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Abstract
This paper presents, within an endogenous growth model, an analysis of the interaction between foreign direct investment (FDI) and financial development in promoting Malaysia's economic growth. Using a co-integration framework, this study estimates a dynamic endogenous growth function that includes the impact of FDI and financial sector evolution as well as some locational determinants for the sample period spanning from 1970 to 2001. The empirical evidence suggests that foreign direct investment, labour, investment, and government expenditure play a pivotal role in local economic prosperity. More importantly, it is found that the interaction between FDI and financial development exerts a significant effect on the growth performance of Malaysia. Perhaps the strongest result to emerge from our study is the significant role played by FDI–finance interaction in the growth process.
Acknowledgement
The authors gratefully acknowledge constructive suggestions received from an anonymous referee.
Notes
1. The literature is very extensive. For an explicit link between financial development and growth, see Greenwood and Javanovic (Citation1990), Roubini and Sala-i-Martin (Citation1992), King and Levine (Citation1993a), Obstfeld (Citation1994), Levine, Loayza, and Beck (Citation2000), and Hung (Citation2003). Levine (Citation1997, Citation2005) provides an excellent and comprehensive survey of the literature.
2. The advantage of the endogenous growth models is that the effects on long-run growth are not confined to those brought by technological changes but also institutional and country-specific factors. For example, government policy can induce a permanent increase in the rate of output growth by making the state of the economic environment in the recipient economy more appealing to foreign investors. Thus, the recipient economy's trade policy, productivity growth, balance of payment constraints, and the size of the domestic market are expected to have an impact on FDI inflows (Dunning Citation1993; Caves Citation1996; de Mello Citation1996, Citation1999).
3. More generally, A represents the exogenous state of the environment which comprises various control and policy variables influencing the productivity level in the economy.
4. This assumption is made based on the specification of Barro and Sala-i-Martin (Citation1995, chap. 6).
5. It is important to note that, besides the development of the financial sector, there are indigenous technologies that may promote economic growth in developing countries.
6. For instance, Schumpeter (Citation1912) emphasizes the role of the banks as financial intermediaries.
7. If government expenditure tends to expand its size (emphasize consumption expenditure) without increasing the marginal productivity of the public sector, the estimated coefficient of β4 is expected to be negative, given that the expenditure will lead to higher money demand and hence reduce the level of private investment. In contrast, the sign of β4 can be positive if the pattern of government expenditure focuses on development expenditure.
8. Nonetheless, these linkages might change if there exists greater competition between multinational corporations (MNCs) and domestic firms in utilizing the scarce factors of production and financial resources. In particular, MNCs might replace the domestic firms and finally reduce the role contributed by local private investment.