M PRA

Munich Personal RePEc Archive

The relationship between trade openness,

foreign direct investment and growth:
Case of Malaysia

A.H. Baharom and M.S. Habibullah and R. C Royfaizal

Universiti Putra Malaysia

17. October 2008

Online at http://mpra.ub.uni-muenchen.de/11928/
MPRA Paper No. 11928, posted 4. December 2008 15:47 UTC
The relationship between trade openness, foreign direct investment and growth:
Case of Malaysia

by

A.H Baharom* , Muzafar Shah Habibullah and R.C Royfaizal

ABSTRACT

This study examines the role of trade openness and foreign direct investment
in influencing economic growth in Malaysia during 1975-2005, using the Bounds
testing approach suggested by Pesaran et al. (2001). The empirical results demonstrate
that trade openness is positively associated and statistically significant determinant of
growth, both in short run and the long run. The result also suggested that foreign
direct investment is positively associated in the short run and negatively associated in
the long run, both significantly. Besides these two variables, the other control variable
namely exchange rate is also significant in the short run as well as in the long run.

1.0 Introduction

International free trade has often been referred to as the “engine of growth”
that propelled the development of today‟s economically advanced nations during the
nineteenth and early twentieth centuries. Rapidly expanding trade especially or
specifically the export sector provided an additional stimulus to growing local
demands that led to establishment of large scale industries.

In some individual countries, notably South-East Asia, the growth of exports

has exceeded ten percent per annum. Exports have tended to grow fastest in countries
with more liberal trade regime, and these countries have experienced the fastest
growth of GDP†.

2.0 Objectives of the study

Studies have flourished recently on economic growth and its determinants.

However very few researchers have taken into consideration the level of trade
openness as an independent variable in their research, and since economic theories
even from the classical era have pointed the importance of being involved in trade as
an important element in growth.
The objective of this study is to evaluate the role of trade openness on economic
growth. Other control variables in the specification are, foreign direct investment
(FDI) and exchange rate (EX). These variables are included in this research because

*
All authors are affiliated with the Department of Economics, Faculty of Economics and Management, Universiti Putra
Malaysia, Serdang, 43400 UPM Selangor. The corresponding author is AH Baharom. Tel: (603) 89467710; E-mail:
[email protected]
†
A.P.Thirlwall “Trade Agreements, Trade liberalization and Economic Growth: A Selective Survey”

1
past studies and economic theories have pointed out the importance of these variables
as a stimulant for economic growth and to get a more accurate result. It is also to
avoid the mistake of missing variables or big errors.

3.0 Review of Related Literature and Empirical Evidence

The results obtained by David Barlow (2006), Panagariya (2004), Chui,

Levine, Murshed and Pearlman (2002) are mixed. While Barlow (2006) discovered
that the level of trade liberalization is found to raise the growth rate, particularly in the
early part of the transition and for the countries nearest to the European Union,
Panagariya (2004) found mixed results between countries, while there are countries
enjoying good growth in their economic performance due to trade openness such as
Botswana, Malta, Singapore and Hong Kong (to name a few) which he called
miracles, at the same time there are countries with negative growth like Kuwait,
Liberia, UAE (to name a few) which he called debacles.

On the local front, Baharumshah and Rashid (1999), Wong and Yip (1999)
Choong , Zulkornain, and Liew (2005), did studies on determinants of growth in
Malaysia, albeit using different methodology, and all of them in one way or another
agrees that export is a important factor of growth, however none of the uses trade
openness or total trade for the study in Malaysia. The export-led growth hypotesis is
also supported by Mahadevan and Suardi (2006).Since it is a known factor that trade
openness is an important variable of growth as claimed by Dexter, Levi and Nault
(2005), we replaced the export variable with trade openness. In the survey of how
large is International Trade‟s effect on Economic Growth which was done by Lewer
and Van Den Berg (2003) reveals that many empirical studies are surprisingly
consistent in terms of the size of the relationship. A percentage point increase in the
growth of exports is associated with a one fifth percentage point increase in economic
growth. Given the power of compounding, the effect is very important for human
welfare.

4.0 METHODOLOGY
4.1 The Economic Growth Model

In this study, the real per capita Gross Domestic Product (RGDPC) growth is
used as a measurement of economic growth. (dependant variable) with the trade
openness (TOP), real effective exchange rate (REER), real foreign direct investment
(FDI) as the independent variables. An autoregressive distributed lag (ARDL) model,
more explicitly bounds test approach as introduced by Pesaran et al (2001) is used to
test and examine the variables.

RGDPCt = f (FDIt , TOPt , REERt, ) or more explicitly stated as unrestricted error

correction model (UECM) as below:

∆ RGDPCt = β0 + β1RGDPCt-1 + β2FDIt-1 + β3 TOPt-1 + β4 REERt-1 +

a b c d
Σβ5,i∆ RGDPCt-i + Σβ6,i∆ FDIt-i + Σβ7,i∆ TOPt-i + Σβ8,i∆ REERt-i + ut
i=1 i=0 i=0 i=0
(1)

2
Where the RGDPC is the real Gross Domestic Product per capita, FDI is the real
Foreign Direct Investment inflow, TOP is the level of openness which is the ratio of
total trade (export plus import) over real GDP, Real Effective Exchange Rate (REER)
and ∆ is the first difference operator.

For the examination of long- run relationship the bound cointegration test based on
critical values taken from Pesaran (2001) will be used with the null and alternative
hypotheses are as below:

Ho = β1 = β2 = β3 = 0 (no long-run relationship)

H1 = β1 ≠ β2 ≠ β3 ≠ 0 (a long run relationship)

4.3 Description of sources of Data

Annual data for the period 1975-2005 was collected from the International
Monetary Fund (IMF), The RGDPC growth data was obtained from the first
difference in the logarithm of real GDPC. The exchange rate was the real effective
exchange rate (REER). For the level of openness, the export and import data was
totalled and divided with GDP to obtain the index. As for the real Foreign Direct
Investment (FDI), again the logarithm of the raw data obtained of the inflow of funds
was used.

5.0 DISCUSSION OF EMPIRICAL RESULTS

A unit root test was done for the dependent variable using the Augmented
Dickey-Fuller (ADF) test to satisfy the pre-requisite condition of the dependent
variable being non stationary or contains a unit root in I(1) and stationary at I(0) as
prescribed by Pesaran (2001). .

5.1 Results of the Unit Root Test for the dependent variable(DF/ADF)

Table 1 Results of the Unit Root Test for the dependent variable (DF/ADF)

DF/ADF
Variables Level 1st difference
Constant k Trend k Constant k Trend k
GDP -1.217339 0 -2.65439 0 -4.669541* 0 -4.534774* 0
Note : Asterisk (*) denote statistically significant at the 5% level

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 Table 2 The Estimated ARDL Model Based on Equation (1)

Variable Coefficient Std. Error t-Statistic Prob.

RGDPC(-1) -0.393825 0.169944 -2.317376** 0.0374

FDI(-1) -.0.031527 0.011756 -2.681797** 0.0188
TOP(-1) 0.204998 0.064705 3.168179*** 0.0001
REER(-1) 0.358881 0.100932 3.168179*** 0.0001
Δ ( RGDPC (-1)) 0.136645 0.103827 1.316079 0.2109
Δ ( RGDPC (-2)) -0.154651 0.104036 -1.4865511 0.1610
Δ ( RGDPC (-3)) 0.198913 0.154720 1.285631 0.2210
Δ (FDI) 0.025032 0.010486 2.387121** 0.0329
Δ (FDI(-1)) 0.043058 0.011153 3.860542*** 0.0020
Δ (FDI(-2)) 0.031764 0.009159 3.467906*** 0.0042
Δ (TOP) 0.470668 0.055826 8.430990*** 0.0000
Δ (TOP(-3)) -0.078358 0.081059 -0.966677 0.3513
Δ (REER) 0.514488 0.072112 7.134574*** 0.0000
C -1.643440 0.482812 -3.403893*** 0.0047

R-squared 0.957124 Mean dependent var 0.040620

Adjusted R-squared 0.914248 S.D. dependent var 0.062524
S.E. of regression 0.018309 Akaike info criterion -4.856689
Sum squared resid 0.004358 Schwarz criterion -4.184774
Log likelihood 79.56530 F-statistic 22.32311
Durbin-Watson stat 1.425233 Prob(F-statistic) 0.000001

Δ denotes first difference

Note : ***,** and * denote significant at 1%, 5% and 10% levels

5.2 Diagnostic checking

Table 3
AR (2) = 1.298 (0.368) AR (4) = 4.256 (0.199)
ARCH (3) = 0.2131 (0.886) ARCH (4) = 0.3688 (0.827)
JB = 1.048509 (0.591997) RESET = 1.321259 (0.333693)
AR (i) for i = 2,4 denote LM-type Breusch-Godfrey serial correlation and ARCH (i) is ARCH Test to test for the
present of serial correlation and ARCH effect at lag i. JB is Jarque-Bera Normality Test while RESET is Ramsey
Regression Specification Error Test.

For the examination of long- run relationship the Wald test (F-statistic) was
calculated by imposing restrictions on the estimated long-run coefficients as explained
previously in this paper, we obtained a F-statistic of 4.371263 which is greater than
the upper bound value, thus we can easily reject H0 and conclude that there is a long
run relationship between the dependent variables and the economic growth.

4
5.3 Bounds Test for Cointegration Analysis Based on the Equation 1

Critical Value Lower Bound Value Upper Bound Value

1% 3.74 5.06
5% 2.86 4.01
10% 2.45 3.52
Computed F-statistics : 4.371263 (significant at 0.05 marginal level)
5.4 Long run Estimated Coefficient

Table 4

Variable Coefficient
TOP 0.52053***
FDI -0.00800**
REER 0.91127***
Note :*** and ** denote significant at 1 % level and 5% respectively

5.5 Short run estimated coefficients – Wald Test

Table 5

Variable Coefficient
TOP 0.39231***
FDI 0.09985***
REER 0.51448 ***
Note :*** denote significant at 1 % level

The long run relationship thus can be written as below:-

GDPt = -1.643440 + 0.52053 TOPt + 0.91127 REERt --0.00800 FDIt

The equation indicates that variables such as TOP, REER are positively
related while FDI has an inverse relation. TOP‟s sign is concurrent with economic
theories and past findings, same goes to REER sign. FDI has a negative sign in the
long run as opposed in the short run, which means that Malaysia as a host country
benefits from the capital injection in the short run but profit withdrawal might
contribute to the long run negative sign .

Results Similar Past Findings

TOP (Positive) Srinivasan and Bhagwati (1999)
Sjoholm (1999)
Bahrumshah and Rashid (1999)
Wong and Chong (1999)
Panagariya (2004)
Dollar and Kraay (2004)
Mahadevan and Suardi (2006)
David Barlow (2006)

5
6.0 Conclusion and Discussion

The result of this research shows that all the independence variables
chosen, FDI, TOP, REER, significantly determine the economic growth in Malaysia
for the chosen period 1975 to 2005, all the independent variables are significant both
in the short run and long run. The results are concurrent with most of the literature
reviewed and theoretical framework. TOP is significantly positive related to
economic growth, and proves that to the most widely held beliefs in the economic
profession,
.
Indeed, opposing the standard ("neoclassical") growth models, whereby trade
openness have no impact on the long-run growth rate of an economy the results
proves otherwise, that is, impact of level of trade openness on economic growth
proves to be a important and significant variable in determining economic growth
both in the short run as well as in the long run, positively. All the independence
variables are found to be significantly stimulating growth for both the short as well as
the long run except for the FDI as mentioned, stimulates growth in short run but
works the opposite direction in the long run. The situation of the determinants of
growth for Malaysia is found to be generally similar to most of the other nations in the
world

The positively significant sign of trade openness, both in the short run and
long run may also signal its impact on increasing a nation‟s income and, as the
export-led growth hypothesis explains, that export contributes positively to economic
growth by facilitating the exploitation of economics of scale, relieving the binding
constraint to allow increases in the import of capital and intermediate goods
enhancing efficiency through increased competition, and promoting the diffusion of
knowledge through learning by doing.

The results of this study will strengthened the view that openness to trade will
continue to be viewed as a key determinant of economic growth. Siding with Sjoholm
(1999) who found that trade does not only increase a nation‟s productivity, it also
increases the nation‟s technology standard through increased competitive pressure,
embodiment in imports, and knowledge transfer through commercial contacts. The
result is echo‟s Baharumshah and Rashid (1999) who outlined that degree of
openness of a country will affect the speed of economic growth of that nation. They
also quoted Bhagwati (1988) who brought up the third hypothesis of many studies in
trade and economic growth where increased trade produce more income and more
income will facilitate trade which is known to be „virtuous cycle‟ .

As further supported by Dollar and Kraay (2004) who outlined that trade
openness is a reasonable reason in accelerating growth as the more rapid growth may
be a transitional effect rather than a shift to a different state growth rate. They also
single out the TOP one-third of developing countries in terms of trade to GDP over
the past 20 years. They further mentioned that expectation for greater openness would
improve the material live of the poor, which in turn will to GP growth as a whole.

6
 The results of this study is also akin to that of Wong and Chong (1999) who
outlined that Asian countries experiencing rapid growth in the past decade are open
economies which had great influences on the trade policies of many developing
countries.

As for the FDI, which is found to be significant positively in the short run, this
is not an isolated finding. Similar results were obtained by Hermes and Lensink
(2000), who found that FDI only enhance growth once a country has reached a given
threshold of human capital and financial market development and for most developing
this threshold has yet to be attained. Carkovic and Levine (2001) also share the same
finding whereby the impact of the exogenous component of FDI on GDP growth is
not significantly different from zero.

We would also like to suggest future empirical studies and literature on trade
and growth towards identifying the exact mechanisms through which trade effects
grow and not just compute the correlation.
.

7
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