailand and Indonesia. However, in the case of China, Hong Kong is the largest investor. As a whole, Japan, the United States and the European Union are among the important investors in East Asia with Japan being the most significant in ASEAN.

The increasing trend is due to numerous improvement and innovation among the ASEAN member countries. It is reported that the factors contributed to the increasing trend is due to favourable regional economic growth, an improved investment environment, higher intraregional investment and strengthened regional integration. All these factors are the main contributor to the increasing flows of FDI in ASEAN countries (World Investment Report, 2008).

FDI also allows the transfer of technology in various form of capital which cannot be achieved through financial investments or trade in goods and services. As mentioned earlier, FDI will promote competition in the domestic input market so that the local firms are more efficient in managing their businesses. Besides that, the recipient of FDI often gain employee training in the course of operating the new businesses which therefore reduce unemployment rate in the country and promote the development of human capital in the host country. As revenue for the government, FDI will offer revenue as the government will impose some corporate tax for the MNEs operating in the host country (Loungani and Razin, 2001).

1.2 DEFINITION OF FDI

“Foreign direct investment reflects the objective of obtaining a lasting interest by a resident entity in one economy (‘‘direct investor”) in an entity resident in an economy other than that of the investor (‘‘direct investment enterprise”). The lasting interest implies the existence of a long-term relationship between the direct investor and the enterprise and a significant degree of influence on the management of the enterprise. Direct investment involves both the initial transaction between the two entities and all subsequent capital transactions between them and among affiliated enterprises, both incorporated and unincorporated (OECD Benchmark Definition Of Foreign Direct Investment, 1999).

According to Balance of Payments Manual Fifth Edition (BPM5) (Washington, D.C, International Monetary Fund, 1993) and the Detailed Benchmark Definition of Foreign Direct Investment: Third Edition (BD3) (Paris, Organisation for Economic Cooperation and Development, 1996), FDI refers to “an investment made to acquire lasting interest in enterprises operating outside of the economy of the investor. The investor’s purpose is to gain an effective voice in the management of the enterprise.

Markusen et al, 1993 defined foreign direct investment as an investment in which the investor acquires a substantial controlling interest in a foreign firm or sets up a subsidiary in a foreign country. It involves ownership and / or control of a business enterprise abroad.

However, in order to undertake direct investment, the investor should consider three conditions as proposed by Dunning (1977, 1981) which known as OLI framework. First is the ownership advantage where the firm should have. This could be a product or a production process to which other firms do not have access such as a patent, blueprint or trade secret. In other words the ownership advantage is anything that gives the firm enough valuable market power to outweigh the disadvantages of doing business abroad.

Second, is the “L” which means that the foreign market should have location advantage which makes it more profitable to produce in the foreign country than to produce at home and export to the foreign market. For example, tariffs, quotas, transport costs and cheap factor prices are the sources of location advantages.

Third, is the “I” which mean that the MNE should have internationalization advantages. This can be done when the MNE think that the product or process is better exploited internally within the firm rather than open to the market.

1.3 DETERMINANTS OF FDI

The determinants of FDI can come from various forms whether from economic perspective, political, social and legal. These determinants play important roles for the investors to find new area for investment and expand their business. In a more recent study, Thompson and Poon (1998) analyse the macroeconomic determinants of FDI from Japan and the United States into East Asian countries, and the linkage between FDI and trade, and other macroeconomic variables. Their findings support some of the earlier findings regarding FDI inflows, but they also assert that the determinants of attracting FDI inflows differ between countries. In addition, the extent of the FDI inflows to a particular host country also differs in terms of its source country, (Japan and the United States). For instance, FDI inflows from Japan into all groups of countries studied were strongly affected by changes in real bilateral exchange rates, but this was not always the case for FDI from the United States ( Ismail and Yusoff, 2003).

These determinants also supported by Overseas Development Institute (1997) which focused on the factors influencing the destination of the investment: host-country determinants rather than industry-specific factors. They found that size of the market should take into consideration before investing in the country. Besides that, openness to trade, low labour costs and productivity, political risk and stability, good infrastructure, government incentives and operating conditions and privatization also important elements that should take into account before the firms make a decision to invest.

Mallampally and Sauvant (1999) find that factors that attracting FDI to developing countries can be summarized as follows:

Host country determinants of foreign direct investment (FDI)

Host country determinants

Type of FDI classified by motives firm

Principal economic determinants in host countries

Policy framework for FDI

Economic, political and social stability

Rules regarding entry and operations

Standards of treatment of foreign affiliates

Policies on functioning and structure of markets (especially competition and policies governing mergers and acquisitions)

International agreements on FDI

Privatization policy

Trade policy (tariffs and nontariff barriers) and coherence of FDI and trade policies

Tax policy

Market-seeking

Resource/asset-seeking

Efficiency seeking

Market size and per capita income

Market growth

Access to regional and global markets

Country-specific consumer preferences

Structure of markets

Raw materials

Low-cost unskilled labor

Skilled labor

Technological, innovative and other created assets (for example, brand names), including as embodied in individuals, firms and clusters

Physical infrastructure (ports, roads, power, telecommunication)

Cost of resources and assets, adjusted for labor productivity

Other input costs, such as transport and communication costs to/from and within host economy and other intermediate products

Membership of a regional integration agreement conducive to the establishment of regional corporate networks.

Economic determinants

Business facilitation

Investment promotion (including image-building and investment-generating activities and investment–facilitation services)

Investment incentives

Hassle costs (related to corruption and administrative efficiency)

Social amenities (for example bilingual schools, quality of life)

After-investment services

Source: UNCTAD, World Investment Report 1998: Trends and Determinants, Table IV.1,p.91

1.4 PROBLEM STATEMENT

In the context of Malaysia, the performance of foreign direct investment is fluctuated since 1995. Among ASEAN countries, for the period from the year 1995 – 2008 Malaysia was the third largest recipient of FDI behind Singapore and Thailand. For instance, in 1995 Malaysia has recorded FDI inflows amounting to US$5,815.0 million being second largest FDI recipients in the region. During the financial crisis which is in 1997, Malaysia still maintained their performance of FDI inflows amounting US$6,323.0 million behind Singapore. However, in 1998 the figure has dropped to US$2,714.0 and the situation become worst as Malaysia recorded FDI inflows in 2001 is just US$553.9 (ASEAN Statistical Yearbook, 2008). However, Malaysia has put up various strategies in order to increase the FDI performance until today. But how far that Malaysia benefited from the FDI activities to the country is still a question mark.

As mentioned earlier, the major FDI investors in ASEAN countries are from USA, Japan, European Union, China and Republic of Korea. Besides Malaysia, the investors from these countries had found new opportunity in other neighbouring Asia countries besides Malaysia. For instance, for the year 2006 Malaysia was among the largest recipient of FDI from USA (US$1,414.4 million), Japan (US$2,849.1 million) and European Union (US$1,000.2 million) among ASEAN countries. However, the trend has changed where in 2007 investors from USA has shifted to invest in Singapore, Indonesia and Vietnam as new sources of FDI. The same situation occurred for investors from Japan and European Union where they found that more attractive countries in ASEAN region for FDI are Thailand, Singapore, Indonesia, and Vietnam. Besides that, in 2008 investor from China and Republic of Korea have more investment in Cambodia, Indonesia, Singapore, Thailand and Vietnam (ASEAN Statistical Yearbook, 2008). Therefore, Malaysia will be left behind in term of FDI if proper plan and strategies is not prepared to compete with other ASEAN countries.

The situation in Malaysia is now become more critical as FDI flows show a decreasing trend. A lot of comments have been posted to the government commented about the FDI performance in Malaysia. In the era of globalization, Malaysia become less competitive in terms of growth of foreign direct investment and export compared to other Asia countries. This can be shown in the figure below.

The reason behind the scenario that Malaysia faced less competition in attracting FDI is because few countries is having as open an economy in terms of trade and investment policies. For example, Malaysia often finds itself competing, not just against countries in the immediate region, but also against those in South America and Eastern Europe. Economic power naturally gravitates towards the larger regional economies, particularly China, India, and Indonesia. This is because these countries have the advantage of scale, both in terms of cost and size of domestic markets if compared to Malaysia (The Tenth Malaysia Plan, 2010).

Basically, Malaysian Government should find other forms of FDI and not only limited to the construction and manufacturing sectors in order to promote FDI in order to attract more investors come to Malaysia. Therefore, the government should put more effort in promoting FDI whether inflows or outflows in order to improve the current situation and encourage more investment in the country as highlighted in Tenth Malaysia Plan under the 10 Big Ideas. It is hope that the implementation of these ideas will transform Malaysia to a high-income economy and developed nation by 2020.

Since the FDI is decreasing and the existing Multinational Corporation which operates in Malaysia shifted their operation to other countries such as Thailand, Vietnam and China, therefore a comprehensive study should be carried out to examine the determinants contributed to FDI inflows in Malaysia compared to other ASEAN + 3 countries such as Thailand, Singapore, Indonesia, Vietnam, China, Korea and India. Due to differences in factors that attracting FDI to the countries, this paper will examine the differences of determinants in FDI among these countries.

This study will use the Gravity Model approach to find that language, border and distance play important role in attracting FDI inflows besides other economic and non-economic variables. Panel data will be used for the period of 1980 – 2008. Finally, it is expected that this papers will show the distinctive factors attracting FDI inflows in Malaysia compared to other countries. Besides that, it is hope that Malaysia can learn about other countries strategies in attracting more investors and maintain the existing MNCs in order to generate more income for the country.

1.5 OBJECTIVE

(i) To investigate the determinants of FDI inflows in Malaysia with other ASEAN+3 countries which consist of Thailand, Singapore, Indonesia, Vietnam, China, Korea and India.

(ii) To examine the differences of factors that are dominant in attracting FDI among these countries.

1.6 SIGNIFICANCE OF STUDY

From this study it is expected that it will help the policy maker to find new strategies in attracting FDI to the countries and compete in the global market. Therefore, more investment in the country will help to generate economy and finally contribute to economic growth.

1.7 ORGANIZATION OF RESEARCH

This paper will be organized as follows: the next section will be discussing about literature review from previous studies based on theoretical or empirical studies. Section 3 is regarding methodology and the model which will be used in the study. This paper will use the Gravity Model to find the determinant of FDI. Section 4 is the results and findings and finally Section 5 will be the conclusions and recommendation.