ANALYSIS THE INFLUENCE OF INTEREST RATES, EXCHANGE

RATE, INFLATION AND GROSS DOMESTIC PRODUCT TO FOREIGN

DIRECT INVESTMENT IN INDONESIA PERIOD 1988-2018

Trisiah Setiyowati
[email protected]

Faculty of Economics and Business, International Program of Islmaic Economics

and Finance, Universitas Muhammadiyah Yogyakarta

ABSTRACT
Foreign Direct Investment (FDI) can help Indonesia in the framework of
development activities. Foreign capital can be used to increase development capital
in Indonesia so as to increase economic growth in order to prosper the community.
This study is used to find out that interest rates, exchange rate of the rupiah against
the US dollar, inflation and gross domestic product affect on Foreign Direct
Investment. The data used by researchers in the form of secondary data from
foreign investment variables, interest rates, the exchange rate of the rupiah against
the US dollar, inflation and gross domestic product which are time series data for
a period of 30 years (1988-2018). This research uses the Error Correction Model
(ECM) method. The results showed that the variable interest rates had a positive
and not significant effect on Foreign Direct Investment (FDI), Inflation has a
negative and significant impact on Foreign Direct Investment (FDI) in the long run.
Whereas in the short term inflation has a negative and not significant effect on
Foreign Direct Investment (FDI), and the exchange rate of the rupiah against the
US dollar and Gross Domestic Product (GDP) had a positive and significant effect
on Foreign Direct Investment (FDI) ) in the long term and short term

Keywords: Foreign Direct Investment, Interest rate, Rupiah exchange rate,

Inflation, Gross Domestic Product, ECM
1. INTRODUCTION

Economic growth is one important indicators to measure the success of

development that occurs within the country (Wahyudin and Yuliadi, 2013).

Economic growth is a process of increasing total income and income per capita by

taking into account population growth and accompanied by fundamental changes

in the economic structure of a country (Baroroh, 2012). According to Ertina (2013),

economic growth is a long-term economic problem of the country towards a better

condition during a certain period and can also be linked as a state of increased

production capacity of an economy that is realized in the form of an increase in

national income.

According to Harrod-Dommar's theory of economic growth, each economy

must reserve or save a portion of its national income to add or replace capital goods.

To spur the process of economic growth, new investment is needed which is a net

addition to capital reserves or stocks (Syahputra, 2017). Todaro (2004) in

Tambunan (2015) explained that of the many factors of general economic growth

it can be said that one of the main sources of economic growth is investment that

can improve the quality of capital or human and physical resources, which can

further improve the quality of resources through discovery new discoveries,

innovations, and technological advancements.

As a developing country, Indonesia needs substantial funds to carry out

national development. The large funding requirement is due to efforts to catch up

with the development lags of developed countries, both in the regional and global

regions. This source of FDI financing is the most potential source of foreign

financing and can guarantee the continuity of development compared to other

sources of financing, this is because the entry of FDI into a country is followed by

a transfer of technology, know-how, management skills, relatively small business

risks and more profitable, Panayotou (1998) in Sarwedi (2002).

Based on information from the data taken from World Bank 2019, the

development of Indonesia FDI has increased and Decreased during the period 1988-

2018. Declining FDI occurred in 2018 and amounted to 29.307,91 million US

dollars, this happened not only in Indonesia but also in global international FDI in

2018 also decreased by 20 percent. Apart from the causes of rising and falling FDI

developments, there are a number of macroeconomic indicators such as Interest

Rate, Exchnage Rate, Inflation, and GDP to advance a country's performance and

potential for FDI (Kuncoro, 2009 in Septifany, 2015)

Nowadays, research on the influence of Interest Rate, Exchange Rate, Inflation

and GDP to Foreign Direct Investement has been carried out, including by Rizky et

al (2016), that partially Foreign Investment has a significant positive effect on

economic growth in Indonesia. This means that if the value of foreign investment

increase, economic growth will also increase. The result of the study that conduct

by Septifany et al (2015) shows that Interest Rate has a positive and significant

effect of FDI in Indonesia, while inflation and exchange rate had a negative effect

and significant effect on FDI in indonesia. In the same year research that conduct
by Gharaibeh (2015) the results shows that inflation variable does not significantly

influence foreign direct investment into Bahrain.

2. LITERATURE REVIEW

a. Foreign Investment

Foreign Investment is a form of investment by building, buying a total or

acquiring a company. Investments in Indonesia are stipulated through Law No.25

of 2007 concerning Foreign Investment. Foreign Investment in this Law is the

activity of investing in doing business in the territory of the Republic of Indonesia

which is carried out by foreign investors, both using complete foreign capital or in

collaboration with domestic investors (Article 1 of Law No.25 of 2007 concerning

Investment Capital).

Foreign investment in Indonesia can be done in two forms of investment,

namely: Portfolio Investment and Direct Investment (Foreign Direct Investment).

Foreign direct investment (FDI) consists of tangible assets, namely the purchase of

land that is used as a means of production, factory construction, expenditure on

inventory equipment accompanied by existing management functions (Ningrum

and Indrajaya, 2018).

b. . Foreign Direct Investment Theory

According to MuchammadZaidun, in investment law there are 3 types of ideas

in interpreting investment policies that can be selected as the basis for investment

law or policy considerations from the interests of the recipient country (home

country), namely Neo Classical Economic theory, this theory explains that the
influx of investment has a positive and accepting impact on foreign investment,

because foreign investment is considered to be very beneficial for the home country.

Dependency Theory, This theory does not accept the inflow of foreign investment,

and views the entry of foreign investors to overwhelm domestic investment and

take over the position and role of domestic investment in the national economy. The

Middle Path Theory, this theory considers that the inclusion of foreign investment

in addition to many benefits also has a negative impact

c . Factors that affect investment

One of important factor in making decision for investment is interest rates.

Anna (2012) said that the interest rate is the level paid or the burden of the use of

funds or in other words the cost of loans. According to Ernita (2013) interest rates

that increase due to a decrease in investment and vice versa, when interest rates

have decreased the investment will increase due to a decrease in investment costs.

Wiagustini (2014: 360) states that the exchange rate represents the number of units

of currency obtained (bought or exchanged) with other units of currency. The

exchange rate can affect investment, the effects that occur depend on the objectives

of investors in investing their capital.

Inflation can affect the stability of the economy in a country because it can

reduce production. The decline in production will not be offset by decreased

demand for goods due to high inflation in a Sukirno country (2005: 381) in Pratiwi

et al., (2015). Inflation has a negative impact on investment activities in the form

of high investment costs. Investment costs will be cheaper if a country's inflation

rate is low and will increase FDI in Indonesia. Economic growth is reflected in the
increased ability of a country to dprovide for the needs (economic goods) of its

citizens. Institutionalization, technological progress, and ideological adjustments

are needed to be able to improve these capabilities (Todaro and Smith, 2012). Good

economic growth will certainly make investors interested in investing in the

country.

3. RESEARCH METHOD

a. Research Variable and Data Type

Type of data in this research is Quantitative data that is secondary data. This

research aims to examine the influence of Interest Rate, Exchange Rate, Inflation

and Gross Domestic Product to Foreign Direct Investment

b. Data Collection Technique and Sources

The data needed in this study was collected by conducting non participant

observation, namely by downloading from various sites relevant to the suitability

of data needs, such as World Bank and BPS.

c. Data Analysis Method

1. Research Method

In analyzing the influence of interest rates, inflation, exchange rates and GDP

variables on FDI in Indonesia is tested using the Error Correction Model (ECM)

research model. This ECM research model is used to test whether or not the

empirical model is consistent with economic theory. Error Correction Model is

also an econometrics tool used with the aim of identifying long-term and short-
term relationships that occur because of the cointegration between research

variables (Basuki, 2017). In this study, the ECM model used is:

D(log(𝐹𝐷𝐼𝑡 )) = b0 + b1D(𝐼𝑅𝑡 ) + b2D(log(𝐾𝑈𝑅𝑆𝑡 )) + b3D(𝐼𝑁𝐹𝑡 )

+b4D(log(𝐺𝐷𝑃𝑡 )) +ECT(-1) + 𝑒𝑡

Where is :

𝐹𝐷𝐼𝑡 = Foreign Direct Investment

𝐼𝑅𝑡 = Interest Rate

𝐾𝑈𝑅𝑆𝑡 = Rupiah Exchange Rate against US Dollar

𝐼𝑁𝐹𝑡 = Inflation

𝐺𝐷𝑃𝑡 = Gross Domestic Product

b0 = Constanta

ECT(-1) = Error Corection Term

𝑒𝑡 = residual

2. Hypothesis test

a). Stationary Test

This stationary data problem is very important because if the regression is not

stationary, it will produce spurious regression. Indications of direct regression can

be seen from the high R-sqared and t-statistics that seem significant.

1) Unit Root Test

Dickey and Fuller (1979-1981) developed unit roots to estimate the

authoritative model of each variable. According to Basuki (2018), This unit root

test is used to test the stationary time series data. if a time series data has been
tested and has results that are not stationary then it can be said that the data has a

unit root problem. the equation model is as follows:

∆𝑭𝑫𝑰 = 𝒂𝟏 +𝒂𝟐 + ∆𝑭𝑫𝑰𝒕−𝟏 + 𝒂𝟏 ∑𝒎

𝒊=𝟏 ∆𝑭𝑫𝑰𝒕−𝟏 + 𝒆𝟏

Where the ∆𝐹𝐷𝐼𝑡−1 = (∆𝐹𝐷𝐼𝑡−1 − ∆𝐹𝐷𝐼𝑡−2 ) and so on, m is the long oftime-lag

based on I =1,2….m. the zero Hypothesis is still δ= 0 or p = 1. The t-statistic of

ADF is same with t-statistic of DF.

2). Integration Degree Test

if the time series data at the unit root test stage is not stationary, then the next

step is to perform a degree of integration test to find out in order of the degree to

which the data will be stationary. Models in the integration test are as follows:

The general model of ECM can be described as follows:

𝒎
∆𝑭𝑫𝑰𝒕 = 𝜷𝟏 + 𝜹∆𝑭𝑫𝑰𝒕−𝟏 + 𝜶𝒕 ∑ ∆𝑭𝑫𝑰𝒕−𝟏 + 𝒆𝒕
𝒊=𝟏

𝒎
∆𝑭𝑫𝑰𝒕 = 𝜷𝟏 + 𝜷𝟐 𝑻 + 𝜹∆𝑭𝑫𝑰𝒕−𝟏 + 𝜶𝒕 ∑ ∆𝑭𝑫𝑰𝒕−𝟏 + 𝒆𝒕
𝒊=𝟏

The t-statistic value of the test results is then compared with the t-statistic value

in the DF table. the∆𝐹𝐷𝐼𝑡 variable can be said to be stationary at degree one if

the q value in both equations looks the same or can be symbolized ∆𝐹𝐷𝐼𝑡 ~𝐼.

3) Cointegration Test

Engle-Granger test (EG) and Augmented Engle-Granger test (AEG) as well

as the Cointegrating Regression Durbin-Watson (CRDW) test, are cointegration

tests that are often used. OLS testing is carried out with the following formula:
 𝑭𝑫𝑰𝒕 = 𝒂𝟎 + 𝒂𝟏 ∆𝑰𝑹𝒕 + 𝒂𝟐 𝑰𝑵𝑭𝒕 + 𝒂𝟑 𝑲𝑼𝑹𝑺𝒕 + 𝒂𝟑 𝑮𝑫𝑷𝒕 + 𝐞𝒕

In the equation what needs to be done is to save the residual (error-terms).

3. Classical Assumption Test

a. Multicollinearity Test

Multicollinearity Test is used to detect the presence or whether or not the

relationship between some or all independent variables in the regression model.

Multiculinierity is a condition where the independent variable is in a linear

condition with other variables.

b. Heterokedesticity Test

Heterokedestidity is a regression problem in which disorder factors do not

have the same variant. So that this can lead to various problems, namely biased

OLS estimators, variants of OLS coefficients will be wrong. (Basuki and Yuliadi,

2015).

c. Autocorrelation Test

Autocorrelation test aims to test whether there is a correlation between the

error of the intruder in the period t with the error of the intruder in the period t-1

(previous). If autocorrelation occurs, it is called an autocorrelation problem. To

find out the existence of autocorrelation or not done by the Lagrange Multiplier

(LM) test. Where if the value of Obs * R Squared is smaller than the value of the

table, the model can be said to not contain autocorrelation.

d. Normality test
 This normality test aims to test whether the residuals are normally distributed

or not. In this test can be done using the Jarque-Berra test (J-B test). In this test it

can be seen if -value> = 10%, it is concluded that the data used in the ECM model

are normally distributed.

e. Linearity Test

Linearity test is used to see whether the model built has a linear relationship

or not. The linearity test can be performed using the Durbin-Watson test, Ramsey

Test or with the Lagrange Multiplier test.

f. Test of Significance

Significance test is a procedure used to test the error or correctness of the

results of the null hypothesis of the sample.

g. F test

This F-statistic test is performed to see how much influence the independent

variable as a whole or together has on the dependent variable. The hypothesis used

in this test is:

𝐻0 ∶ 𝛽1 = 𝛽2 = 0, meaning that together there is no influence independent

variable to the dependent variable.

𝐻𝑎 ∶ 𝛽1 ≠ 𝛽2 ≠ 0, it means that together there is influence independent variable

to the dependent variable.

h. T test
 T-test was conducted to determine the significance of the influence of the

independent variables individually on the dependent variable by assuming the

lanin variable is constant. The hypothesis used in the t-test is:

If the probability is> 0.05, it means that it is not significant.

If probability <0.05 means significant.

4. RESULTS AND DISCUSSION

a. Data Stationarity Test

From this study it can be seen that testing at the level only variable inflation and

interest rates are stationary because the probability value of the variable magnitude

is below 0,05 while the variables FDI, KURS and GDP are declared not stationary

because the probability value of each variable is magnitude above 0,05. Thus,

because all variables are known to be not stationary, data testing is done at the First

Difference level.

Table 4.1.
Unit Root Test Results (First Difference)
Variable Level Prob
FDI 0.8592 0.0001
IR 0.0398 0.0000
KURS 0.8759 0.0007
INF 0.0001 0.0000
GDP 0.9656 0.0034
Source: Processed Results of Eviews 10 Student Version
b. Long-term Estimated Test

Table 4.2.
Long-term Estimated Results
Variabel Coefficient T count
IR 0.020430 0.568601
LOG(KURS) 1.011043 5.567833
INF -0.043556 -2.93219
LOG(GDP) 0.816598 3.142647
Prob (F-Statistic) 0.000000
Source: Processed Results of Eviews 10 Student Version

The table shows the Prob (F-statistic) of 0.000000, which is smaller than 0.05,

indicating that the existing long-term equation is valid. The value t count of Interest

Rate 0.568601 KURS is 5.567833 , inflation -2.932198 and GDP 3.142647, those

3 variables (kurs, Inflation and GDP) also have significant probability which is

below 0.05 shows that the variable KURS, inflation, and GDP have a long-term

effect on the FDI variable.

c. Cointegration Test

Cointegration test is a continuation of the unit root test which aims to find out the

long-term relationship between the variables used in this study.

Table 4.3.
Data Unit Root Test Results
Variable Probability Information
ECT 0.0039 There is cointegration
Source: Processed Results of Eviews 10 Student Version
In table 4.8, it is known that the probability value of the ECT variable is below

0.05. This shows that the ECT variable is stationary at the level and implies that the
interest, exchange rate, inflation and GDP variables are cointegrated so that the test

can proceed to the estimation stage of the short-term equation.

d. ECM Models

Based on table 4.9, the probability value (F-statistic) of 0.000000 which is

below 0.05 and the value of ECT (-1) which has a significant negative value,

indicates that the ECM model used is valid and significantly influences both in the

short term and long-term. Adjusted R² value of 79% shows that 21% of the diversity

of FDI variables is influenced by independent variables outside the model (Basuki

and Yuliadi, 2015).

Table 4.9.
Short-term Estimated Results (ECM)
Variabel Coefficient T count Prob.
D(IR) 0.007831 0.320536 0.7513
D(LOG(KURS)) 1.620686 2.343179 0.0277
D(INF) -0.018997 -1.869767 0.0738
D(LOG(GDP)) 2.762203 3.524852 0.0017
ECT(-1) -0.648887 -4.094900 0.0004
𝑅2 0.807144
𝐴𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑅 2 0.766965
Prob(F-statistic) 0.000000
Source:Processed Results of Eviews 10 Student Version

Short-term estimation results show that in the short term changes in exchange

rates and gross domestic product have a positive and significant effect on FDI.

e. Classical Assumption Test

1). Multicollinearity Test

 Based on the test results, there is no correlation matrix was found, the

magnitude above 0,85. Thus it can be concluded that there is no multicollinearity

problem in this model.

2). Heteroscedasticity Test

Based on the processed data by Eviews 10, the prob value is obtained. Chi-

Square 0.1948 is greater than 0.05. Then it can be concluded that the model does

not have a heteroscedasticity problem in the ECM model.

3). Autocorrelation test

Based on the LM test the value of prob. Chi-square of Obs*R-square of 0.3531

which is hifgher than 0.05. It can be concluded that there is not an autocorrelation

in the ECM model.

4). Linearity test

Based on the linearity test results the value of prob. The F-statistic of 0.4078, which

is greater than 0.05, shows that the ECM model used is appropriate.

5). Significance Test

Table 4.14.
ECM Equation Regression Results
Variabel Coefficient t- Statistic Prob.
C -0.144660 -1.260698 0.2195
D(IR) 0.007831 0.320536 0.7513
D(LOG(KURS)) 1.620686 2.343179 0.0277
D(INF) -0.018997 -1.869767 0.0738
D(LOG(GDP)) 2.762203 3.524852 0.0017
ECT(-1) -0.648887 -4.094900 0.0004
F-statistic 20.08898
 Prob(F-statistic) 0.000000
Adjusted R2 0.766965
Durbin-Wats on Stat 1.264587
Source: Processed Results of Eviews 10 Student Version
a. Test F

The F-statistic results of 20,08898 with F-statistic probability values of

0.000000. because the result of a significant probability that is smaller than 0.005

means that it can be concluded that Interest Rates, Exchange Rates, inflation and

GDP together have a significant effect on FDI.

b. Test F

1) Effect of Interest Rate t-statistics on FDI

Based on table 4.14 obtained t-test of 0.320536 with a significant level of

0.7513. because the significant level is greater than 0.05, the interest rate partially

has no significant effect on FDI.

2) Effect of Exchange rate t-statistics on FDI

Based on table 4.14 obtained t-test of 2.343179 with a significant level of

0.0277. because the significant level is less than 0.05, the exchange rate is partially

a significant positive effect on FDI.

3) Influence of t-statistics Inflation on FDI

Based on table 4.14 obtained t-test of -1.869767 with a significant level of

0.0738. because the significant level is greater than 0.05, the inflation rate does not

significantly influence FDI.

4) Effect of GDP t-statistics on FDI

Based on table 4.14 obtained t-test of 3.524852 with a significant level of

0.0017. because the significant level is less than 0.05, partially the GDP has a

significant positive effect on FDI.

c. Determination Coefficient Test R²

The coefficient of determination R² used in this study is to use R² when

evaluating the best regression model. Because in this study using more than one

independent variable. Based on the regression results in table 4.14 it can be seen

that the Adjusted R-squared value of 0.766965 shows that the variation of the

independent variables (Interest Rates, Exchange Rates, Inflation, and GDP)

amounted to 79.69%. While the remaining 21.31% is explained by other

variablesoutside the variables studied.

5. CONCLUSION AND SUGGESTIONS

Interest rates have a positive but not significant effect on FDI in Indonesia. For

this reason, it is hoped that Bank Indonesia as a government representative can

maintain economic growth in Indonesia with all fiscal and monetary policies and

provide competitive credit interest rates so as to attract investors to invest their

capital in Indonesia.

Exchange rate variables have a positive and significant effect on FDI in

Indonesia. investors will invest in countries that have a stronger currency. With that,

the government is expected to be able to maintain economic stability by making

appropriate policies in determining the dollar exchange rate that can attract

domestic and foreign investors.

Inflation has a negative and not significant effect on foreign direct investment

(FDI). Although inflation does not really affect FDI in Indonesia, the government

is expected to keep controlling inflation in Indonesia by balancing between fiscal

policy and monetary policy so that the economy is always in stability.

The Gross Domestic Product (GDP) has a positive and significant effect on

Foreign Direct Investment (FDI) Indonesia. GDP and FDI are interrelated, If a

country's GDP increases, FDI will also increase and vice versa if GDP decreases,

FDI will also decrease. From this, the government is expected to continue

increasing the value of Indonesia's GDP in order to attract foreign investors to invest

in Indonesia. To improve Indonesia's economic growth, the government needs to

pay attention to aspects of equitable distribution of income to the community,

reduce poverty, minimize Government Expenditure, reduce inflation, and

strengthen the exchange rate

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