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.trade openness; foreign direct investment; economic growth; Malaysia

Baharom, A.H.

Habibullah, M.S.

Royfaizal, R. C

English

Research Papers in Economics

 
  1 
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: 
baharom@econ.upm.edu.my 
† A.P.Thirlwall “Trade Agreements, Trade liberalization and Economic Growth: A Selective Survey”  
  2 
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)  
  3 
                      
 
 
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)  
 
Variables
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
DF/ADF
Level 1st difference
 
 
 
 
 
  
  4 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
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.  
 
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 
          
  5 
 
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) 
  
  6 
 
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.  
 
  
  7 
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. 
  . 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
  
  8 
 
 
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The relationship between trade openness, foreign direct investment and growth: Case of Malaysia

The relationship between trade openness, foreign direct investment and growth: Case of Malaysia

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