OPENNESS, FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN MALAYSIA

OPENNESS, FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH IN MALAYSIA

Tsen, Wong Hock

(ProQuest Information and Learning: … denotes text missing in the original.)

I. INTRODUCTION

Malaysia is a small open economy. The openness of the Malaysian economy to international trade in terms of total trade to gross domestic product (GDP) has increased over time. The average of the ratio, i.e. total trade to GDP over the period 1970-1979 was 88.6 percent. The average of the ratio increased to 113.1 percent over the period 1980-1989 and 178.2 over the period 1990-1999. In 2000, the ratio was 230.8 percent. The openness of the Malaysian economy is expected to increase with liberalisation and globalisation of the world economy. Malaysia has achieved high economic growth rates since the 1970s, one of the success stories in Southeast Asia. The average economic growth rate per annum in Malaysia over the periods 1970-1979, 1980-1989 and 1990-1999 were 8.4 percent, 5.8 percent and 7.2 percent, respectively. The economic growth in Malaysia remained impressive after the Asian financial crisis, 1997-1998, which is a relatively short period. In 2000, the economic growth rate of Malaysia was 8.5 percent (Table 1).1

Monetary aggregates in Malaysia increased significantly over the period 1970-2000. The average of the ratio, i.e. M1 to GDP over the period 1970-1979 was 18.2 percent and increased to 19.3 percent over the period 1980-1989 and 25.5 percent over the period 1990-1999. In 2000, the ratio was 23.7 percent. The ratio of M2 to GDP also increased significantly. In the period of 1970-1979, the average of the ratio was 41.9 percent and increased to 64.7 percent over the period 1980-1989 and 88.5 percent over the period 1990-1999. In 2000, the ratio was 104.1 percent. In the same periods, M3 to GDP and domestic credit to private sector (DC) to GDP also increased significantly (see Table 1). A steady and stable growth in monetary aggregates is considered important for economic growth. Moreover, the growth of monetary aggregate over GDP is usually viewed as financial deepening, which entails growth of financial instruments. Generally, financial development includes financial deepening, financial broadening and financial liberalisation. Financial broadening means an increase in the number of financial institutions and financial instruments. Financial liberalisation means deregulation of interest rates,-free movement of foreign capital and removal of other restrictive practices (Ansari, 2002).

The relationship between openness to international trade and economic growth, and financial development and economic growth are focus of economists (Roubini and Sala-i-Martin, 1991). Generally, it is argued that openness to international trade and financial development has a positive impact on economic growth. The reason for the argument is partly based on the conclusions of many empirical studies, which claim that outward-oriented economies consistently have higher economic growth rates than inward-oriented economies. It is also partly due to the failures of import-substitution strategies, particularly in the 1980s and overstated expectations from trade liberalisation (Yanikkaya, 2003: 57). Lloyd and MacLaren (2000) argue that the fast-growing East Asian economies were partly a result of their early openness to international trade; less openness of economies to international trade will slow down their economic growth rates. Although there is a near consensus about the positive impact of trade flow on economic growth, the theoretical economic growth literature, which studies the economic growth impact of trade restrictions, reports that the impact is very complicated in the most general case and the results are mixed as to how trade policies play a role in economic growth. The fact that empirical studies describe openness to international trade very differently makes the classification of countries according to their level of openness to international trade a formidable task (Yanikkaya, 2003). King and Levine (1993), amongst others, show the positive link between financial development and economic growth, and financial development has predictive power for future economic growth. However, the empirical findings of the relationship between financial development and economic growth are inconclusive.

The study on openness to international trade and economic growth in the literature was carried out mainly using cross-section or panel data (Harrison, 1996, Yanikkaya, 2003). Harrison (1996: 443) investigated the impact of openness to international trade on economic growth and reported that the choice of time period for analysis is critical: whereas only one of the seven measures of openness to international trade positively affects economic growth when cross-section data are employed, three of the seven proxies for openness to international trade reveal a positive association with economic growth when the data are averaged over five-year periods and six of the seven measures are statistically significant (in either levels or differences) using annual data. The different results, which arise from the use of cross-section and panel data suggest the impact of openness to international trade on economic growth would be different in the short-run and long-run. Moreover, Yanikkaya (2003) examined the impact of openness to international trade on economic growth and addressed potential statistical problems inherent of estimation and to interpreting these results. The results do not seem to be sensitive to the different statistical methods, specifications, datasets and outlier problems. Although the results of different estimators (OLS, SUR and 3SLS) are somewhat similar to each other, the fixed-effects estimator implies a much weaker relationship between openness to international trade and economic growth. Thus, the time dimension of the impact of openness to international trade on economic growth can be an interesting issue to be considered.

The empirical studies in the literature were examined mainly with the focus of the impact of openness or financial development and not of both of them on economic growth. Moreover, they examined the impact of openness or financial development on economic growth mainly using cross-country data (Harrison, 1996; Yanikkaya, 2003; Rioja and Valev, 2004). On the other hand, the main objective of the study is to investigate the impact of openness to international trade and financial development on economic growth in Malaysia using time series data. Furthermore, the study considers the contagion effect of the Asian financial crisis, beginning in the middle of 1997 and ending in 1998 (Bank Negara Malaysia, 1999). Therefore, two sets of data are used in the study, i.e. 1970-2000 and 1970-1996. In 1970-1996, the year 1996 is chosen as the cut-off period to avoid the contagion effect of the Asian financial crisis. Most empirical studies on Malaysia do not consider the matter.

The investigation into the impact of openness to international trade on economic growth could be in bilateral series, i.e. between openness to international trade and economic growth or a more complicated model. In this study, the empirical model is based on an augmented production function, which is close to the one that is estimated by Harrison (1996). The Johansen (1988) cointegration method is used to estimate the empirical model to investigate the long-run impact of openness to international trade and financial development on economic growth. Vamvakidis (2002) reported that the impact of openness to international trade on economic growth is only a recent phenomenon, which may imply that investigating the impact of openness to international trade on economic growth in a longer period is important. Moreover, the study uses different measures of financial development. The Granger-causality between openness to international trade and economic growth, and financial development and economic growth are also investigated. This issue is getting less attention in the literature of the impact of openness or financial development on economic growth

The rest of the paper is organised as follows: Section II discusses openness, financial development and economic growth. Section III explains the methodology and data. Section IV presents the empirical results and discussions. Section V contains some concluding remarks.

II. OPENNESS, FINANCIAL DEVELOPMENT AND ECONOMIC GROWTH

Openness

There is a lack of a clear definition of openness to international trade or trade liberalisation. Over time, the definition has evolved considerably from one extreme to another. Krueger (1978) discusses how trade liberalisation can be achieved by employing policies that lower the biases against the export sector. This implies that one country can open her economy by employing a favourable exchange rate policy towards its export sector and at the same time can use trade barriers to protect its import sector. Harrison (1996) states that the concept of openness to international trade could be synonymous with the idea of neutrality, which means that incentives are neutral between saving a unit of foreign exchange through import substitution and earning a unit of foreign exchange through exports. Thus, a highly outward-oriented economy may not be neutral in this sense, particularly if it shifts incentives in favour of export production through instruments such as export subsidies. It is also possible for a regime to be neutral on average and yet intervene in specific sectors. A good measure of trade policy could capture differences between neutral, inward- oriented and outward-oriented economies. Openness to international trade is also usually thought of free trade, i.e., all trade distortions are eliminated. Therefore, it is crucial to understand the definition of Openness to international trade because each of them could have different theoretical implications for economic growth and different linkages with economic growth (Yanikkaya, 2003). Moreover, Edwards (1993: 1365) stated that the literature on the subject has not always been successful in dealing with precise definitions of trade regimes, nor has it been able to handle successfully the difficult issue of measuring the type of trade orientation followed by a particular country.

There are many measures of openness to international trade such as the trade shares over the GDP, population densities, trade barriers, bilateral payment arrangements, exchange rate – the black market premium and indices of trade orientation (Yanikkaya, 2003). However, none of the measures is free of methodological problems (Harrison, 1996: 425; Yanikkaya, 2003). One of the measures, which is widely used in the literature, is the trade shares over the GDP or more specifically the exports plus imports divided by GDP. This measure is usually available to a country and in a long period. Moreover, this measure may have some limitations, i.e., it depends on resource endowments, country size and many other determinants of international trade and the level international trade restrictions. A country may have a high trade ratio because it is small or has resources which are valuable to other countries rather than because it has low restrictions on trade with other countries (Lloyd, 1999:5). Nonetheless, many empirical studies have employed this measure and reported that generally it has a significant positive impact on economic growth. The use of this measure is said to be an important step towards understanding the relationship between international trade and economic growth proposed by the new growth and new trade theories (Yanikkaya, 2003).

The impact of openness to international trade on economic growth could be sensitive to the variables measuring openness to international trade and also other explanatory variables used in the empirical model. Harrison (1996) found that not all the measures of openness to international trade are significant although most of them have a positive impact on economic growth. Thus, one of the solutions is to employ as many different measures of openness to international trade in a study (Harrison, 1996; Vamvakidis, 2002; Yanikkaya, 2003). However, most of the measures of openness to international trade are not available for developing countries or are limited by sample size. Thus, their use for a long-run analysis is limited.

Openness and Economic Growth

The idea that international trade is an engine of economic growth is very old, dating back at least to Adam Smith and David Ricardo. Adam Smith used the concept of absolute advantage while David Ricardo used the concept of comparative advantage to show that international trade increases the welfare of a country. Nevertheless, the idea of international trade was not very popular during long periods in the 20th century. Protectionist theories argue that protectionism can improve economic growth. This idea became dominant and for decades the majority of developing countries implemented industrialisation policies based on a very limited degree of international openness. These policies came to be known as ‘import substitution industrialisation strategies’. These strategies were based on two fundamental premises. The first fundamental premise is deterioration in the international price of developing countries results in an over-growing widening of the wealthy gap between rich and poor countries. The second fundamental premise is in order to industrialise, developing countries require temporary assistance in the form of protection to the newly-emerging manufacturing sector, which the reasoning was closely related to the infant industry argument for industrialisation (Edwards, 1993).

However, even though the protectionist theories had become dominant, a small group of academics embarked, independently, on major empirical investigations aimed at assessing the consequences of alternative trade regimes. These researches argued that there was abundant evidence suggesting that the more open and outward-oriented economies had outperformed those countries pursuing protectionism (Edwards, 1993: 1359). Nonetheless, the debate continues today, even as the world is experiencing an unprecedented period of trade liberalisation and many empirical studies that claim to have found a positive impact of openness to international trade on economic growth (Edwards, 1998: 383).

There are many theoretical models that have been proposed to demonstrate the positive relationship between openness to international trade and economic growth. In new growth theories, technological change is assumed to be endogenous. In contrast with neoclassical growth theories, technological change is exogenous and it is unaffected by the trade policy of a country. More openness to international trade raises imports of goods and services, which include new technology. The new foreign technology is then introduced to the domestic economy and will be learned by domestic producers. Thus, a more open of a country to international trade will improve domestic technology and increase productivity. Moreover, market expansion effects will lead to a greater variety of products, capital inputs and intermediate inputs, and thus to greater factor productivity. More productive research and development (R&D) will result in spill over effects associated with innovations and avoidance of duplication of R&D costs (Weinhold and Rauch, 1999; Lloyd and MacLaren, 2000). Therefore, an economy that is open to international trade may grow faster than a protected or closed economy and thus, openness to international trade is expected to have a positive impact on economic growth. Barro and Sala-i-Martin (1995), amongst others, argue that technological change can be influenced by a country’s openness to international trade.

Openness to international trade, however, does not raise economic growth unambiguously. Levine and Renelt (1992) showed that the relationship between openness to international trade and economic growth happens through investment. Openness to international trade may stimulate inflow of foreign direct investment (FDI). On the other hand, an increase in international competition may discourage domestic investment. Thus, the net effect of the two driving forces is ambiguous, depending on the changes in domestic and foreign investments. Grossman and Helpman (1991) indicate that protection could raise the long-run economic growth if government intervention in trade encourages domestic investment along the lines of comparative advantage. On the other hand, Batra (1992), amongst others, argues that freer trade is the primary source of economic downturns. Trade liberalisation and increased openness are believed to reduce tariffs and thereby the tariff cut reduces the relative price of domestic manufactures goods. In this case, manufacturing goods domestically becomes less attractive than importing foreign goods and hence the domestic economy may suffer a loss.

Theoretical disagreement on the role of openness to international trade is matched by mixed empirical evidence. Nevertheless, many empirical studies find a positive relationship between openness to international trade and economic growth.2 Yanikkaya (2003) examined the impact of openness to international trade on economic growth of over 100 developed and developing countries using panel data from 1970 to 1997. The results showed that openness to international trade does not have a simple and straightforward relationship with economic growth. However, contrary to the conventional view on economic growth effects of trade barriers, the results showed that trade barriers were positively and, in most specifications, significantly associated with economic growth, particularly for developing countries and they were consistent with the findings of theoretical economic growth.

Vamvakidis (2002) examined the relationship between openness to international trade and economic growth in developed and developing countries using cross-section data over the period 1920-1990. Estimating economic growth over a long period provides useful conclusions on the robustness of openness to international trade and other explanatory variables in the empirical model. The results showed that there was no positive relationship between openness to international trade and economic growth before 1970. The relationship was found to be negative. The positive relationship between openness to international trade and economic growth was only a recent phenomenon. However, it was sensitive to the measures of openness to international trade. The finding may suggest that openness to international trade when protection in the world economy is high does not result in economic growth benefits.

Harrison (1996) examined the relationship between openness to international trade and economic growth in developing countries using cross section and panel data for the period from 1960 to 1987. The empirical estimation is based on an augmented production function. The results suggested that the choice of time period for analysis is critical, i.e., more evidence of the positive impact of openness to international trade on economic growth is found when a longer time series data is used. This may suggest the importance of analysing the short-run and long-run impact of openness to international trade. Generally, the results were quite robust. Openness to international trade positively affects economic growth. The results of Granger-causality suggested that the causality between openness to international trade and economic growth runs in both directions, i.e. more openness to international trade precedes a higher economic growth and a higher economic growth leads to more openness to international trade. Edwards (1998) amongst others reported that openness to international trade is found to have a positive impact on economic growth.

Financial Development and Economic Growth

The idea of financial development promoting economic growth dates back at least to Joseph Schumpeter in the early 1990s (King and Levine, 1993). A lot of attention is given to the relationship between financial development and economic growth. Mckinnon (1973) and Shaw (1973), amongst others, showed that financial development is a necessary condition for achieving a high rate of economic growth. The endogenous growth theories were advocated to explain the positive impact of financial development on economic growth.

In the theoretical Arrow (1964) and Debreu (1959) world characterised by a complete set of state-contingent claims, with no information or transaction costs, there is no need for financial intermediation. However, this benchmark world is clearly built upon unrealistic assumptions. Intermediaries become essential once imperfections or fractions are introduced in the model. If market conditions are actually less than perfect, then economic exchange is costly and if it is sufficiently costly, it may not occur at all. Financial intermediaries make these exchanges affordable, thus offsetting the underlying market imperfections and frictions (Khan and Senhadji, 2000).

A sound financial system is important for economic growth. Financial systems: (i) facilitate the trading, hedging, diversifying and pooling of risk; (ii) allocate resources; (iii) monitor managers and exert corporation control; (iv) mobilise saving; and (v) facilitate the exchange of goods and services (Levine, 1997). In summary, the financial system facilitates the allocation of resources over time and space (Khan and Senhadji, 2000). The increased availability of financial instruments and institutions reduces transaction and information costs in an economy.

Empirical findings on the relationship between financial development and economic growth are less conclusive. Nevertheless, the usual finding is that financial development has a positive impact on economic growth. King and Levine (1993) showed a strong positive relationship between financial development and economic growth. They also showed that financial development has predictive power for future economic growth and interpreted this finding as evidence for a causal relationship that runs from financial development to economic growth. The study covered a cross-section of 80 countries for the average of the period 1960-1989.

Khan and Senhadji (2000) examined the relationship between financial depth and economic growth of 159 developed and developing countries using cross- section data and panel data of 5 years average, which generally covers the period of 1960-1999. The results showed the strong positive and statistically significant relationship between financial depth and economic growth in the cross-section analysis. The result is robust to different measures of financial depth. They concluded that financial depth is important for economic growth. However, the results are weaker when a time dimension is introduced in the model. Arestis and Dementriades (1997) argue that the over-simplified nature of results obtained from cross-country regressions may not accurately reflect individual country circumstances. They used quarterly data over the period 1979:IV-1991:IV and found a positive relationship between financial development and economic growth for Germany, but insufficient evidence to suggest that in the United States that financial development causes economic growth. They concluded the results of individual countries, which were obtained from a time series, exhibit substantial variation across countries, even when the same variables and estimation methods were used.

Christopoulos and Tsionas (2004) combined cross-sectional and time series data to examine the relationship between financial development and economic growth in ten developing countries. They employed the cointegration methodology for panel data. The results showed that there is fairly strong evidence in favour of the hypothesis that the long-run causality runs from financial development to economic growth and not vice versa. Time series evidence is also supportive of the idea that there exists a unique cointegrating vector between economic growth, financial development and other explanatory variables (investment share and inflation). The study also reported that there is no short-run causality between financial deepening and economic growth and that the impact is necessarily long run in nature. The important policy implication is that policies aiming at improving financial markets will have a delayed but significant impact on economic growth.

Rioja and Valev (2004) examined the relationship between financial development and economic growth of 74 countries using panel data over the period 1960-1995. The results showed that the impact of financial development on economic growth was not uniform, but varied according to the level of financial development of the country. The positive impact of financial development on economic growth is high in countries with middle and high levels of financial development and it is not clear what the effect is in countries with a low level of financial development.

Ansari (2002) investigated the impact of financial development, money and public spending on Malaysian national income over the period 1960-1996. The study used annual data. A vector error correction model was estimated. The results from the impulse response functions and variance decomposition showed that financial development affects economic growth in Malaysia. This conclusion is supported by the statistical significance of the error correction terms. There is some support for the Mackinon-Shaw repressionist proposition. However, there is no strong evidence to support either the monetary or fiscal policy effectiveness in Malaysia.

III. METHODOLOGY AND DATA

An increase in the employment or capital increases the real GDP per capita. Thus, coefficients of the employment and capital are expected to be positive. From the previous section, openness to international trade is generally argued to have a positive impact on economic growth. Thus, the coefficient of openness to international trade is expected to be positive. Also, more development in financial sector is argued to have a positive impact on economic growth. Thus, the coefficient of financial development is expected to be positive.

The empirical estimation in the study begins with the unit root tests. The aim of unit root tests is to examine whether a series is stationary or non-stationary. A series has a unit root is said to be a non-stationary series. In contrast, a series which does not has a unit root is said to be a stationary series. The need of unit roots tests is to avoid spurious regression or nonsense correlation. In the study, the Dickey and Fuller (1979) and Phillips and Perron (1988) unit root test statistics are employed. The Dickey and Fuller (1979) unit root test statistic uses the parametric approach, i.e., to change the estimating regression to solve the heterogeneity and serial correlation in an error term. In contrast, the Phillips and Perron (1988) unit root test statistic uses the non-parametric approach, i.e., to modify statistic to obtain estimator and statistic. The Dickey and Fuller (1979) unit root test statistic is a low power test under the null hypothesis of a unit root that posits root close to the unit circle or tends to stationary. The Phillips and Perron (1988) unit root test statistic is known to be more robust in an error term process, i.e., an error term is allowed to be weakly heterogenous.

According to Engle and Granger (1987), series that are integrated of the same order may cointegrate together. The cointegrated series may drift apart from each other in the short-run but the distance between them tends to be constant or in a stationary process in the long-run. More formally, a vector of series (n × 1), y, is said to be cointegrated if each of the series is integrated of the same order, an existing non-zero cointegrating vector (n × 1), α’ such that the linear combination of these series, α’y^sub t^ are stationary or is said to be integrated of zero and denoted by I(0).

The two likelihood ratio test statistics can be sensitive to the choice of the lag length used in the estimation of the test statistics. Thus, the choice of the lag length in this study is determined by the Schwarz Bayesian criterion (SBC). The procedure has several advantages over the residual-based Engle and Granger (1987) two-step procedure in testing for a long-run relationship among economic variables. Phillips (1991) documented the desirability of this technique in terms of symmetry, efficiency and unbiasedness. The procedure does not suffer from a normalisation problem and is robust to departures from normality (Phillips, 1991; Kremers et al., 1992).

In the Granger (1969) sense of a variable X causes another variable Y if the current value of Y can better be predicted by using past values of X. When series are cointegrated, the testing of Granger-causality is to be in an ECM. If the joint test, by the mean of classical F-test, of lagged variable X is significantly different from zero, then it implies that X Granger causes Y. On the other hand, if the joint test of lagged variable Y is significantly different from zero, then it implies that Y Granger causes X. The minimum final prediction error (FPE) criterion proposed by Akaike (1970) is used to determine the optimal lags of the model.

Two sets of data are used in the study, i.e. 1970-2000 and 1970-1996. The second set of data is introduced to avoid the contagion effect of the Asian financial crisis, 1997-1998 in the estimation. The GDP, population, exports, imports, and gross fixed capital formation data were obtained from the Department of Statistics Malaysia (DOS). The monetary aggregates data, i.e. M1, M2 and M3 were obtained from Bank Negara Malaysia (BNM). The employment data were obtained from the Ministry of Finance (MOF), Malaysia. The GDP deflator (1995=100) and domestic credit to private sector data were obtained from the International Monetary Fund (IMF).

IV. EMPIRICAL RESULTS AND DISCUSSIONS

The Empirical Results: 1970-2000

The results of the Dickey and Fuller (1979) and Phillips and Perron (1988) unit root test statistics are reported in Table 2. The lag length used to compute the Dickey and Fuller (1979) test statistics is based on the Akaike (1973) information criterion (AIC). For the Phillips and Perron (1988) unit root test statistics, the results that are reported are based on four truncation lags, which are used to compute the test statistics after considering truncation lags one to four in computing the test statistics. Generally, the results of the Dickey and Fuller (1979) and Phillips and Perron (1988) unit root test statistics show that all the variables are non-stationary in level but becoming stationary after taking the first differences. Thus, all the variables, namely the real GDP per capita (Y^sub t^), the employment (L^sub t^), the capital (K^sub t^), openness to international trade (O^sub t^) and measures of financial development (FID^sub 1,t^, FID^sub 2,t^, FID^sub 3,t^ and FID^sub 4,t^) are said to be integrated of order one.

… statistic. Values in parentheses are the lag length used in the estimation of the Dickey and Fuller (1979) or Phillips and Perron (1988) unit root test statistics. Critical values for t^sub γ^ (Z(t^sub γ^)) with a drift (no-trend) at 1% and 5% for sample size 35 are -3.63 and -2.95, respectively. Critical values for t^sub γ^ (Z(t^sub γ^)) with a drift and a time trend (trend) at 1% and 5% for sample size 35 are -4.24 and -3.54, respectively (MacKinnon, 1996). ** denotes significance at 1 percent level. * denotes significance at 5 percent level.

The results of the Johansen (1988) multivariate cointegration procedure are reported in Table 3. The results of the λ^sub Max^ and λ^sub Trace^ test statistics are computed with unrestricted intercepts and no trends. For all the models, the results of the λ^sub Max^ and λ^sub Trace^ test statistics show that the null hypotheses, i.e., H^sub 0^: r = 0 is rejected at 95 percent critical value and H^sub 0^: ≤ 1, r ≤ 2, r ≤ 3 or and r ≤ 4 are not rejected at 95 percent critical value. Thus, there is one cointegrating vector. This finding suggests that there is a long-run equilibrium relationship among explanatory variables in each of the models. The results of the normalised cointegrating vector are reported in Table 4. All explanatory variables in each of the models are found to have the expected signs. An increase in the employment or capital increases the real GDP per capita. An increase in openness to international trade increases the real GDP per capita. Finally, an increase in financial development increases the real GDP per capita. The result is robust to different measures of financial development. Thus, openness to international trade and financial development are said to have a positive long-run impact on economic growth.

The Granger representation theorem shows that cointegration implies an error correction representation. The study uses the general-to-specific modelling strategy to find the representation. For this purpose, equation (5) is estimated. Initially, three lags of each first difference variable is used, then the dimensions of the parameter space are reduced to a final parsimonious specification by sequentially imposing statistically insignificant restrictions. The results of error correction models (ECMs) are reported in Table 5. On the whole, the results show all the models to have a high adjusted R^sup 2^, ranging from a low of 0.90 in Model 1 and Model 5 to a high of 0.95 in Model 2. Moreover, all the models fulfil the conditions of no-autocorrelation, no-functional form (except Model 3), and normality and homoscedasticity of error terms. The one-lagged error correction terms are all found to have the expected negative sign and are statistically significant.3 Thus, the finding supports the validity of an equilibrium relationship among the variables in each of the cointegrating equations. The results show openness to international trade and financial development to have a significant impact on economic growth.

The results of the Granger-causality test are reported in Table 6 (see above). There is strong evidence that openness to international trade Granger causes economic growth and not vice versa. However, Granger-causality between financial development and economic growth is less robust, depending on the measure of financial development. FID^sub 1,t^ and FID^sub 3,t^ are found to have Granger-causality on economic growth and not vice versa. Economic growth is found to have Granger-causality on FID^sub 2,t^ and not vice versa. Finally, FID^sub 4,t^ and economic growth are found to have bi-direction of Granger-causality.

Generally, the results show openness to international trade and financial development to have a long-run and short-run positive impact on economic growth in Malaysia. The finding is robust to different measures of financial development. In another study, Ansari (2002) used a different methodology and also reported the importance of financial development on economic growth in Malaysia. Moreover, there is strong evidence that openness to international trade Granger causes economic growth and not vice versa. However, Granger-causality between financial development and economic growth is less robust. Generally, a more open economy and a sound financial sector are important for economic growth.

The Empirical Results: 1970-1996

The results of the Dickey and Fuller (1979) and Phillips and Perron (1988) unit root test statistics, which are not reported for space is concerned, show that all the variables are said to be integrated of order one. The results of the Johansen (1988) multivariate cointegration procedure are reported in Table 7. The results of the λ^sub Max^ and λ^sub Trace^ test statistics are computed with unrestricted intercepts and no trends. Generally, the results of the λ^sub Max^ and λ^sub Trace^ test statistics show Model 1 and Model 5 to have one cointegrating vector. For Model 2, the results of the λ^sub Max^ and λ^sub Trace^ test statistics show three show to have three cointegrating vectors. For Model 3 and Model 4, the results of the λ^sub Max^ test statistic show to have one cointegrating vector, while the results of the λ^sub Trace^ test statistics show to have two cointegrating vectors. Nonetheless, the results of the normalised cointegrating vector, which are reported in Table 8, are based on unrestrictive one cointegrating vector. On the whole, explanatory variables in each of the models are found to have the expected signs, except the measures of financial development in Model 2 and Model 3 exhibit the unexpected negative sign.

The results of ECMs are reported in Table 9. On the whole, the results show all the models to have a high adjusted R^sup 2^, ranging from a low of 0.84 in Model 1 and Model 4 to a high of 0.94 in Model 2 and Model 5. Moreover, all the models fulfil the conditions of no-autocorrelation, no-functional form, and normality and homoscedasticity of error terms. The one-lagged error correction terms are all found to have the expected negative sign and are statistically significant.4 The results show openness to international trade and financial development to have a significant impact on economic growth. However, the signs of openness to international trade and financial development are mostly found to be negative.

The results of the Granger-causality test are reported in Table 10. There is strong evidence that openness to international trade Granger causes economic growth and not vice versa. However, Granger-causality between financial development and economic growth is less robust. FID^sub 3,t^ is found to have Granger-causality on economic growth and not vice versa. There is no evidence of Granger-causality between FID^sub 2,t^ and economic growth. Finally, FID^sub 1,t^ and economic growth, and FID^sub 4,t^ and economic growth are found to have bi-direction of Granger-causality.

In comparing with the results obtained from the data set 1970-2000, the results obtained from the data set 1970-1996 show the less robust of the impact of financial development on economic growth. The rest of the results are about the same as the one obtained from the data set 1970-2000.

V. CONCLUSION

The main aim of the study is to investigate the impact of openness to international trade and financial development on economic growth in Malaysia. The empirical model in the study is based on an augmented production function, where the real GDP per capita is specified as a function of the employment, the capital, a measure of openness to international trade and financial development. The study uses different measures of financial development. The unit root test results show that on the whole all the variables are found to have a unit root. Moreover, the results of the Johansen (1988) multivariate cointegration procedure show that economic growth, the employment, the capital, a measure of openness to international trade and financial development are cointegrated. All the variables are found to have the expected signs, except the measures of financial development in Model 3 and Model 4, when data set 1970-1996 is used. ECMs are estimated. The results show openness to international trade and financial development to have a significant impact on economic growth. Generally, the results suggest that openness to international trade and financial development are important for economic growth in Malaysia. Furthermore, there is strong evidence that openness to international trade Granger causes economic growth and not vice versa. However, Granger-causality between financial development and economic growth is less robust, depending on the measure of financial development. Therefore, policies toward a more open economy and a strong financial sector are important.

Openness to international trade is found to have an important impact on economic growth. This is consistent with the prediction of mostly international trade theories that international trade is an important engine for economic growth. Vamvakidis (2002) and Harrison (1996), amongst others reported openness to international trade affects economic growth positively. Openness to international trade can lead to an increase in specialisation that will accelerate productivity growth by more fully realising economies of scale. Moreover, the more open economy is expected to face more competitiveness and which stimulates productivity, which in turn stimulates economic growth. Therefore opening the Malaysian economy to international trade is beneficial for economic growth. For example, the removal of tariffs to realise the ASEAN Free Trade (AFTA) is expected to further increase intra-ASEAN trade, which could be important for economic growth in Malaysia. The manufacturing sector is expected to further strengthen its capacity and competitiveness and to take advantage of the opportunities and challenges arising from global and regional development in trade and investment. Nonetheless, openness to international trade without strategically considering the conditions of domestic economy could be dangerous. Openness to international trade Granger causes economic growth in Malaysia and not vice versa that is consistent with the small open economy assumption.

The study also addresses the importance of financial development on economic growth by using several measures of financial development. Generally, financial development is found have an important impact on economic growth in Malaysia. Ansari (2002), amongst others, reports that financial development affects economic growth in Malaysia. Thus, it is important for Malaysia to further develop its financial sector in the country. A strong, efficient and competitive banking system is important to meet the challenges of globalisation and to sustain from future shocks, and thus to minimise the adverse effects on the economy. The lesson from the Asian financial crisis. 1997-1998, reminds of the importance of a sound financial system to reduce the potential for financial instability. Countries in Asia that do not have a strong financial system suffered the most during the crisis. Furthermore, the financial sector is expected to play an important role in providing options for high-growth activities, such as in the knowledge-and technology-intensive activities, which are crucial for future economic growth in Malaysia. Financial development Granger causes economic growth in Malaysia and vice versa, depending on the measure of financial development. Generally, financial development does not only a the long-run impact on economic growth but also has a short-run impact on economic growth in Malaysia. Conversely, Christopoulos and Tsionas (2004) reported that there is no short-run causality between financial deepening and economic growth and that the impact is necessarily long-run in nature.

In summary, Malaysia is a small open economy and is expected to further open her economy. A more open economy and a sound financial sector are important for economic growth.

NOTES

* A version of the paper has been presented at the Ã’ International Conference of the Asian Academy of Applied Business, 10-12 July 2003, Sutera Harbour, Sabah, Malaysia. The author would like to thank the referees of the journal for their comments.

1. School of Business and Economics, Universiti Malaysia Sabah, Locked Bag 2073, 88999 Kota Kinabalu, Sabah, Malaysia.

2. The economic growth rates are computed using GDP volume index (1995=100) (IMF).

3. See Roubini and Sala-i-Martin (1991) and Edwards (1993) for a literature survey of openness to international trade and economic growth.

4. The plots of CUSUMSQ and CUSUM statistics which are not reported show no evidence of instability of the estimated ECMs.

5. The plots of CUSUMSQ and CUSUM statistics of the estimated ECMs which are not reported indicate no evidence of instability.

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Wong Hock Tsen1

Universiti Malaysia Sabah

Copyright Universiti Malaysia Sarawak Jan 2005

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