Applied Econometrics and International Development Vol. 10-1 (2010) THE ROLE OF FDI INTENSITY IN ACHIEVING PRODUCTIVITY DRIVEN GROWTH IN MALAYSIAN ECONOMY AHMED, Elsadig Musa* Abstract: This study investigates the decomposition of labour productivity growth into contributions of capital deepening, increased usage of Foreign Direct Investment intensity (FDI intensity), and the simultaneous contribution of the quality of these factors. This is expressed as the Total Factor Productivity (TFP) per unit of labour growth in achieving productivity-driven growth in the Malaysian economy. The results of this modified intensive growth theory model show that the productivity growth of Malaysia’s economy is input-driven and being based on FDI when the results of TFP per unit of labour growth were compared. The study also finds that there is a negative contribution of the TFP per unit of labour growth during the sub-period of 1987-1996, although the contribution of the labour productivity was one of the highest during this sub-period. Keywords: FDI intensity, input-driven, TFP per unit of labour, Malaysia’s economy JEL classification: E23; C22 1. Introduction Productivity Report, 2006, .presents that the productivity growth of Malaysia surpassed many of the Organisation for Economic Cooperation Development (OECD) countries such as Sweden (2.8%), Japan (2.5%), Germany (2.0%), Denmark (1.8%) and USA (1.5%). Among the Asian countries, Malaysia led in productivity growth as compared with Thailand (3.5%), Taiwan (2.7%) and Singapore (1.2%). The productivity level of Malaysia at US$11,716, was higher than India (US$1,276), Indonesia (US$2,128), China (US$2,885) and the Philippines (US$2,914). However, highly industrialised and matured economies such as Japan, Norway, and USA with high GDP per capita, high degree of innovation and a large pool of educated workforce recorded productivity levels of between 2.5 to 6.9 times higher than Malaysia. There is a need to ensure that Malaysia continuously attains high productivity growth to be globally competitive. The Malaysian economy, in the meantime, is operating as a production-based economy based on manufacturing output. The productivity-driven economy is a dream that will be achieved by implementing the Malaysian national vision of 2020. This vision would transform Malaysia into a developed state if is properly implemented. Consequently, by 2020, the Malaysian economy should be driven by knowledge and the wealth thereof. The results of this study will be useful for productivity-driven policy formulation, if used by the Malaysian government policy makers. Thanks to Malaysia’s comparative advantage in unskilled labour intensive that helped to attract foreign direct investment (FDI) in the latter half of the 1980s. The Malaysian * Elsadig Musa Ahmed, Economics Unit, Faculty of Business and Law, Multimedia University, 75450 Melaka, Malaysia. E-mails: [email protected] , [email protected] Applied Econometrics and International Development Vol. 10-1 (2010) government accelerated trade liberalisation policies and drastically eased restrictions with respect to capital ownership of foreign companies. Economic Report, 2002, explains that there are a few reasons why Malaysia has experienced good economic growth over the past few years. One of the major factors was the aggressiveness of the Malaysian government to attract FDI into the country. Through several Government Ministries/agencies such as the Ministry of International Trade and Industry (MITI), Malaysian Industrial Development Authority (MIDA), and other State governments’ Agencies, Malaysia was able to attract overseas investors to invest in Malaysia. Between 1985 and 1990, FDI in Malaysia was at the average of USD1.1 billion (in current dollars) per year. With continuous efforts and programmes, the FDI has increased to USD 5.0 billion (in current dollars) in 1993 and USD 5.3 billion (in current dollars) in 1996 and has decreased to USD 3.203 billion in 2002 and thereafter. The success of pulling the FDI into Malaysia was part of the Malaysian government’s program to transform the country from an agricultural based into an industrial based economy. Most of the past studies on the sources of growth in Malaysia were conducted either at the macro level for the Malaysian economy or focused specifically on the manufacturing sector. Included in the first category were studies done by Ikemoto (1986), World Bank (1993), Gan and Robinson (1993), Kawai (1994), Zarina and Shariman (1994), Gan and Soon (1998), and Jenny (2001). Studies that have attempted to measure sources of growth and TFP growth for the manufacturing sector were benefited from the work done by the World Bank (1989), Maisom and Arshad (1992), Maisom and Ariff (1993), Maisom et al (1994), Okamoto (1994), Tham (1995, 1997), Nik Hashim (1998), Rahmah and Idris (2000), Zulaifah and Maisom (2001) and Rahmah (1999). This study aims to investigate the role of FDI intensity through decomposition of labour productivity growth into contributions of capital deepening, increased usage of FDI intensity, and the simultaneous contribution of the quality of these factors expressed as the TFP per unit of labour growth in achieving productivity driven growth in the Malaysian economy. This paper unfolds as follows. Section 2 describes the effects of FDI on productivity, whereas Section 3 contains descriptions on the estimation methods employed in this paper, and Section 4 demonstrates details of the data. Results of the empirical analysis are explained in Section 5. Finally, Section 6 presents the conclusion and policy implications. 2. The Effects of FDI on Productivity A growing number of studies have been engaged in the analysis of the belongings of foreign direct investment (FDI) on productivity in the host country. Alfaro et al (2006) give details that there is a widespread belief among policymakers that FDI generates positive productivity effects for host countries. The main mechanisms for these externalities are the adoption of foreign technology and know-how, which can happen via licensing agreements, imitation, employee training, and the introduction of new processes, and products by foreign firms; and the creation of linkages between foreign 196 Ahmed, E.M. The Role of FDI Intensity in Achieving Productivity Driven Growth in Malaysia and domestic firms. These benefits, together with the direct capital financing it provides, suggest that FDI can play an important role in modernizing a national economy and promoting economic development. However, the empirical evidence on the existence of such positive productivity externalities is sobering. In addition, they express that the macro empirical literature finds weak support for an exogenous positive effect of FDI on economic growth. Findings in this literature indicate that a country’s capacity to take advantage of FDI externalities might be limited by local conditions, such as the development of the local financial markets or the educational level of the country, namely, absorptive capacities. Borensztein et al (1998) and Xu (2000) show that FDI brings technology, which translates into higher growth only when the host country has a minimum threshold of stock of human capital. Alfaro et al (2004), Durham (2004), and Hermes and Lensink (2003) provide evidence that only countries with well- developed financial markets gain significantly from FDI in terms of their growth rates. Meanwhile, Carmen et al (2005) explain that while in theory, the nexus between FDI and growth (in terms of output and productivity) is in general positive, the empirical literature is far less conclusive. Some studies find positive effects from outward FDI on the investing country (Van Pottelsberghe and Lichtenberg, 2001; Nachum et al., 2000), but suggest a potential negative impact from inward FDI on the host country. This results from a possible decrease in indigenous innovative capacity or crowding out of domestic firms. Thus, in their view, inward FDI, on average, is primarily intended to take advantage of host country characteristics instead of disseminating new technologies originating in the sending country. Other studies report more positive findings: Nadiri (1993) finds positive and significant effects from US sourced capital on productivity growth of manufacturing industries in France, Germany, Japan and the UK. Also Borensztein et al. (1998) find a positive influence of FDI flows from industrial countries on developing countries’ growth. However, they report also a minimum threshold level of human capital for the productivity enhancing impact of FDI, emphasizing the role of absorptive capacity. Blonigen and Wang (2004) stress explicitly cross-country heterogeneity as the crucial factor which determines the effect of FDI on growth. Moreover, it is equally likely that the impact of FDI on the host economy differs greatly according to the receiving industry. As a very intuitive example, heavy FDI in the extractive sector in Nigeria has not improved the country’s growth performance (Akinlo, 2004). It is conceivable that the potential for positive spillovers does not solely depend on a country’s overall absorptive capacity, but that the latter varies across sectors or industries inside an economy. Thus, the impact of FDI differs depending on the receiving sector or industry in connection with the country specific absorptive capacity or stage of development. The economy wide effect of FDI will then further depend on the extent of intra-industry versus inter-industry spillovers.