Greater capital flows, lower financing costs

While many would associate the Belt and Road Initiative (BRI) with greater infrastructure connectivity among participating countries, promoting financial cooperation and enhancing capital flows are also objectives of the BRI in a bid to establish a transnational platform in order to deepen economic cooperation and financial integration.

As capital flows between BRI countries heighten, there would be an increase in macroeconomic liquidity, defined as the amount of currency circulating in an economy, in countries which are net recipients of such capital flows. This translates into greater availability of credit in these economies. Therefore, businesses now have more funds available to them for their expansion purposes.

While foreign direct investment from Malaysia to China has been modest compared to our neighbour Singapore, which is a major investor in the Chinese economy, China has consistently been one of the largest contributors of foreign direct investment into the Malaysian economy since 2017. In 2020, Malaysia recorded a net inflow of foreign direct investment amounting to RM14.6bil, of which close to 18% was attributed to flows originating from the Chinese economy.

The influx of such investment flows not only benefits the Malaysian economy in terms of greater macroeconomic liquidity, but also in terms of job creation and higher economic growth, as foreign direct investments from China are mainly channelled to the construction and manufacturing sectors.

Looking at the effect of foreign direct investment flows on financing, it has been well-established that foreign direct investment relieves financial constraints of firms as more credit becomes available in the local economy. From the banking perspective, the inflows of foreign direct investment free up loan allocation previously taken up by large firms, thereby giving banks more leeway to provide loans to small firms. With the increase in macroeconomic liquidity throughout the economy, the basic intuition of supply and demand states that more credit should be offered or obtained at a lower cost.

Apart from foreign direct investment, there is another component of capital flows – unrecorded capital flows. Such flows are also known as illicit flows, hot money and residual flows. This category of capital flows is unique as such flows bypass official channels, such as trade and foreign direct investment, to reach markets which are restricted in emerging economies. In the presence of capital control, unrecorded capital flows may go into an economy in the disguise of trade, get laundered in domestic banking institutions before ultimately reaching firms in the form of bank loans. It is worth noting that China imposes a $40,000/annum limit on how much private residents could mobilise their capitals out of the Chinese economy whereas Malaysia imposes little restrictions on foreign exchange transactions by residents.

A recent research paper by Xuefeng Pan and Weixing Wu, published in the Journal of International Financial Markets, Institutions & Money, draws attention to the effect of such unrecorded capital flows on the financing costs of state-owned enterprises (SOEs) as well as private firms in China and Malaysia.

Using data from 1,471 Chinese firms and 623 Malaysian firms spanning a nine-year period from 2006 to 2014, the authors found that unrecorded capital flows into the Chinese economy lower financing costs of the SOEs, which make up approximately 42% of total Chinese firms in the sample, but not for private firms. The authors attribute this finding to the proximity of SOEs to banks in which unrecorded capital flows need to first go through before reaching firms as bank loans. This reasoning is further strengthened by the finding that SOEs located in cities with a larger presence of city commercial banks enjoy even lower financing costs than those located in cities where city commercial banks have smaller market share.

In the case of Malaysia, firms in Malaysia generally enjoy lower financing costs from an increase in unrecorded capital flows into the country. However, foreign firms, which account for about 13% of the sample, are bigger winners than other firms in terms of benefitting from the lower financing costs due to such flows. Unlike Chinese SOEs which benefit from unrecorded capital flows due to their proximity to banks, foreign firms see a larger reduction in financing costs from such capital flows due to the discrimination faced when applying for loans from local banks. As foreign firms are generally charged higher interest when applying for bank loans, capital inflows have a larger effect on reducing their financing costs.

In conclusion, capital flows, be it in the form of trade, foreign direct investment or illicit flows, benefit firms in terms of providing greater accessibility to credit and ultimately lowering their financing costs. Therefore, initiatives such as the BRI which enhance economic cooperation and financial integration should be given continuous attention and consideration by governments for the greater good of the economies of participating countries.

Dr Liew Ping Xin is an Assistant Professor at Universiti Tunku Abdul Rahman. The views expressed here are entirely the writer’s own.

The SEARCH Scholar Series is a social responsibility programme jointly organised by the Southeast Asia Research Centre for Humanities (SEARCH) and the Centre of Business and Policy Research, Tunku Abdul Rahman University College (TAR UC), and co-organised by the Association of Belt and Road Malaysia.