7:36 AM Jan 22, 1996

FDI'S "DECAPITALIZATION TRAP" IN MALAYSIA

Kuala Lumpur 21 Jan (TWN/Martin Khor) -- Concern over a growing balance of payments deficit is casting a shadow over the much-heralded "miracle economic growth" of Malaysia, one of Asia's rapidly emerging economies, often held out as a model of second tier NICs.

Whilst the Gross National Product has expanded by eight to nine per cent annually in the past seven years, the current account of the balance of payments has also been increasing from US$ 2.2 billion in 1992 (or four percent of Gross National Product) to US$ US$ 7.1 billion last year (nine percent of GNP).

This has sparked a national debate as to whether the economy is "overheating." Proponents say the current account deficit is unsustainable and should be cut down by slowing of growth. The other camp, led by Prime Minister Mahathir Mohamad, believes that steps can be taken to reduce the deficit without sacrificing the high growth rate.

All agree, however, that the deficit is serious and must be tackled. Economic planners and analysts are now combing through trade data to assess its causes.

They have, as expected, found such longstanding items as the traditionally large freight payments made to foreign ships carrying the country's traded goods, insurance paid on these goods, and large amounts spent by Malaysian students and tourists abroad.

There are also the imports of luxury or expensive products, such as motor vehicles, Italian tiles and household furniture, that contribute to the deficit.

But there is a less visible, but more surprising and important source of the balance of payments problem.

According to many public and private sector economists, the recent big jump in the current account deficit has been largely caused by outflows of funds resulting from the boom in foreign investments of the last several years.

This may seem paradoxical, as foreign investors bring money into the host economy. Malaysia's experience, however, confirms the general finding that what comes in through one door (as capital inflow and export earnings) goes out through other, multiple doors (including payment for imports of machinery and intermediate goods, payments and fees and repatriation of profits).

The outflows on account of foreign investment overall can be heavier than the inflows. In such a situation, foreign investment can have a net negative effect on the balance of payments.

This interesting relationship emerged at a recent economic forum on "Reducing the Balance of Payments Deficit" organised by the Asian Strategy and Leadership Institute and opened by the Prime Minister.

The basic facts are that in 1995, the current account's US$ 7.1 billion overall deficit was made up of a small US$ 0.2 billion deficit in the merchandise balance and a hefty US$ 7.1 billion deficit in the services account.

The services sector is thus the weak spot in Malaysia's economy. The services account measures payments to foreigners for freight and insurance, education, travel and investment income which includes profits on investment and interest on debt. The biggest leakage by far is caused by the outflow of profits of foreign firms.

Malaysia's top planner, Economic Planning Unit director-general, Ali Abul Hassan Sulaiman, said that "it is the net outflows for investment income payments (particularly repatriation of profits and dividends for foreign-owned companies) that is the single major contributor of the services account deficit."

By 1996, he added, gross profits repatriation by foreign-owned companies is projected to reach US$ 6.4 billion, or 73 percent of the total services deficit.

Ali also revealed that in 1994, net outflow of investment income totalled US$ 3.7 billion. Of this, interest payments made up 15 per cent, whilst profits and dividends (mainly from the manufacturing sector) accounted for 85 percent of investment income and 73 percent of the total services deficit.

To reduce profit repatriation by foreign firms, Ali suggested that incentives be given to investors to reinvest in or diversify their operations in the country.

However, as one economist pointed out, this proposal, raises a tricky question: if there is further reinvestment by foreign firms, the stock of foreign capital would rise, resulting in a higher future stream of profits and dividends.

If so, there is the dilemma of reducing the present effects of the profit outflow but facing the potential of even higher streams of profit outflow in future. The problem is thus not solved but postponed, and to a potentially higher level.

At the same seminar, several economists also pointed out another major problem arising from foreign investments: the foreign firms import large amounts of intermediate and capital goods that are used to produce the final products. This has caused the country's import bill to balloon in recent years, at rates higher than the growth of exports.

The local economists suggested a more cautious attitude towards the growth of foreign investments and that, instead, more attention be paid to raising the status of local companies.

Dr Tan Tat Wai, managing director of a local steel company and a former consultant with the Central Bank, highlighted the dependence of the Malaysian manufacturing sector on foreign firms and called for the development of local enterprises.

He said that whilst manufactured exports had become dominant, these were heavily dependent on electrical appliances and electronic components which account for two-thirds of the country's manufactured exports and half of total exports.

Dr Tan added that foreigners now dominate the manufacturing sector, especially in the electronics industry, where there are only a handful of Malaysian companies. He contrasted this to Taiwan, where to a large extent the computer industry is pioneered, run and managed by Taiwanese.

"We have to break into the fast growing field of manufacturing, as in the long run we need to have our own locally-owned enterprises," he said, adding that local firms will tend not to transfer their activities abroad as easily as foreign firms may, when other countries begin to have a comparative advantage.

According to Dr Ghazali Atan, chief economist of a leading financial institution, the MBF Unit Trust Management, the profit and dividend outflow arising from foreign investment "can be as bad as the notorious debt trap of the 1980s, if not tackled properly."

Using a economic model as illustration, Dr Ghazali showed that in a matter of years the outflow of foreign profits would exceed the inflow of new foreign capital, and that this gap could well increase over time.

Terming this phenomenon as the "decapitalisation trap", Dr Ghazali also showed that between 1980 and 1995, the profit outflow exceeded new foreign capital inflow in Malaysia in almost all of the years.

"The net financial effect is that the country hosting foreign investment becomes a net contributor of capital, and not a net recipient," he said. "If there is no compensating factor, the country will get into a balance of payments problem on the services account."

Dr Ghazali proposed that domestic investments be promoted to grow at a faster rate than foreign investment to ensure the predominance of local ownership of the economy. Instead of promoting foreign ownership, Dr Ghazali said it was preferable to import foreign manpower, expertise and technology. "Profits would then accrue to local interests and this will limit the outflow of foreign profits."

He also called for "localisation of foreign interests", whereby foreigners integrate themselves with the local economy.

The discussion on Malaysia's current account deficit throws important light on the need to assess the impact of foreign investment on the host country's balance of payments, growth and financial position.

It is generally believed that foreign investment gives a boost to a host country's foreign exchange earnings and growth and Malaysia has often been held up as a model of foreign investment-driven and export-led growth.

But its rising balance of payments problems in recent years show that foreign investment can be a mixed blessing, as it can have a net negative effect on the balance of payments.

Just as importantly, the Malaysian case points to the need of policy makers to be able to regulate the inflow and operations of foreign investors, and to take measures discouraging outflows of funds due to the high imports and profit repatriation of foreign firms.

The European Commission's proposal for a multilateral investment treaty in the World Trade Organisation makes the assumption that increased rights for foreign companies to invest wherever they choose, with minimal or no regulation by governments, will have positive effects for host countries.

The Malaysian case seems to contradict this assumption. It shows that foreign investment can lead to serious imbalances in the balance of payments which ultimately place constraints on growth.

Moreover, it shows that to obtain positive effects from foreign investment (and reduce negative effects), a host government would need to have the powers to impose conditions and regulations on foreign firms, as well as to retain the policy options to encourage the growth of local enterprises.

The proposed multilateral treaty would remove the present ability and authority of governments to restrict the entry of foreign investment, impose conditions on ownership and operations of foreign firms and to give special treatment to encourage the growth of local firms, would be removed.

This would make it most difficult or even impossible for host governments to ensure that foreign investments do not lead their countries into balance of payments difficulties, or to take effective measures to solve a balance of payments problem when one arises.