Foreign direct investment in Malaysia: Historical and contemporary perspectives - Articles

Foreign direct investment in Malaysia: Historical and contemporary perspectives

Professor Prema-chandra Athukorala, Emeritus Professor of Economics, Arndt-Corden Department of Economics, Crawford School of Public Policy, Australian National University

Foreign direct investment (FDI) has played a pivotal role in growth and structural transformation of the Malayan—and then Malaysian—economy.¹ During the colonial era, FDI was instrumental in Malaya’s economic modernization through the expansion of rubber and tin industries Since independence in 1957, patterns of FDI in Malaysia have changed greatly, reflecting shifts in domestic policy regimes and in global production systems.

After modest engagement in import-substitution industrialization under moderate tariff protection in the 1960s, FDI gained significance in economic transformation under a decisive policy shift to export orientation. Massive FDI inflows helped propel Malaysia into an upper-middle-income country. Since about the mid-2010s there has been a notable slowdown in FDI inflows and, perhaps portending worse to come, in comparison with the other major FDI-receiving countries in Southeast Asia. Malaysian policymakers have become worried about when the country will graduate from middle- to high-income status (World Bank, 2022).

This article puts the current situation of FDI in the Malaysian economy in historical perspective. In addition to being directly relevant to the country’s policy debate, it provides insights for understanding the role of FDI in growth and structural transformation in other countries that have emerged from colonialism. After overviewing the role of FDI in the colonial era, the article presents a survey of post-independence policy regime shifts, with an emphasis on changes since the New Economic Policy (NEP) of 1970. It then reviews trends and patterns of FDI against policy regime shifts and global and regional changes, followed by a discussion of the factors underpinning the recent slowdown in FDI inflows. It concludes with a summary of key findings and suggestions for further research.

The colonial inheritance

The extension of British colonialism in Malaya was gradual, starting with Penang in 1786 and spanning the period up to the early 20th century. During early colonial expansion, British commercial interests were confined to entrepôt trade. Trade in agricultural products and tin began in the Malay hinterland and was undertaken by merchant houses operating in the three Straits Settlements. European (largely British) capital began to play a role in Malaya's economic transformation with the progressive consolidation of British control over the territories of the Malay peninsula after the signing of the Pangkor Engagement with Perak in 1874 (Sultan Nazrin Shah, 2019).

British planters initially experimented with agricultural products including cocoa, coffee, tea, rubber, and palm oil.² The plantation system based on FDI dramatically transformed the traditional agrarian economy with rubber emerging as the major plantation product, as the development of the motor car precipitated worldwide demand for rubber from about the early 1900s.³ Malaya had suitable geographical conditions to cultivate rubber and much land for expanding plantations to meet rapidly increasing demand. The first rubber estates were developed by individual planters. When demand for rubber climbed steeply, planters began to raise capital by establishing joint-stock companies in London and Shanghai (Barlow, 1978).

British merchant firms in the Straits Settlements acted as the conduit for British capital to enter the peninsula (Drabble and Drake, 1981; Drake, 1979). With accumulated marketing and financial knowledge, familiarity with Malayan conditions, and strong connections in commercial circles in Britain, these organizations provided the necessary reassurance for the British public to invest in newly formed rubber companies. Once these rubber companies entered Malaya, the merchant houses expanded their conventional trading activity to management of rubber estates for the joint-stock companies, and provided trading, banking, insurance, and other ancillary services for the plantation sector. With this broadening of operations, the merchant firms became known as ‘agency houses’, which by 1920 controlled over 75 per cent of the area under plantation, about half of rubber production, and over two-thirds of Malaya's import and export trade.

Commercial tin mining started in the late 1840s after the discovery of rich deposits in the Larut district of Perak (Drake, 1979). During the rest of the 19th century, Malaya's tin industry remained largely a preserve of Chinese entrepreneurs, with investment coming from Chinese merchants in the Straits Settlements. European—predominantly British—companies began to inject capital, managerial expertise, and new technology into the industry, mainly in the early 20th century. The breakthrough for European firms was the introduction of large-scale dredging that gave them an advantage over Chinese firms: in 1912, some 80 per cent of Malaya’s tin production was under Chinese management, but by 1930, British firms managed 65 per cent (Sultan Nazrin Shah, 2019, p. 29). Agency houses, as in the rubber industry, provided a channel for quick access to capital for tin-mining companies, but the administration of tin mining, unlike that in the rubber industry, was in the hands of international mining groups as part of their worldwide operations.

The estimated stock of foreign capital in Malaya in 1914 was US$194 million (Table 1), a figure that surged to US$560 million in 1930, then declining sharply in the Great Depression but recovering modestly to US$455 million by 1937. In that year, 70.2 per cent of foreign capital was in rubber companies, 17.5 per cent in tin-dredging firms, with the balance in trading, manufacturing, and other miscellaneous activities, including breweries, colliers, and electricity companies (Callis, 1942, pp. 51, 56). British enterprises accounted for slightly over 70 per cent of investment in Malaya (Callis, 1942, p. 57).

Britain’s trade and investment policy was liberal compared with the other colonial powers of the time: trade restrictions—‘imperial preference’—was skilfully used as a bargaining weapon, rather than limitations on the entry of non-British capital (Christopher, 1985), allowing for a significant presence of capital from other sources. In 1929, the United States (US) Department of Commerce reported 28 American companies trading in Malaya with investments in petroleum, rubber, and tin. Firms from the Netherlands invested somewhat more than US companies in Malayan agricultural crops and trade, but had no investment in rubber. French entities had considerable investment in tin. Japanese firms invested in iron—Malayan iron was its most important source of supply outside the territories under its control (Callis, 1942, p. 56).

Table 1: Total foreign investment in Malaya,¹ 1914, 1930, and 1937 (million US dollars)

Notes:
¹Exclusive of Chinese investment, estimated at roughly US$200 million.
²Mainly government loans, but also including industrial debentures.
Source of data: Callis (1942), pp. 56–57.

Malaya was much more prosperous than most territories in the British Empire, and returns on investment in Malaya were among the Empire’s highest by the 1930s (Rönnbäck et al., 2022). Benchmark gross domestic product (GDP) figures show real per capita income growth of 4.1 per cent annually between 1900 and 1929, more than double the rate of Japan. In 1929, per capita GDP in Malaya (excluding Singapore) was US$1,910, compared with US$1,191 in Japan (Huff, 2002, p. 1,077; Maddison, 1995, pp. 94–97). Between 1910 and 1939, real private final consumption expenditure in Malaya increased from Straits$206 million to Straits$518 million (at constant 1914 prices) (Sultan Nazrin Shah, 2017, appendix 2). However, economic prosperity was not accompanied by a shift in the economic structure towards manufacturing to meet the expanding domestic demand.

Malaya's manufacturing sector employed just 7.1 per cent of workers in 1921, a share that had increased to only 9.8 per cent in 1947 (Huff, 2002, table 3). Even in 1961, the earliest year for which sectoral GDP estimates are available, manufacturing accounted for only 6 per cent of GDP (Wheelwright, 1965). Nearly half of manufacturing was accounted for by factory processing of primary products—that is, rubber processing and tin smelting. Within ‘secondary manufacturing’⁴ , organized factory production was largely linked to the primary sector—mainly production of machinery for rubber and tin industries and a range of ‘non-tradable’ manufactures⁵ such as building material, furniture, and aerated water for the modern sector of the economy, which all evolved around the plantation sector and tin mining (Allen and Donnithorne, 2013; Thorburn, 1977; White, 1999).

Primary processing and ‘organized’ secondary manufacturing was predominantly, if not solely, the preserve of Western firms. The rest of secondary manufacturing comprised small-scale and cottage production of food and handicrafts undertaken predominantly by Chinese and to a lesser extent Indians entirely for the domestic market (IBRD, 1955). There was no incentive for foreign investors to engage in manufacturing to meet domestic demand, given the colonial free trade regime that assured ready availability of imports at world prices.

Policy regime shifts post-independence

After independence, Malaysia remained open to foreign investment and trade.⁶ Within this broader outward orientation, the country’s trade and investment policy regimes have, however, made notable departures from the colonial laissez-faire economic policy, with significant implications for the role of FDI in growth and structural change in the economy. Policy emphasis has been on reducing dependence on traditional primary industries by promoting domestic manufacturing, initially through import-substitution industrialization and then through export-oriented manufacturing. There has also been an emphasis on accepting the role of FDI, subject to ‘Malaysianization’ of the domestic economy.

As in most other countries that emerged from a colonial past, industrialization in independent Malaysia initially focused on import substitution. Under the Pioneer Industries Ordinance of 1958, ‘pioneer status’, which involved attractive tax concessions, applicable equally to local and foreign capital, was granted to firms with favourable prospects to help develop the country further. Additional measures to promote foreign investment included a government guarantee to pay compensation in case of nationalization, double taxation agreements with host countries, and a guarantee for repatriation of capital and profit (Wheelwright, 1965, pp. 34–35).

As part of industrial policy, the structure of import tariffs was consolidated with the elimination of Commonwealth preferences; new tariffs of 15 to 25 per cent were introduced to protect domestic manufacturing. However, unlike most other countries, domestic industries were protected through these moderate tariffs, not quantitative restrictions. Thus, the domestic incentive structure was little insulated from changes in world market prices. Along with policies for industrialization, to reduce the country’s dependence on rubber and tin, emphasis was on consolidating and rationalizing traditional staple industries and on promoting palm oil.

The Malaysian approach to promoting FDI as part of the import-substitution development strategy was in sharp contrast to conventional wisdom among newly independent developing countries. Most of these countries adopted a rather cautious and selective approach to FDI, reflecting the ‘dependency-school’ ideology of loss of national sovereignty involved in any dependence on international investment.

Malaysia’s unique policy emphasis on FDI was rooted in a dilemma faced by the Malay-dominated government in relying on Chinese-dominated domestic private capital as the vehicle for industrialization: a policy of industrialization that relied of indigenous entrepreneurship would have increased the economic power of Chinese. So, the government’s preferred policy choice was to engage foreign investors—generally multinational enterprises (MNEs)—in joint ventures in pioneer industries to provide opportunities for expanding Malay equity holdings with the objective of nurturing a Malay middle class (Wheelwright, 1965; Jesudasan, 1989).

By the late 1960s, Malaysia's policymakers increasingly recognized that the easy stage of import-substitution industrialization was coming to an end because of domestic market saturation, and the policy pendulum shifted to export orientation (Lim, 1992). In 1968, the government enacted the Investment Incentive Act to promote manufacturing exports. Incentives offered to export-oriented ventures included exemption from company tax and duty on imported inputs, investment tax credits, and accelerated depreciation allowance on investments in buildings and machinery.

The ethnic factor came to the forefront in national development policy after the May 1969 racial riots. The government’s response was the NEP, a sweeping affirmative action programme announced in 1970. The NEP was designed to maintain national unity through two objectives: eradicating poverty through employment generation, and restructuring Malaysian society to eliminate the identification of race with economic function and geographical location (Faaland et al., 1990, pp. 310–321).

To achieve the first objective, the development strategy was reformulated with an emphasis on export-oriented industrialization. The Free Trade Zone (FTZ) Act was passed in 1971 to entice export-oriented FDI. Under the Act, Malaysian states were permitted to set up FTZs separate from the principal customs area where fully export-oriented firms could operate with up to 100 per cent foreign ownership, with a wide assortment of incentives and exceptions from import duties (Warr, 1987). For the second objective, long-term targets were established for Bumiputra (ethnic Malay) ownership of share capital in limited liability companies, and for the proportion of Bumiputra employed in manufacturing and engaged in managerial positions. These restrictions were, however, not applicable to FTZ enterprises, thus creating a dualistic ownership structure.

The Industrial Coordination Act of 1975 required all firms beyond a certain size to be licensed by the Ministry of Trade and Industry, and expected them to comply with NEP goals on the ethnic distribution of employment and shareholdings. Also in 1975, the Petroleum Development (Amendment) Act was passed to enable the government to obtain control of companies in the petroleum and petrochemical sectors through management shares, without compensation.

As part of the NEP, the government began indigenizing primary-commodity industries through normal share-market deals rather than forced nationalization (Faaland et al., 1990, pp. 233–236). Newly established state enterprises bought equity from British owners, ‘thus achieving the combined aims of indigenization and Malaysianization’ (Lindblad, 1998, p. 108), while preserving the government commitment to rely on FDI as a vehicle for economic development. Takeovers were financed mainly from increased oil revenues from the east-coast state of Terengganu after the 1973–74 oil price hike by the Organization of the Petroleum Exporting Countries (Jomo, 2004) and supplemented by foreign borrowing. From the early 1970s to the early 1980s, the government purchased most of the British-owned tin-mining companies and the main agency houses operating in the country.

The economic activism propelled by the NEP entered a pronounced, but short-lived, phase in the early 1980s. In November 1980, the government announced a state-sponsored heavy industry policy for strengthening manufacturing’s foundations. In November 1980, the Heavy Industries Corporation of Malaysia (HICOM), a public-sector holding company, was incorporated to act as the apex body for implementing the policy. HICOM embarked on a massive investment programme to develop heavy industries in areas such as transport equipment, petrochemicals, iron and steel, cement, paper and paper products, and machinery and equipment. Heavy industrialization was implemented to a degree with FDI, mainly from Japan, but with the government providing the lion’s share of capital.

The macroeconomic crisis of 1985–86⁷ caused problems for HICOM’s industries, most of which had only just begun production, and forced the government to rethink its commitment to the policy. The management of HICOM enterprises was revamped by the appointment of private-sector managers, mainly executives of foreign joint-venture partners. The economy was also further opened to FDI. The Industrial Coordinating Act of 1975 was amended in 1986 to limit Bumiputra involvement in companies only to projects with investment of roughly $1 million or more or to firms with at least 75 Malaysian workers. The amendment also eased limits on the number of expatriates that could be employed in foreign affiliates. Also, foreign investors could now own 100 per cent of new projects that sold their products to firms in FTZs that employed at least 350 full-time Malaysian workers. The Promotion of Investment Act passed in 1986 strengthened other incentives for foreign investors.

Malaysia continued giving priority to promoting FDI, despite its radical policy choice of capital controls—confined to short-term flows—in response to the 1997–98 Asian Financial Crisis (AFC) (Athukorala, 2001). Profit remittances and repatriation of capital by foreign investors were exempted. Moreover, some new measures were introduced to further encourage FDI. These included allowing 100 per cent foreign ownership in domestic manufacturing regardless of the degree of export representation, and relaxing restrictions on foreign investment in landed property to allow foreigners to purchase all types of property above RM 250,000.

Trends and patterns of FDI

Figure 1 shows FDI inflows into Malaysia in 1961¬–2020 in current US dollar terms (left panel) and relative to gross domestic capital formation (GDCF) (right panel). During the 1960s, annual FDI remained below US$100 million without showing any discernible trend. FDI amounted to about 10 per cent of GDCF. Perhaps, in the absence of binding import restrictions other than modest tariffs, there was no compelling reason for foreign producers to establish import-substituting plants in Malaysia. The bulk of the new investment in manufacturing came from British firms, induced by new tariffs. Some agency houses also began manufacturing locally, either on their own account or in partnership with their principal British manufacturers. With their already established distribution facilities, trading reputations, and connections with other companies and financial institutions, agency houses were well placed to participate in the emerging manufacturing sector under modest tariff protection.

Figure 1: FDI in Malaysia rose sharply as export-oriented manufacturing grew from the 1980s, but after early 2010s stabilized and then declined sharply

Sources of data: Data compiled from Bank Negara Malaysia 1994 (data for 1961¬–69) and UNCTAD World Investment Report database (1970–2020).

A 1968 survey of limited liability companies by the Department of Statistics–Malaysia showed that the stock of foreign investment in the economy was valued at US$2.1 billion (Table 2), about 40 per cent of total GDCF⁸ in the economy. Nearly 60 per cent of foreign capital was still invested in primary production, with manufacturing accounting for 22 per cent. In manufacturing, foreign capital accounted for about half of total fixed capital. About 90 per cent of the gross value of sales of manufacturing entities belonged to British companies. The direct contribution of the agency houses in manufacturing constituted about one-half of total British capital in Malaysian industry (Saham, 1980, pp. 12, 25–27, 140).

Table 2: Foreign ownership of fixed capital assets,¹ 1968

Note: ¹ Book value of net fixed assists.
Source of data: Saham (1980), table 3.2 (from Department of Statistics–Malaysia, 1968).

In the early 1970s, FDI started to enter export-oriented manufacturing, increasingly to electronics and electrical (E&E) parts and component assembly. This new wave of foreign investment was associated with the start of the shift of labour-intensive tasks in these industries from the US, Japan, and Europe to low-wage countries. MNEs established assembly plants in Singapore first, and then in Malaysia and other neighbouring countries as wages and rents began to increase in Singapore (Athukorala and Kohpaiboon, 2015). In Malaysia, MNEs set up an assembly plants, first in Penang's FTZ, and later to FTZs in other states, in particular Johor and Melaka (Rasiah, 1995; Singh, 2011).

FDI inflows increased from US$98 million in 1970 to US$1.3 billion (12 per cent of GDCF) in 1983. Following a dip during the macroeconomic crisis in the mid-1980s, inflows increased sharply to reach US$7.4 billion (15 per cent of GDCF) in 1996, the year before the onset of the AFC. In contrast to the earlier primary-product exporting and import-substitution regimes, most of the new foreign investments were in export-oriented manufacturing (Athukorala, 2007). Agriculture and mining had lost their importance as a destination for FDI. According to investment approval records of the Malaysian Industrial Development Authority (MIDA), during the 1980s manufacturing and primary production accounted for 73 per cent and 6 per cent, respectively, of approved investment, with investment in services accounting for most of the balance. In manufacturing, E&E goods accounted for over one-third of total FDI (Table 3).

Table 3: FDI in Malaysia by industry,¹ 1985–2021 (%)

Notes:
¹Data relates to approved investment projects. ²Includes petrochemicals.
³Includes machinery and equipment. ⁴Furniture, leather goods, and other light manufactures.
Sources of data: Compiled from Ministry of Finance, Economic Report (1985 to 2010), and MIDA, Investment Performance Report (2015 and 2020).

The source-country composition of FDI also changed dramatically from the early 1970s, with the share of the United Kingdom (UK) plummeting (Table 4). From the early 1970s, FDI from the US, Japan, and countries in the European Union (EU), in particular Germany, began to expand rapidly. From the early 1980s, Japan was on its way to becoming the largest investor, as Singapore’s share declined. Firms from Singapore invested mainly in the neighbouring state of Johor. The source-country profile of FDI fluctuated sharply during the first two decades of the 21st century, with China—and Singapore once more—becoming major source countries.

Table 4: Source-country composition of FDI in Malaysia¹ (%)

Notes:
¹Approved investment. --- Data not available or negligible.
Sources of data: Compiled from Ministry of Finance, Economic Report (1985 to 2010), and MIDA, Investment Performance Report (2015 and 2020).

Impact of Financial Crises: Regional comparisons

The AFC severely disrupted Malaysia’s impressive trajectory in attracting FDI and annual inflows tumbled (see Figure 1). However, the magnitude of the FDI slump was not very different from that in two other crisis-affected countries, Indonesia, and Thailand (Table 5), despite Malaysia's capital controls launched in 1998 (Athukorala, 2001 and 2003). Except for limits on foreign exchange for travel overseas by Malaysian citizens, there was no retreat from the country's long-standing commitment to a relatively open trade and investment policy.

The post-AFC contraction in FDI in Malaysia, as well as in Indonesia and Thailand, continued until about 2005. Total FDI inflows to Malaysia during this period were about 25 per cent lower than in the proceeding five-year period. The continuation of FDI contraction well beyond economic recovery from the crisis was largely a reflection of a large overall decline in global FDI flows in 2000–03 (UNCTAD, 2005). Total global FDI inflows declined from US$134 billion in 2000 to US$63 billion in 2003, recovering marginally to US$65 billion in 2004.

FDI inflows to Malaysia recovered to pre-crisis levels by 2007 and rose until about 2015, but with a sharp drop in 2009 owing to the Global Financial Crisis (Figure 1 and Table 5). However, subsequent years have recorded a contraction, notably vis-à-vis most Southeast Asian peers. FDI inflows fell sharply from an average of just under US$11 billion in 2010–14 to US$7 billion in 2020–21 (Table 5). (In fact, in 2020, a year when FDI was affected by the Covid-19 pandemic, FDI was just US3.1 billion and the contribution of FDI to GDCF at 4 per cent was the lowest since the FDI collapse in the aftermath of the AFC).⁹

Table 5: FDI inflows to Malaysia and other major Southeast Asian economies, selective periods 1970–2021 (period averages)

Note:--- Data not available
Source of data: Compiled from UNCTAD World Investment Report database.

The fraction of Indians in Malaya’s population rose very sharply in the decades between 1901–1921, from just 6 per cent to 15 per cent, as rubber planting expanded and inflows were at their peak. But the Indian share of the population fell after 1931 and was just 11 per cent by 1947, as many Indian plantation workers were repatriated as a result of the rise in unemployment over the Great Depression years (Figure 1).

Beyond the plantations, Indians were recruited, inter alia, for public works, as police and guards, and also to serve in the lower ranks of the colonial bureaucracy. Most came from Tamil areas in south India. They were considered to be more accustomed to British rule, more amenable to discipline than the Chinese, and more willing to work for low wages. Access to low cost Indian labour migration helped ensure the rubber industry’s spectacular growth and profitability. Since there was work for wives and older children on the rubber estates, Indian migration included whole families. But low wages, indebtedness, poor social status, and physical isolation kept estate Indians apart and they tended to exercise little influence on Malayan society.

By 1990–94, Malaysia accounted for nearly 30 per cent of total inflows to the six major economies in Southeast Asia, and was the largest after Singapore (see Table 5). The share has declined since, reaching just 5.2 per cent by 2020–21; it has been overtaken by Indonesia, the Philippines, and Vietnam. Malaysia’s share in total world FDI inflows has shown a similar pattern, declining sharply from 2.3 per cent in 1990–94 to 0.5 per cent in 2020–21. Overall, Singapore's share in world FDI inflows has recorded a massive increase, reaching a staggering 7.1 per cent on average in 2020–21—the largest FDI share of all host countries except China (13.5 per cent).

What explains Malaysia's recent sharp decline in FDI?

The two factors that figure prominently in the contemporary policy debate are competition from China and increases in manufacturing wages.

Competition from China: There is evidence of significant investment contraction in final assembly of consumer E&E goods in Malaysia as an outcome of competitive pressure from China (Athukorala, 2014). But initially this contraction was more than counterbalanced by the expansion of parts and components assembly to meet increased demand for final assembly in China. Over the past decade, this counterbalancing effect may well have dissipated as production bases in China deepened to undertake parts and components production locally to meet demand from final assembly.

A 2021 econometric analysis of the determinants of Malaysia’s exports within global production networks (mostly E&E goods) over 1992–2020 provides some indirect evidence of this negative effect from Chinese competition (Kamariah-Ghazali, 2021). According to this study, a 1 per cent increase in China’s world market share in these exports was associated with about a 4 per cent reduction in Malaysia’s exports, after controlling for other relevant factors.

Increases in manufacturing wages: The average factory worker's wage in Malaysia has been higher than that of the other major countries in Southeast Asia except Singapore, and this gap has widened somewhat in recent years (Table 6). Presumably, this would have made Malaysia more susceptible to Chinese competition and relatively less attractive as an investment location for export-oriented manufacturing than these other countries.

Table 6: Average monthly earnings of manufacturing workers in major economies in Southeast Asia, 2011-2020

Notes: ¹Average monthly earnings of workers in the employment category of 'plant and machinery' as per the 13th International Conference of Labour Statistics classification of the International Labour Organization.
--- Data not available.
Source of data: Compiled using data extracted from International Labour Organization database: https// ilosstatat.ilo.org.

Nevertheless, a comparison of the Malaysian experience with other regional countries’ (see Table 5) suggests that it is not possible to ascribe recent declines in FDI inflows to the above-mentioned two factors alone. Vietnam and Indonesia have an advantage over Malaysia in terms of relatively lower labour costs, but the differences are not so big to explain recent divergence in FDI inflows. The average factory worker's wage in all three countries amounts to less than 10 per cent of the comparable figure for that in MNEs’ home countries (represented here by the average wage in the United States). More important, Singapore has emerged as the second-largest FDI recipient in the world after China despite its massive wage gap with the other five Southeast Asian countries. A deeper analysis incorporating these two factors with variables that appropriately capture the overall investment environment is, therefore, needed.

Dualistic incentive structure

The standard indicators of the overall investment climate such as openness to trade and investment, cost of starting a business, customs procedures, the quality of business-related infrastructure, and dispute resolution as regards foreign equity ownership, show that Malaysia's overall FDI regime compares well with those in its Southeast Asian neighbours and in most other countries (World Bank, 2022). However, these general indicators fail to reveal the country's deep-rooted dualistic incentive structure, which is directly relevant for understanding recent FDI trends.

While the existing export-oriented manufacturing industries, especially for E&E goods, are fully open to foreign ownership, many other industries with potential for attracting FDI are governed by regulations designed to conform with the multi-ethnic country's socio-political objectives in a manner that runs counter to the global profit-maximizing objective of MNEs. The employment and ownership quotas introduced under the Industrial Coordination Act of 1975 (see above) still apply to firms operating in these sectors. Further, the presence of government-linked companies—a relic of the heavy-industry drive in the mid-1980s—still distorts the incentive structure and acts as a de facto constraint on MNE entry in many sectors (Gomez, 2011; Menon and Ng, 2013).

Given the paucity of relevant data, it is not possible to explicitly test the impact of dualism in Malaysia's FDI policy regimes. However, the sectoral/industry profile of FDI does provide indications of the impact of policy dualism (Table 4). Within manufacturing, E&E industries have accounted for over one-third of total FDI inflows. The data shows that the decline in FDI in E&E industries has contributed significantly to the decline in total FDI over the past few years.

Malaysia's transport industry, which until recently had been dominated by the two national car companies, Proton and Perodua, is perhaps the most obvious case of a dualistic regime constraining FDI. In many developing countries, this industry has been a key magnet for foreign investors in recent years. The most striking example is Thailand, the 'Detroit of Asia', which has become a major production centre of global automotive networks.

In Singapore, commodity composition of manufacturing exports has greatly diversified from E&E into other industries including petrochemicals, pharmaceuticals, and medical devices (Chia, 2011). Moreover, manufacturing still accounts for around 80 per cent of FDI in Malaysia, whereas in recent years globally there has been a significant shift in FDI towards services.

Proton’s Automobile Plant in Tanjung Malim
Source: New Straits Times, 28 May 2017

Skill and innovation deficits

Until recently, MNEs in export-oriented manufacturing in Malaysia, which accounted for the overwhelming share of FDI, were involved in simple assembly activities that required unskilled and semi-skilled labour. Over time, however, the country’s competitive edge in these types of activities has eroded, mainly reflecting increasing domestic wages and the emergence of low-wage investment locations elsewhere. It appears that Malaysia has not upgraded the capacities and incentives needed to become an innovation-driven economy, in line with its aspiration to graduate to high-income status.

In innovative capacity, Malaysia lags far behind the regional leader, Singapore. Even though Malaysia's share of the population aged 15 and over with a completed secondary education is the highest in the region, shortages of high-level human resources have been a major constraint on industrial upgrading. This view is supported by firm-level evidence from Penang, the centre of Malaysia's E&E industry (SERI, 2008; Ong, 2022). Most of the major MNEs covered in these surveys have reported shortages of research and development and design engineers, process engineers, and technical and production workers as a major constraint on their future expansion. The shortage of mid-to high-skill labour is more prevalent in electronics manufacturing, medical technology, precision machining, ecotourism, and civil engineering.

Conclusion

Post-independence FDI has been a major driver of Malaysia’s growth and structural transformation. It played a vital role in export-oriented industrialization elevating the country's economy to upper-middle-income status. In the second decade of the 21st century, however, the Malaysian FDI engine has begun to run out steam as its relative attractiveness for foreign investors has faded in Southeast Asia.

The transformation of the structure of FDI, from the colonial pattern of primary product dominance to export-oriented manufacturing, had brought to the forefront the role of government policy in shaping FDI in the economy's growth and structural transformation. In the colonial era, country-specific advantages in agricultural and mineral resources were the key driver of FDI. In the modern era of export-oriented manufacturing, foreign investors pay attention to comparative advantages in international production relative to other host countries in their country selection.

A preliminary exploratory analysis suggests that the emerging dip in FDI cannot be explained by the diminishing relative labour cost advantage and competition from China alone. Further analysis encompassing the deep-rooted dualistic nature of the investment policy regime, the skill shortages, and the limited innovative capabilities of the economy is needed to inform policy.