«Global Economy and Finance Journal Vol. 3 No. 1 March2010, Pp. 31-43 Determinants of International Capital Flows: The Case of Malaysia Muhammad Asraf ...»
Global Economy and Finance Journal
Vol. 3 No. 1 March2010, Pp. 31-43
Determinants of International Capital Flows:
The Case of Malaysia
Muhammad Asraf Abdullah∗ Shazali Abu Mansor** and
This paper examines the determinants of international capital inflows into
Malaysia in the forms of pull and push factors. The results from Johansen
and Juselius cointegration test confirm the existence of a long run stable
equilibrium relationship among the variables in the model. In addition, the Error Correction Model (ECM) has been utilized to detect the long run divergence from the equilibrium relationship between the explanatory variables and capital inflows in the specified model. The Wald tests from the ECM further support the notion that real GDP, domestic Treasury bill rate, budget balance, current account balance and US production do Granger cause capital inflows into Malaysia in the short run. The empirical findings in this study show that the pull factors especially budget balance and current account are imperative in explaining inflows of capital into Malaysia. Another interesting finding is the role of real factor as denoted by domestic and industrial country’s outputs in affecting the capital inflows.
Field: International Economics
1. Introduction Economic liberalization and globalization have resulted in rapid mobility of resources between nations to reap the comparative advantage of the respective country. As a small open economy, Malaysia is not an exception to attract capital in pursuing its development agenda. Thus, Malaysia has been depending on capital inflows as one of the vital sources of growth for decades since its formation in 1965. With industrialization policy took effect in 1960s, Malaysia has expanded as one of the most attractive destinations for foreign direct investment (FDI) in Asia. This is particularly true when the United Nations Conference on Trade and Development (UNCTAD) through World Investment Report 2008 listed Malaysia as one of the highest FDI potential countries along with other countries to name a few Brunei, Hong Kong, Singapore, Thailand and United Kingdom (World Investment Report, 2008).
This was translated into high exports manufactured goods from 22% in 1980 to 79.7% in 2007. Among the manufacturing sub-sectors, the electrical and electronics sector contributed the most to total manufacturing export since the 1970s. Determinants of capital flows are varied depending on the scope of *Muhammad Asraf Abdullah, Department of Economics, Faculty of Economics and Business, Universiti Malaysia Sarawak. Email: firstname.lastname@example.org **Shazali Abu Mansor, Department of Economics, Faculty of Economics and Business, Universiti Malaysia Sarawak. Email: email@example.com ***Chin-Hong Puah, Department of Economics, Faculty of Economics and Business, Universiti Malaysia Sarawak.
Email: firstname.lastname@example.org ♣Financial support from UNIMAS through the Fundamental Research Grant Scheme [FRGS:
05(07)/621/2006(54)] is gratefully acknowledged. All remaining flaws are the responsibilities of the authors.
Abdullah, Mansor & Puah capital flows studied. In essence, capital flows comprise of FDI, portfolio investment and other kind of investments. Due to its broader scope, different researchers tend to focus on different factors when analyzing driving forces of capital inflows. Basically there are three factors that potentially draw capital into a country namely politic, social and economy. Studies on the influence of economic factor on capital inflows can be detected in many literatures, to name a few, Zhang (2000), and Wei and Liu (2001), when both researchers assert the importance of the size of an economy and lower factor prices in host country in attracting capital flows into a country. Next, the importance of social aspects such as human capital development, linguistic issues, and viability of infrastructure services have been found to be proven in contributing to the surge of capital inflows into a country as asserted in Wei (1995), Wei (2000), and Zhao and Zhu (2000). Political issues notably host country government’s commitment in promoting FDI (confronting with corruption issue, favourable policy towards FDI such as removal of factor price distortions) need to be addressed as this may affect the interest of home country to invest in the host country (Wei, 2004; Balasubramanyam and Mahambare, 2004). No doubt, these three factors are equally important in attracting inflows of capital into a country.
Although there are numerous studies attempting to analyze this phenomenon, this paper examines the determinants of capital inflows into Malaysia in the forms of pull and push factors. In studying drivers of capital flows into a country, it is crucial to examine the variables in the context of pull and push factors. The segregation of the variables into these factors enables us to conclude whether the attributing factors of capital inflows into a country are stimulated by domestic variables or the reverse. The pull factors refer to domestic variables namely parameters within the control of a particular country itself, while push factors refer to external forces that are beyond the control of a country. Pull factors employed in this study include real Gross Domestic Product (GDP), Treasury bills rate, budget balance and current account balances. Meanwhile, the push factor is represented by US Industrial Production Index (IPI) as a proxy of the industrial country’s productivity indicator. The remaining part of this paper is organized as follows: In Section 2, we provide a brief literature review on the determinants of capital flows.
Section 3 gives the overview of capital inflows into Malaysia. The data and methodology will be described in Section 4. Section 5 presents the empirical results and discussions. Finally, we conclude in the last section.
2. Literature Review
There are many factors that determine the inflows of capital into a country ranging from domestic to international settings. The relative significance of the factors varies from one country to another as well as types of factors. Among literatures in the early 1990s that examine the determinants of capital flows is found in the work of Calvo et al. (1993) who assert that the push factor such as low US interest rates plays a significant role for increasingly inflows of capital to Latin America, hence explaining the accumulation of foreign reserves and appreciating real exchange rates in Latin America.
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Instead of concluding that push factors as the main drivers for capital inflows, Hernandez and Rudolf (1995) argue that domestic variables (pull factors) as embedded in domestic policies carried out by developing countries are central in explaining the surge of capital flows. Sound macroeconomic policies that promote savings and exports are likely to enhance foreign investment, hence maintaining the sustainability of capital inflows into developing countries in the long run.
The importance of pull factors in driving capital flows to developing countries also assert by Montiel and Reinhart (1999) who conclude that the domestic macroeconomic policy (pull factor) - the sterilization policy has significantly attracted short term capital inflows to Asia than to Latin America. In contrast, the finding from the push perspective confirms: (i) International interest rates stimulate more inflows of capital to Latin American countries than Asian countries; (ii) interest rate effects are intra-regional in pattern; and (iii) contagion effect brought by the Mexican crisis is more regional in pattern.
Next eminent study on the significance of pull factors in attracting private capital flows is found in the study by Dasgupta and Ratha (2000). The researchers discover that the net portfolio flows are related negatively with the current account balance, but positively with both country’s per capita income and growth performance. In addition, the study also highlighted a significant positive relationship between FDI flows and portfolio flows to developing countries.
Hernandez et al. (2001) stress that the effects of pull factors are stronger than the push factors in influencing capital flows to emerging markets in the 1990s.
The results confirm that the net private capital flows to emerging countries seems to support the expected outcome, when it relates positively with the inflows of capital into emerging markets. In terms of pull factors, foreign debt service and gross domestic investment play significant roles in attracting private capital flows to the countries studied. Both variables link inversely with capital flows. However, the importance of public sector balance in attracting inflows of capital into a country does not hold in this study. Another literature that supports the eminent of pull factors in attracting capital inflows to emerging markets is reported in a study carried out by Mody et al. (2001). The study concludes that pull factors such as consumer price index, domestic credit, industrial production index, domestic interest rate, credit rating, reserve-import ratio and domestic stock market index have significantly attracting capital flows into all the economic regions in the sample studied.
Nevertheless, the effect of push factors like the shocks in US high-yield spread, swap rate and US interest rates on capital flows are more in short term basis as they will adjust to an equilibrium state in the long run.
Adopting the Structural VAR model (SVAR), Culha (2006) generalizes that the pull factors namely the real interest rates, budget balance and current account balance appear to be the more pertinent factors in explaining the inflows of capital to Turkey. Despite the significant finding on the dominance of the pull factors in determining capital inflows into Turkey, the author also discovers a new trend in his latest set of data that external forces such as foreign interest rates is likely to change the amount of capital flows into a country. De Vita and
33 Abdullah, Mansor & Puah
Kyaw (2008) find a mixed result when both the pull and push factors in terms of real factors (domestic output and industrial country’s output) are equally important in explaining capital inflows to developing countries. They also notice that among all the push and pull variables employed, real variables appear to be significant in supporting inflows of capital to developing countries in the medium and long run.
3. Overview of Capital Inflows to Malaysia Rapid economic growth experienced by Malaysia since the post independence in 1965 is partly attributed by the inflows of FDI into the country. This can be seen from the high surge of capital inflows into Malaysia from 1975 to 2004 (see Table 1).
Capital inflows to Malaysia increase from USD742.34 millions in 1975 to its peak of USD17,188.95 millions in 2004 before recording a deficit of USD 1,182.87 millions in 2005 (see Table 1). Since the introduction of the industrialization policies in 1957, Malaysia has undergone three phases of industrialization, namely the import substitution strategy (1957-1968); export promotion strategy (1968-1980); and restructuring of industrial sector to cover heavy industries, exports variation and selected import substitution strategies (Mohd Rosli, 2000). All of these policies particularly the export promotion strategy have significantly attracted FDI into Malaysia from 1975 to 1995.
The reversal of capital flows from its peak of USD 6627.93 millions in 1995 to negative USD 940.84 millions in 2001 was best explained by the economic downturn experienced by many Asian countries after the Asian financial crisis in 1997. A substantial increase in capital inflows from a deficit of USD 940.84 millions in 2001 to the highest point of USD 17,188.95 millions was partly due to attractive portfolio assets as a result of speculation on appreciation of the Malaysian Ringgit against the US dollar. This favourable outcome, however, is
34 Abdullah, Mansor & Puah
only temporary as it contracts portfolio flows from its peak of USD 17,188.95 millions (2004) to -USD 1,182.87 (2005) when the speculation does not actually brings fast returns as assumed by the investors (Fong, 2008).
Malaysia’s policy towards attracting inflows of capital into the country is considered to be very facilitating and it covers a wide range of strategies (Shazali and Alias, 2002). Apart of the policies and strategies, the macro economic performances could provide a strong signal to potential investors to invest. Macro economic indicators such as strong economic fundamentals (pull factors) as well as facilitating policies like new investment incentive packages and liberalization of foreign exchange administration measures are among the crucial determinants of international capital inflows into Malaysia (Ooi, 2008).
4. Data and MethodologyData Description
This study uses quarterly data which span from 1985Q1 to 2006Q4 that can be obtained from various issues of the International Financial Statistics (IFS) published by International Monetary Fund (IMF) and the Central Bank of Malaysia’s Monthly Statistical Bulletin. The reason for employing such a time frame is due to data limitation. This is because of unavailability of quarterly data for different types of capital inflows in the IMF publications at the point when the study is carried out. The dependent variable in this study is the capital inflows (CAPF) which is obtained by summing up foreign direct investment, portfolio investment liabilities and other investment liabilities. The rational to form aggregated data from these three flows is because they are major components of capital flows in the financial account of a country.