Jun 19, 1998

MALAYSIA: FDI HAS NEGATIVE EFFECTS ON BOP, SAVINGS SAYS NEW STUDY

 

Geneva, 18 June (Chakravarthi Raghavan) -- "The net effect of Foreign Direct Investment on the balance of payments had been negative, and FDI appeared to have taken more out of the economy than it had put in," according to a just published new study by Phang Hooi Eng, a Senior Manager in the Economics Department at Bank Negara Malaysia (the Malaysian central bank).  

However this negative effect, says Phang, may be more than offset by retained earnings which are ploughed back either for reinvestment in the business or for new investment in related or new areas of business.  

Also, because of Malaysia's very liberal exchange control regulations, except for one year (1984), the foreign sector has experienced a persistent deficit in its saving-investment gap, Phang adds.  

This gap was serviced by the local sector, but when local savings dropped significantly and was insufficient to finance the deficit in the foreign sector, "the outcome was an overall deficit in the country's saving-investment gap, with resultant consequences of having to borrow from overseas to finance this gap," she adds.  

Phang has done research work on several aspects of the Malaysian economy, especially issues pertaining to the manufacturing and construction sectors as well as investment, intra-regional trade, incentives and effective rate of protection as well as market structure. She has previously (1990/91) done research work at ESCAP/UNCTC joint unit on Transnational Corporations.  

The study, "Foreign Direct Investment: A study of Malaysia's Balance of Payments position", uses a variety of data sources to look at the direct effects of FDI on the BOP.  

But given the difficulties of finding appropriate shadow prices for evaluating various inputs and outputs, and the need to break down foreign contribution into its financial and technological components, the study has not attempted to measure the "total" effects on the economy, but only discusses the indirect effects.  

And while FDI brings both benefits and ill-effects, the study advocates measures that the government could take to encourage domestic investment and, at the least will not favour foreign investment at the expense of local. The country, she adds, has to adopt a more selective approach to promoting and encouraging FDI, since FDI "also has important negative effects on the country's balance of payments." 

On this, and some other matters, Phang's study, based on data, contradicts the bald dismissal of these negative effects by a WTO Senior Advisor, Zdenek Drabek. In a paper published in the FONDAD publications to promote the MAI, Drabek says the arguments of critics about FDI's adverse effects on BOP, savings and, through decapitalization effect, on domestic growth, "are not viable" and receive "declining support from academics, policy-makers, journalists and other experts as "there is no theoretical reason" to provide support for these ideas. Drabek paper, presented in November 1997 (four months after the meltdown of Asian markets began), says the empirical evidence also contradicts these fears "as illustrated by the economic successes of Southeast Asian countries."  

Some of the measures to counter the adverse effects suggested by Phang though would be difficult, if not impossible, if developing countries accept and negotiate multilateral investment rules or frameworks (on basis of proposals at the OECD, WTO, or UNCTAD), which would provide rights for foreigners to invest in a country and get 'national treatment' with locals after investment. 

Foreign firms in Malaysia, Phang finds, are more export-oriented, but also have a "higher import content". While for local firms, import content decreased from 0.22 in 1981 to 0.18 in 1985, and increased again to 0.22 in 1988, for foreign firms the import ratio in the manufacturing sector rose from 0.41 in 1981 to 0.45 in 1985, dipping slightly to 0.43 in 1988. 

Only the two firms in the electronics industry had imports exceeding 80% of their output, but in all other sectors there was no significant difference in import propensity between local and foreign firms. This is because much of the technology in local manufactures is copied from foreign manufacturers who have been in the field much longer, and local manufacturers have not yet built a sufficiently high level of sophistication in technology and R & D efforts.  

Since the electronics industry is the most important in the manufacturing sector in terms of output, exports and imports, the significant difference between local and foreign firms will have a significant impact on the BOP.

On the other hand, the significant differences in import propensity between foreign and domestic firms could be accounted for either by the practice of transfer pricing by foreign firms or because the two foreign firms are engaged in producing more sophisticated electronics products embodying higher technology and therefore use more imported inputs. But this higher import propensity will have implications on the country's trade balance.  

Looking at sources of growth for local and foreign firms -- and effects of import substitution, export-expansion and growth in domestic demand -- Phang finds while some industries developed in response to the export market, others expanded in tandem with the country's industrialization. The non-ferrous metal industry was developed to cater to the domestic market, and thus contributed to an import-substitution growth. But when it was unable to cope with high local demand, more had to be imported, resulting in a negative trade balance. 

Apart from this industry, import-substitution had a positive effect on output growth only for a few industries, most of them resource-based, producing intermediate goods - transport equipment, petroleum and coal products, plastic materials, fabricated metal products, electrical machinery and appliances, paper and paper products, meat preparation, pottery, glass and glass products, wood and cork products and beverages. But for the majority of industries, import substitution effect was negative.  

The industries with highly negative import substitution effects were also those which were most outstanding in export-expansion -- telecommunications and sound recording equipment, chocolate and sugar confectionary, petroleum and coal products, footwear and other industries.  

For the wearing apparel and telecommunication industries, the high positive contribution of export expansion was accompanied by negative import substitution and this appears to show "that Malaysia is the dumping ground for foreign companies in these two industries and they exported what the home market could not absorb." Another plausible explanation is that in these two industries import content was high and value-added was low. In the case of other industries with outstanding contribution to export expansion, home market demand has also had a negative impact. These were the industries most favoured by government's export promotion drive and have benefited most from incentives for export expansion.  

Phang says that the discussion of various elements in the study shows that while FDI stimulates and generates trade, its net contribution to the country's balance of payments is very much reduced by outflows due to the higher import propensities of foreign firms, repatriation of investment income, technical and royalty payments and freight and insurance payments.  

At the macro-level, data presented by Phang shows that the direct effects of FDI on the bop had been negative over 1980-1987, peaking in 1984 with a net drain of Malaysian Ringet (RM) 3.2 billion, and only RM 0.4 billion less than value of gross FDI inflows in that year. 

The main reason for this appeared to be that net return on trade (exports less imports) was low compared to the repatriation of investment income in the form of dividends and profits.  

When the margin between exports and exports widened considerably in 1988, the net effect of FDI on bop became positive. And when the trade margin as well as net capital inflow doubled in 1989, the net effect on bop increased twelve-fold from RM307 million in 1988 to RM3.8 billion in 1989.  

But as output and exports became more biased towards import intensive non-resource based manufactures, imports exceeded exports in 1991 and this deficit in trade balance for foreign companies caused the net effect on bop to change sharply from a surplus of RM2.0 billion in 1990 to a deficit of RM1.1 billion in 1991; estimates for 1992 show that trade balance effect reversed from a net outflow in 1991 to a inflow in 1992, and the net impact on bop was a positive RM3.7 billion.  

Hence, concludes Phang, data on the direct effects of FDI on BOP of Malaysia appear to suggest that countries should encourage foreign firms to export more than they import to ensure that foreign firms are not taking out more than they have put into the host country.  

Phang's data shows that the ratio of foreign savings to GNP had increased from 1.6% in 1987 to 4.1% in 1989, except for 1984, foreign savings had fallen short of the financing needs of foreign investment for the whole period 1983-89 so that there was a persistent deficit in the saving-investment gap for foreign sector.  

Upto 1985, insufficiency of local savings to finance investment needs had been highlighted, but the deficit in foreign sector had not been considered mainly because the foreign sector was relatively small. Even when it gained in importance in 1987, this deficit did not receive much attention because the surplus in the local sector had been strong during 1987-88 and there was no deficit in the overall savings-investment gap.  

It was only in 1989 when there was a dramatic decline in household savings and the surplus in local private sector was not enough to finance both the deficit in the public sector and the deficit in the foreign sector, that this shortfall was detected but only as a deficit in the overall savings-investment gap.  

But the present analysis, Phang adds, provides a new dimension to the negative impact of FDI on the country's savings and consequently its balance of payments if foreign investors are allowed to have access to local funds. 

"This study," says Phang in her conclusions, "shows that FDI has both negative and positive effects on the country's BOP. While it is true that in the early period of the 1980s, FDI provided the catalyst for economic growth and provided employment opportunities, the country has to adopt a more selective approach to promoting and encouraging FDI because it also has important negative effects."  

Analysing the various differences between foreign and local firms, emerging from her study, Phang suggests that in terms of trade orientation, exports from local firms can be encouraged through encouraging them to go into joint ventures with foreign firms or building strategic alliances so as to penetrate foreign markets.  

The government has also to look more deeply into the question of technology transfer because at present the local firms cannot compete with foreign firms in higher technology industries, especially investment and intermediate goods industries. Local firms thus tend to be displaced by foreign firms.  

And given the finding of net negative effect of FDI on the BOP, and the persistent deficit in the savings-investment gap of the foreign sector, Phang suggests the Malaysian government could consider strategies and implement policies to discourage outflows. 

One area, she says, would be to reconsider the ruling which allows foreign firms to borrow from domestic sources so long as the borrowings don't exceed twice the value of funds brought in. Perhaps, this rule has to be tightened and more stringent conditions imposed so that foreign investors do not "crowd out" domestic investors.  

And since foreign firms have greater access to foreign funds, the government could consider strategies to encourage such firms to bring in more foreign funds to finance their investments in Malaysia rather than to utilise domestic or local sources of funds. 

Since foreign firms now have access both to domestic and foreign sources of funds, FDI in Malaysia is affected by the exchange rate as well as the differential between foreign and local interest rates.  

And if the deficit in savings-investment gap is due mainly to the foreign sector, as the study shows, then there are strong grounds for the government to seriously consider ways and means not only to ensure that foreign firms bring in more funds to finance their investments but also to encourage them to plough back more profits either for reinvestment or new investments in related or new areas of business, particularly in more technology-intensive or knowledge-intensive industries where local firms do not yet have comparative advantage.  

After ten years of progress in partnerships made possible by FDI, Malaysian industries have perhaps reached a sufficient stage of maturity for government to embark on a new threshold of development that will emphasize an industrialization strategy involving higher end of the value added chain.  

FDI could be encouraged into smart partnerships with local investors in industries with high value added and strong linkages with supporting industries and services, in other words inviting FDI to encourage development of strong and viable industrial clusters. 

And it is timely for the government, Phang concludes, to encourage local manufacturers to progress from original equipment manufacturers to becoming integrated manufacturing and marketing companies that do not merely manufacture products according to their client's specifications, but in fact produce and export products carrying their own brand names.