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Abstract: In this paper, we apply vector error correction modeling (VECM) to 1970-2008 data. The objective is to analyse the long-run causal relationship between foreign direct investment (FDI), domestic investment (DI) and economic growth in Malaysia. The presence of complementary/substitution effect between FDI and DI is also investigated using impulse response function and variance decomposition analysis. The results suggest a long-run bilateral causality between economic growth and DI. There is no evidence of causality between FDI and economic growth. On the other hand, the results suggest a short-run crowding-in effect between FDI and DI.
Keywords: Causality, domestic investment, economic growth, foreign direct investment
JEL classification: F21, O16. C22
(ProQuest: ... denotes formulae omitted.)
1. Introduction
The impact of foreign direct investment (FDI) and domestic investment (DI) on economic growth has recently been the subject of intense debate (Maher and Christiansen 2001). The effect of FDI on economic growth depends on whether FDI compliments or substitutes DI (De Mello 1999). Some writers have stressed that FDI accelerates economic growth due to its complementary effect on gross domestic investment (GDI) while others found evidence that suggests a negative impact of FDI to recipient's economy because it crowds-out/ substitutes DI. For example, Ndikumana and Verick (2008) found evidence that supports a complementary effect of FDI on DI in African countries but Borensztein et al. (2008) found less robust complementarity of FDI and DI. However, Lumbila (2005) attests that FDI and GDI can complement each other and positively affect growth only if policy and the macroeconomic environment are sound.
The positive impact of FDI on DI and growth is realised when foreign firms provide new investment opportunities to domestic firms by introducing new technology and machinery (Sun 1998); creating new demands for local inputs (Cardoso and Dornbusch 1989); and introducing new industries in the host economy. On the other hand, FDI may harm GDI and the growth of the host economy if foreign firms will compete with local firms in the use of domestic resources and reduce investment opportunities for local investors (Jansen 1995; Agosin and Mayer 2000). Therefore, in analysing the impact of FDI on growth, it is important to consider the linkage between FDI and DI so that policy implications can be established to maximise...