The Relationship between Foreign Direct Investments and Domestic Investments - Literature review Example

Foreign direct investment Student’s name: Instructor’s name: Course code: Date of submission: Abstract This paper assesses the relationship between foreign direct investments and domestic investments that is whether compliments or substitutes. Both investments have been a source of economic development in developing countries. The paper outlines the link between these two types of investments and their effects on economic growth of developing countries. The paper aims to study how foreign and domestic investment has influenced the growth of the Malaysian economy from 1970-2005 by use of time-series data. Data used in empiric analysis was from tables sourced from the United Nations conference on trade and development (UNCTAD) to find out how FDIs and economic growth in Malaysia relate. The results clearly show that LGNI, LGDP and LFDI series in Malaysia are I (1) series. Introduction Many multinational enterprises have especially from developed and some developing countries are investing abroad via FDIs. Thus, a question arises whether FDIs compliment or substitute the domestic investment in home countries. Policy makers in countries should assess how foreign direct investment outflows affect the domestic economy since domestic investment rates the accumulation of physical capital hence determining the economic growth rate. It is therefore important to understand the impact of FDIs on local investment so as to make market reforms capable of boosting local investment and economic growth. Foreign direct investments and domestic investments have played a big role in economic growth worldwide. Foreign direct investments deploy valuable assets in developing countries and most of these investment assets are intangible. These assets are mostly technology, skills, management and networks for marketing internationally, product quality and design, brand names etc.. The foreign direct investments help in the growth of the economy of developing countries. Foreign direct investments as influenced economic growth in Malaysia and made it one of the fastest developing countries. The theoretical view The effects of FDIs outflows on domestic economy vary from one country to another depending on the motives of the foreign investing firm and the characteristics of the economies of the different home countries (Jasin, 2007). Capital outflows transfers are part of privately owned domestic savings abroad and effects of such outflows differ in countries possessing abundant savings to those lacking sufficient capital. Hejazi and Pauly (2003) identified two ways in which FDIs may affect home country’s local investment. Firstly, firms investing abroad tend to transfer some of their capital meaning part of domestic savings is moved abroad and under imperfect financial market conditions and financial resource scarcity, domestic firms will lack financial liquidity to cater for new investments and it will be difficult for them to raise capital in domestic financial markets. Therefore, FDI outflows affect home country’s domestic investment negatively. Secondly, firms shift their production abroad due to either seek efficiency, market or strategic assets. Firms may shift their production abroad so as to increase efficiency by re-locating production facilities to nations with cheap resources. In this case, domestic production is not reduced and the outward FDI may facilitate the rate of domestic investment via firms exporting intermediate goods and capital (Hejazi and Pauly, 2003). Firms may shift their production facilities abroad to seek market both domestically and abroad. In this case, FDIs outflows in services would affect the rate of domestic investment either positively or in a neutral way since FDI won’t substitute exports. If FDI outflows substitutes exports, then it's clearly shown that FDI outflows will reduce domestic investments Al- sadig, 2012). However, as a firm moves its facilities abroad, it may promote intermediate products export from home country to firm’s foreign affiliate. Firms moving their assets abroad for strategic asset seeking aims to obtain vital assets lacking in their home country for the long term benefit of the firms (Bengoa & Sanchez, 2003). This type of FDI has positive effects on local investments since access to relevant technologies and skills may will improve productivities of such firms and hence under-take new activities in the home countries, hence improving the economy of their home countries. In conclusion based on the above theories, the impact of foreign direct investments outflows on the home country’s domestic investment may be positive, negative or neutral. Therefore foreign direct investments and domestic investments can relate as either substitutes or compliments depending on motives of foreign investments by investing firms or economic characteristics of different countries. Policies of Malaysia in foreign direct investments Herzer and Schrooen (2007) says that the role macroeconomic factors such openness to economy, interest rates, market size and human capital has led to attraction of foreign direct investment in Malaysia. Since the 1970s Malaysia has always been regarded as the most attractive country for foreign direct investment in the Asian region. Available studies show that the government authority of Malaysia outlines favorable policies to attract investors. The success of Malaysia is due to a number of factors of good business environment that include sound macroeconomic performance, social stability, economic stability, political stability , expanding domestic markets , availability of a variety of natural resources, labor supply and other business resources accompanied with conducive macroeconomic policies. In south- east Asia, Malaysia is the promising developing country characterized with good physical infrastructure, high institutional quality and large investments in public education (Xu and Wang, 2007). Malaysia also has consistent commercial policy, good macroeconomic management, investment promotion and efficiency and high level of economy openness making it an attraction destination for foreign direct investment (Jasin, 2007). The rising trend in foreign direct investment in Malaysia is due to the growing market orientation and a policy shift. The authorities are putting in place tariffs that favor foreign direct investment which in return grows the country’s economy. In Malaysia, labor is easily available due to increasing population and the domestic market is high hence attracting more and more investors (Hejazi & Pauly, 2003). The country authorities ensure security is tightened hence giving investors confident to invest in the country hence attracting more and more foreign direct investment. Policies put in place have made Malaysia an attraction for foreign direct investment. Foreign direct investment is highly encouraged and investors are made to feel at home. This has made Malaysia one of the top and fast developing countries in Malaysia. Data empiric For the past two decades, Malaysia has been an attraction for foreign direct investments due to its political stability, lower wage rates among other factors. The figure below shows FDI inflow in Malaysia from 1970-2004. Malaysia has been receiving a lot of FDI for the last two decades. From 1970s to 1990s, FDI in Malaysia has been growing rapidly. However, since the early 1990s, periods of slowdown have been experienced. In 1993, FDI in Malaysia dropped drastically due to slowdown in investments from Japan and Taiwan. Reason for this was increasing wage rates in Malaysia and other Asian countries (Xu & Wang, 2007). Total FDI flows peaked in 1996 by receiving $7.3 billion dollars. It was later affected by the financial crisis in 1997. Since early 2000s, FDI inflows tend to fluctuate randomly in Malaysia, however it achieves average inflows totaling to $3 billion a year. YEAR FDI INFLOWS IN MILLION DOLLAR 1970 200 1971 225 1972 230 1973 400 1974 380 1975 362 1976 363 1977 400 1978 510 1979 625 1980 730 1981 850 1982 1110 1983 1115 1984 1050 1985 1200 1986 720 1987 600 1988 700 1989 200 1990 180 1991 4100 1992 6050 1993 3800 1994 6100 1995 6300 1996 7300 1997 3600 1998 3950 1999 3900 2000 3800 2001 3700 2002 3200 2003 3400 2004 3600 Figure 1. FDI Inflows to Malaysia, (in million dollars) 1970-2004 Source: United Nations Conference on Trade and Development (UNCTAD), various issues. In South East Asia, Malaysia is the second fastest growing economy with an average of 8% GNP growth annually for the past 7 years. Since 1957, Malaysia has shifted from being an agricultural based economy to an export and diversified economy. Its market is openly oriented 15% tariffs and near non-existent barriers of non-tariffs and foreign exchange controls. Due to a stable political environment, its per capita income is increasing and potential for regional integration throughout ASEAN making Malaysia an attractive prospect for FDI. Good environment in Malaysia attracts FDI leading to economic growth. The economic growth rate has improved from 22% to 39% in the past seven years (Jasin, 2007). Good favorable conditions enable investors to face a few problems in their businesses in order to make more profits with life security. Important factors that influence foreign direct investment include economic and political stability, lower wages, and accessibility to plenty of raw materials, person safety and special rights. The long term political stability in Malaysia gives investors confidence that their business will succeed and bring more profits. Due to increased foreign direct investment in Malaysia, more and more jobs have been created. Employment rates have gone up from 32% to 53% and now majority of the population are employed (UNCTAD, 2012). This has improved the per capita income in the country. Moreover, due to employment opportunities, crime rate has gone down and also secured has been tightened to cater for sort of crimes so as to attract more and more investors. Improved rate of employment has given rise to improved standards of employment. Educational facilities and social amenities have been developed to standards and public education has been expanded. This has improved the literacy level in the country and productive citizens are being developed from early stages (Jasin, 2007). Due to these developments, tourists’ rates are increasing and Malaysia is benefiting from foreign income which is further used to improve and develop the economy of Malaysia. The rate of foreign income has increased from 15% to 38% in the past seven years (UNCTAD, 2012). Generally, the foreign direct investment in Malaysia has highly enabled the economy of the country to grow and be one of the best in developing countries not only in Asia but worldwide. Conclusion Foreign direct investment and domestic investment can both exist as substitutes and compliments. Factors that matter are the motives of investing firms and the characteristics of those countries. Foreign direct investment is highly encouraged in Malaysia. It has improved the economy of Malaysia and made Malaysia one the fast and best developing countries in the world. The authorities of Malaysia have put in place policies that attract foreign investors and make their settlement in Malaysia easy and comfortable. Therefore countries are encouraged to put favorable policies in place for foreign direct investment since it will improve their economies especially developing countries. References Al-Sadig, A. 2012. “the Effects of Foreign Direct Investment on Private Domestic Investment: Developing Countries”, Empirical Economics, pp. 1–9 : 10.1007/s00181-012-0569-1. Bengoa, M. & Sanchez-Robles, B. 2003. Foreign direct investment, economic freedom and growth: new evidence from Latin America. European Journal of Political Economy, 19, 529-545. Hejazi, W., and Pauly, P. 2003. “Motivations for FDI and Domestic Capital Formation”, Journal of International Business Studies 34: pp. 282–289. Herzer, D. and Schrooten, M. 2007. “Outward FDI and Domestic Investment” , DIW Discussion Paper 679. (Berlin: Deutsches Institut für Wirtschaftsforschung). Jasin, A. K. 2007. “Malaysia in its Best Shape”, Agenda Daily, Retrieved on March 4, 2007 from: www.agendadaily.com UNCTAD 2012. World Investment Report, Towards a new Generation of Investment Policies, (Geneva: United Nations Conference on Trade and Development). 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