Monday, August 2, 2010

FDI Is Not The Issue; Investment Is

The Star’s Managing Editor has compiled a 10-point list of how to improve Malaysia’s investment climate:

10 ways of doing without FDI

A STIR of sorts has been caused by the story that foreign direct investment (FDI) into the country for 2009 fell 81% to US$1.4bil (about RM4.5bil) from US$7.3bil (RM24bil)...

...If greater value-added is what we are after, then increasingly more investments have to be made in the services area – think tourism or education for instance. That does not necessarily need foreign investment – we can use local money.

We have plenty of money in Malaysia – as much as RM250bil at last count. That’s roughly the excess of deposits over loans sitting with the banks throughout the country.

All that money and nowhere to go within the country, is our problem. The money is not chasing investments in the country. And that can mean only one thing – there is a lack of opportunity here.

FDI flows in any particular year into Malaysia pales in comparison to the amount of idle money in the system. What we have to do is to find ways to use that and we will more than mitigate the effects of reduced FDI. Here are 10 ways we can do that.

I don’t have a quibble with any point on the list – they’re mostly common sense policies, some short term, some long term. Some won’t be very effective, such as cutting tariffs (they’re very low already; excise duties are another matter), while a couple are of the “duh, why didn’t I think of that” variety, like streamlining incentives for both international and domestic investors.

But the key point that the article brings up mirrors my own thoughts, which is that declining FDI is not really the issue. FDI helps boost growth by topping up domestic sources of savings that can boost investment, which is extremely critical for developing countries with limited financial resources. That’s not an obvious problem for Malaysia.

I do have to point out one technical error – the RM250 billion number quoted for the excess of deposits over loans is correct as far as it goes, but it isn’t a useful metric nor does it even come close to showing what’s potentially available for lending purposes. First is that if these deposits were used for investment purposes, it will simply flow from one account (the investor) to another (workers, vendors, land-owners etc). Additionally, under a fractional reserve banking system, every loan granted creates its own deposit, which makes the level of current deposits useless as a way to measure potential loanable funds.

The theoretical limits to loan growth are the statutory reserve ratio requirements set by Bank Negara which currently stands at 0.5%. That’s equivalent to a potential multiplier of 200 times banking system reserve deposits (both statutory and excess) with BNM. Using this standard, the banking system can increase loans given out to RM34 trillion compared with the RM828 billion as it stands now (June 2010; implying a reserve ratio of around 20%).

In practice, the limit is really the risk-weighted capital adequacy and new liquidity framework ratios. What the potential lending capacity is available here is harder to figure out due to the different risk weightings attached to loans and other assets, but I wouldn’t be surprised if we can double outstanding loans without falling below regulatory requirements for capital and liquidity.


  1. Dear HishamH,
    That is assuming the regulators were being prudent when they came out with the reserve requirement.

    0.5% is ridiculously low and I believe you more or less allude to that. 20% is perhaps stable considering our huge exposure to the housing sector, auto mobile loans and personal credit.

    Lets take the auto loans sector for example. At last check it was north of RM 100 billion, perhaps something like RM 110 billion. Loans are backed by a collateral which is overvalued relative to its true economic worth (due to protectionism).

    Now is it possible that the auto sector suddenly sees a wave of defaults? I guess that will tie in with other macro indicators like inflation, employment and wages. The FDI link is thus a second order link. An inflow of FDI reflects confidence that there can be real expansion in the manufacturing sector. the case now is certainly thumbs down so we must look at the FDI from the point of view of an unbiased expectation of future economic growth.

    Furthermore, if there was greater expansion I further contend there would be an upward pressure on wages. Right now, if we were to look at the monthly average wage rate for the manufacturing sector, it has been showing a steady decline.

    So my contention is that FDI is an indicator of future expectations on growth in the manufacturing sector. Alternatively a slowdown in the manufacturing sector will put downward pressure on wage and increase unemployment

    If these indicators turn south then it is not beyond the realms of possibility to start to see a wave of defaults hitting the erstwhile reliable "household" sector.

    People forget one clear thing. The households of 2010 are statistically different from the households in 2000. The loan to value, the % of disposable income, the demographic mix (age), the pressure on wages - all of these things are statistically different. (Wengers Contention #1).

    BNM should start to publish more in-depth delinquency stats. Wenger's Contention #2 - the default rates for new loans, adjusted for its age (i.e compared against similar vintage) should show some interesting news.

    Right now I feel the number has been skewed due to
    (a) Securitization of bad loans
    (b) New product characteristics i.e. the Overdraft facility as opposed to straight term loan
    (c) Abnormally low interest rates

    These are contentions and gut feelings. Without unbiased data, we can't tell for sure.

  2. Wenger,

    With respect to the reserve requirement you missed my point. Under the present regime, as true in most of the developed world, the statutory reserve ratio is completely irrelevant as no banker pays any attention to it. It's a just a relic from the days of the Gold standard, and we might as well abolish it.

    I see the banking systems' excess reserves as a factor of three things: protection against counterparty liquidity risk, loan demand and supply, and the relative lack of supply in low-risk securities compared to money. The actual reserve ratio (statutory + excess reserves) is a function of risk perception and liquidity, and has been pretty volatile - it peaked at over 43% in April 2008 before crashing to 20% in a matter of months.

    As far as FDI being a forward indicator, I think it would only be an indicator for export oriented manufacturing, not the manufacturing sector as a whole (we don't have the domestic market for that to be attractive).

    Nor is growing the manufacturing sector really all that critical any more in my view. As we shift to becoming a high income nation, we're really entering the post-industrial phase, where the services sector and consumption are more important. And that requires less in terms of banking system support (less investment in physical capital required).

    I also see manufacturing as having a big case of indigestion, hence the downward pressure on wages. We started the recession with too much capacity, and we've left it in an even worse state of over-capacity. Further investment in the manufacturing sector (domestic or foreign) is going to just exacerbate the situation, and further reduce returns to capital. Unless this is resolved, we're not going to see much in the way of FDI in the future - which in turn suggests that any FDI we look for should not be in the manufacturing sector.

    Note that there hasn't really been much implication on employment from the gyrations in manufacturing the past two years, a function of having mainly foreign labour in the sector.

    With respect to loan defaults, publishing the aging report would be nice. But in its absence watch the trend in IIS. When that starts rising, it'll indicate trouble down the road (it's heading down at the moment).