Research

Method II

The effect of inward FDI on income

inequality in Asian developing countries

a preliminary empirical study

Jin Xin s1796895

Arslan Bissembayev s1822934

1. Introduction

There is a great interest in recent years in the effects of foreign direct investment (FDI)
on developing countries. The share of developing and transition economies in the world
foreign direct investment inflows was around a third of total $1.8 trillion in 2007
(UNCTAD, 2008). Many development economists and international institutions believe
that FDI stimulates economic growth, productivity and efficiency for host countries
through dissemination of technologies, management skills and human capital to the
receiving countries (Dollaer and Kraay, 2002 Bhagwati, 2005). Whereas the productivity
and efficiency views of FDI on economic growth have received tremendous spotlight,
however, what is often neglected is the effect of FDI on income distribution in host
countries. While FDI may bring benefits to the overall economy, it by no means ensures
that every person in the receiving country is better off. For instance, one of the top FDI
destination countries among Asian developing countries-China has experienced huge
success in attracting FDI, starting from less than $10 billion in the mid 1980s to more
than $100 billion in 2005. While the overall economy benefited from the growth which
partially thanks to the introduction of FDI, growth has been uneven and income
distribution disparity has become more and more severe (Chaudhuri and Ravallion, 2006;
Chen and Wang, 2001). As found by Luo and Zhu (2008), in 2004, urban households
generally earned 3.2 times as the rural households did and coastal households earned 1.4
times more than inland households did, thus the income difference between urban and
rural, coastal and inland were among the highest in the world.
Many literatures have been discussing the effects of FDI on income distribution,
though the role of FDI on income inequality still remains highly controversial. Our paper
empirically tests the role of FDI in wage distribution using a panel data analysis of 31
Asian developing countries from the period 1986 to 2005. This paper contributes to the
empirical studies mainly in three ways. First, we allow non-linearity in our models. This
is inspired by the learning or spillover arguments of FDI which advocate that FDI may
average wages if local firms learn and receive spillovers from the FDI giving countries.
Second, we take into account a dynamic lagged FDI in our second model as we argue that
based on the learning arguments, it takes time for local firms to catch up and therefore
FDI today may have an effect on wage distribution in a later time. Third, an interaction

2
term between FDI and trade openness is introduced in our third model. Many literatures
have shown there is relationship between trade openness of an economy and FDI. In
developing countries where most of FDI are vertical, there is complementarity found
between the two. Our empirical evidence in section 6 has indeed provided significant
results that show trade openness stimulates FDI and reduces wage inequality problem
when indigenous firms catch up through learning from MNEs.
Our paper is organized as follows: Section 2 describes the studies conducted to this
topic. Section 3 presents the theoretical background of our model and explains which
factors and how they affect income inequality. In section 4 we introduce our three
econometrics models. Section 5 describes data chosen. Section 6 presents the empirical
findings of our research and we give our conclusion in section 7.

2. Literature review

This section summarizes a review on papers conducted to the relationship between FDI
and income inequality. Basu and Guarigilia (2005) found a positive relationship between
FDI and income inequality for 119 developing countries over the period 1970-1999. They
found that FDI promotes growth but at the expense of growing income inequality. They
argued that due to the low initial human capital of receiving countries, low-skilled
workers are unable to access the FDI-based technologies. According to them, this
problem arises because credit markets in most developing countries are not well
developed and lack of subsidies reduces poor people’s incentives to develop capabilities
which are necessary to acquire new technologies. Tsai (1995) used cross-country data of
33 developing countries but only found a positive relationship between FDI and income
inequality in East and South East from 1970 to 1990. After adding geographical dummy
variables he found that geographical factors significantly affect the degree of
inequality.Alternatively to those studies, study conducted by Wan, Lu and Chen (2003)
which is based on the modernization theories found that FDI reduces income inequality
in the case of China. They estimated income generating function in which trade and FDI
were incorporated as another two independent variables. They found that capital inputs
and infrastructure were the main sources of regional inequality. Privatization and

3
increased FDI and trade significantly reduced the income inequality and helped to
balance income inequality across regions. Figini & Görg (2006) also found that FDI
decreases income inequality in developing countries by applying new growth theories.
However, in their previous study on Mexico, Feenstra and Hanson (1997) did not find
any significant relationship between FDI and income inequality. Apregis and Katerin
(2007) studied the same topic for certain Asian transition and post Soviet economies and
found that the empirical results show significant relationship only if all countries are
tested in one single sample. There is no significant relationship found after they
implemented dummy variables for low and high income countries.

3. Theoretical background

Even though economic participants in an economy can receive income either in the
form of wage, physical capital rent, or perhaps capital gain by investing in the financial
market, wage income is the main source of income for most of the people, as physical
and financial capital gain tend to be more skewed towards the rich (Morley, 2001b).
Therefore, in our analysis, we would take wage inequality as a measure of income
inequality.
The theoretical framework applied in our analysis originally comes from Aghion and
Howitt (1998), which they call the endogenous growth model. It concerns the effect of
social learning on economic growth, and the effects of differences in workers’ skill levels
on aggregate output and wages. Figini & Görg (2006) further developed the model and
applied it in their study on the effects of FDI on wage inequality, in which the providers
of FDI, the Multinational Enterprises (MNEs), are regarded as disseminators of new
technologies and management skills. These firm-specific assets grant them a leading
productivity advantage over domestic indigenous firms and thus provide room for
indigenous firms to catch up. Therefore, according to Figini & Görg, the process of how
foreign direct investment affects the wage distribution can be viewed in the following
two steps.
First, MNEs introduce new technologies to host countries which demands skilled
workers. As the demand for skilled laborers goes up, wage payments for these skilled

4
workers will go up, and therefore the wage gap between skilled and unskilled workers
becomes larger. In the second step, as more FDI flows into the host countries, indigenous
firms gradually catch up through imitating the more advanced technologies introduced by
the MNEs. As a result, both indigenous firms and MNEs would demand skilled workers,
and the demand for unskilled workers would decline towards 0. In the end, there will be
no wage inequality. Lashitew (2008) identified four ways through which indigenous
firms can learn and receive spillovers from the MNEs and thus improve their
productivity, which are technology transfer, competition and human capital development
as well as FDI as an export “catalyst” (Görg and Strobl, 2001). All of the four ways
help local firms improve productivity and therefore local firms will also demand skilled
workers. In short, the endogenous growth model of FDI on wage inequality by Figini &
Görg (2006) and the spillover argument provide us a predictable outcome that could be
tested empirically, especially on developing countries. Specifically, it allows us to test
whether there is an inverted U-shaped relationship between FDI and wage inequality.
Hence, our hypotheses would be as follows:

Hypothesis 1: FDI increases wage inequality before the spillovers take effect.
Hypothesis 2: FDI decreases wage inequality over time when indigenous firms learn
and receive spillovers from MNEs.

The reason we only focus on testing developing countries is that the mechanism of the
endogenous model may not apply to developed countries, since developed countries may
not have an aggressive attitude towards new technologies as developing countries do.
Developed countries are themselves new technology-innovators, thus their workers are
already relatively skilled and it will be less change in the labor condition even if MNEs
introduce new technologies. Consequently, the effect of FDI on wage distribution may
not be obvious. Specifically, we confine our research to the Asian developing countries
because for the last several decades Asian countries have received a large amount of
foreign direct investment and FDI is regarded as one of the primary sources of economic
development (Qureshi 2001). Total FDI in Asia increased from $396 million in 1980 to
$102,066 million in 2001. In effect, Asia is considered as one of the major destinations

5
for FDI. On the other hand, however, while countries like China, India or Vietnam may
have experienced huge growth rates, they did not seem to have outperformed their
counterparts in terms of poverty reduction, that is, these countries failed to distribute
income and resources evenly among their citizens. Therefore, it would be worthwhile to
investigate into the relationship between FDI and income inequality in the Asian
economies.

4. Methodology

4.1 Basic model

To empirically investigate the relationship between FDI and wage inequality, we took
guidance from the theoretical framework as discussed in section 3. Our basic model for
estimation is given below:

WGINEQ it =β 0+ β 1 FDI it + β 2 FDI 2it + β 3 X it +∅ i+ γ t +ε it (1)

where WGINEQit is a measure of wage inequality of country i at time t, FDI it a measure

of inward FDI stock as a percentage of GDP of country i at time t. FDI2it will captures the
non-linear relationship between FDI and wage inequality. According to the theory in
section 3, we would expect the coefficient of FDI is positive and that of FDI2 negative. Xit
is a vector of control variables that can be potential determinants of wage inequality. φ i
accounts for country-specific, time-invariant effects, while γt captures time specific
effects. εit are independently and identically normally distributed error terms for all i and t
with zero mean and variance σ2. Country fixed effects control for all country-specific,
time-invariant variables whose omission could bias the estimates in a typical cross-
sectional study; the justification for adding time-period fixed effects notes that they
control for all time-specific, country-invariant variables whose omission could bias the
estimates in a typical time-series study (Baltagi, 2005). For the optimal use of maximum
available information, we would use the balanced panel for empirical estimation.
We choose FDI stock rather than flow in order to be consistent with the assumption of
the theory discussed above, which regard FDI as a contribution to the stock of

6
technologies available in the receiving countries. Velde (2003) identified three factors
that influence income distribution through a microeconomic approach, which are the
demand of factors of production and the supply of factors of production, as well as the
distribution of factors of production. We argue that the distribution of factors of
production is part of the supply side of factors of production, since distribution of factors
is mostly a matter of availability of factors in different places, say in our case, the
distribution of workers in rural areas and urban areas. Therefore, in our analysis, we
identify two of the factors that may correlate with wage inequality, with one relating to
the demand side of labor and the other supply side of labor. They are openness to trade
and education, respectively.
Traditional trade theory can be applied to understand the relationship between wage
inequality and openness to trade. The cornerstone of traditional trade theory is the
Heckscher-Ohlin model (1933) with capital and labor being the two factors of
production. According to the model, a country will export the good which intensively
uses the relatively abundant factor of production. Concerning our analysis is restricted to
labor, we will take skilled and unskilled labor as the two factors of production. Therefore,
developing countries which are relatively unskilled labor abundant will export unskilled
labor-intensive products while developed countries export skilled labor-intensive goods.
Built on the model, Stopler & Samuelson (1941) further extended the model and
contended that international trade would raise the reward to the abundant factor of
production and decrease the reward to the factor of production that is used scarcely. As
for the case of developing countries, therefore, international trade would raise the income
to unskilled workers while decrease the income to skilled workers, correspondingly wage
differential between these two types of workers would be lowered. Therefore, we would
expect that the more open the developing country is, the smaller the wage differential is.
The other control variable concerns the supply side of labor is education. As argued by
Birdsall & Londono (1997), human capital and education is key drivers of income
distribution. Behrman et al (2000) found a widening wage differential between
university and high-school graduates and lower education groups of people during the
1990s. Therefore, we would expect the higher percentage the educated population, the
higher ratio of skilled workers, and thus the smaller the wage differential.

7
 4.2 Dynamic model with lagged effects

4.2.1 One aspect of concern relates to the possible lagged effects of FDI on wage
inequality. As already argued in our theoretical background in section 3, as more and
more FDI flows into the host countries, indigenous firms will catch up through learning
from MNEs over time. With indigenous firms also demanding skilled labor, we would
expect there will be no wage inequality. However, as a commonly recognized convention
that learning is a kind of endeavor which takes place in a gradual manner, thus it would
be reasonable to argue FDI that takes place today would not have an immediate effect on
wage distribution today. In our case, it translates to FDI inflow today reducing Gini
coefficient in a later time. We use ‘n’ as a notation of the number of lagged years. The
specific number of years of lag is introduced in section 6, where we discuss our empirical
evidence. By including the lagged effects of FDI, we introduce our second model as
follows:

WGINEQ it =β 0+ β 1 FDI it−n+ β 2 FDI 2it −n+ β 3 X it +∅ i+ γ t +ε it (2)

with n<t.

4.2.2 Another concern is the possible interaction effect between FDI and trade
openness. As argued by Dunning (1993) & Brainard (1997), changes in openness
influence the inflow of FDI to an economy, however, the effect varies according to the
mode of FDI. As for non-export oriented horizontal FDI in which MNEs start from
scratch in the host countries, if there are strict restrictions, the preferred solution for
MNEs would be to serve markets locally, and thus if tariffs and other trade restrictions
are low, MNEs would have served foreign markets through exports. This implies a
negative relationship between openness and FDI. However, by contrast, in the cases of
export-oriented FDI and vertical FDI, trade openness would reinforce FDI, since costs of
serving another market are lower. Comparably, in an empirical survey of trade
liberalization and FDI in the emerging markets, Martens (2008) argued that there is

8
complementarity between trade openness and FDI, as he contended that most of the FDI
in developing countries are vertical FDI in which MNEs locate their production in those
countries to exploit relatively cheaper resources. Since our sample concerns developing
countries in Asia, we expect the bulk of FDI are vertical and thus there is a positive
relationship between trade openness and FDI. Moreover, the author also found when
trade and FDI are complements, not only can trade openness positively affect FDI, but it
can also be the other way around, i.e. FDI can also contribute to trade openness, which he
referred as bi-directional causality. De Mello Jr and Fukasaku (2000) also found this bi-
directional causality in their study which focused on the relationship between trade and
FDI. Specifically, local firms increase their exports either indirectly through improving
their productivity (Lashitwe, 2008) or directly through learning from MNEs about how to
export (Barrios et al., 2003 and Greenaway et al., 2004). Therefore, in our case, it is
reasonable to include an interaction effect between FDI at time t-5 and trade openness at
time t. Our model then becomes:

WGINEQ it =β 0+ β 1 FDI it−5+ β 2 FDI 2it −5 + β 3 X it + β 4 FDI it−5∗OPEN it + ∅i + γ t + ε it

(3)

5. Data

Our data consists of a balanced panel of 31 Asian developing countries for the period
from 1986 to 2005. The specific countries and years chosen are based on the data
availability. We measure wage inequality (WGINEQ) using Gini coefficient which is
commonly used as a measure of inequality of income. A Gini coefficient of zero
represents perfect equal distribution while a 100 represents perfect inequality. Instead of
measuring FDI in absolute value terms, we take FDI stock as a percentage of GDP. This
is more plausible because a large GDP amount might not ensure a large amount of FDI; it
is the relative FDI that is comparable among countries. In terms of trade openness, we
follow the traditional and most-accepted form of measure taken by economists, which is
the percentage of total export and import volumes in terms of GDP. Gross secondary
enrolment ratio is a measure of education which takes both male and female enrolments

9
into account. The reason of taking secondary enrolment ratio as a measure of education is
that secondary education helps people lay the foundations for lifelong learning and
human development by offering more subject- or skill-oriented instructions after they
complete the provision of primary education (UNESCO Institute for Statistics).
Most of the data is obtained from the world development indicators (WDI) dataset
provided by World Bank except for the data of FDI. We choose world development
indicators dataset because WDI provides one of the most accurate and updated
information on development, which is obtained from official registers, administrative
records and national agencies. The data of FDI is however obtained from United Nations
conference on trade and development (UNCTD), due to the unavailability of the data of
FDI stock in WDI dataset, and UNCTD is also one of the most trusted sources. Overall,
despite the fact that both World Band and UNCTD are two of the most trustworthy
sources, data availability and reliability are the major issues to our research. In our case,
the data of Gini coefficients is highly unbalanced and 494 out of 620 (79.7%) data is
missing. The unreliability problem could be due to the fact that national statistical
systems of most developing countries are of inferior quality, leading to unreliable data.
The same situation applied to the data of secondary enrolment ratio. 58.1% data is not
available1.

6. Empirical evidence

Table 2 presents the results of model (1) in its basic form which does not take into
account the lagged effects of FDI and the potential interaction effect between FDI and
trade openness. Column 2 and 4 gives the estimation of coefficients and p-values
respectively. It is notable that both the coefficients of FDI it and FDI2it are statistically
significant at the 5% significance level, with the coefficient of FDIit being positive and
that of FDI2it negative. This exactly adheres to our theoretical arguments discussed in
section 3, which predicts an inverted U-shaped relationship between FDI and wage
inequality. However, as argued in section 4.2.1, learning or spillover effect normally
takes place on a gradual basis, it is therefore important to take into the dynamic lagged

1
Refer to table 1 in our appendix

10
effects of FDI, as indicated by our model (2). Here, we apply a time period of five years
as the lag for the effect of FDI to take place in reducing wage bias, as suggested by
Morris (2008). In addition, the author also suggested that test on lag effect start from the
earliest year, which refers to t-5 year. Thus, the coefficient of both FDI it-5 and FDI2it-5 are
tested and FDIit-5 and FDI2it-5 are removed if the null hypotheses that the two coefficients
are equal to zero were not rejected. This process continues until the last lag included is
statistically significant. Indeed, our statistical evidence turns out the coefficients of FDIit-5
and FDI2it-5 are both significant, with p-values of 0.006 and 0.004 respectively 2.
Specifically, the coefficient of FDIit-5 is positive and that of FDI2it-5 is negative. Therefore,
our second model shows quite satisfying results which is consistent with our theory
predicting that FDI introduced years ago decreases wage differences today as local firms
learn from MNEs and thus improve their productivity and demand for skilled labors. In
our case, it appears that it takes five years for FDI to be effective in narrowing wage
differences.
We further developed our model by introducing an interaction effect between FDI and
trade openness, which is reflected in model (3). Table 4 presents the results. It can be
seen that the coefficients of FDIit-5 (l5 as shown in the table) and that of FDI 2it-5 (l5sq as
shown in the table) are still positive and negative respectively. However, after
introducing the lagged effects of FDI, the negative coefficient of FDI 2it-5 is no longer
statistically significant, with a p-value of 0.135. This might happen since when non-
linearity and lagged effects as well as an interaction term are tested at the same time in a
single model, the predictive performance of the model might be reduced. By contrast, the
interaction between FDI and trade openness is nevertheless significant, with a negative
coefficient. This is consistent with our argument made in section 4.2.2, where we contend
that since most FDI in developing countries are of vertical nature, there is a
complementarily between openness and vertical FDI so that they reinforces each other,
and thus the openness of a developing country facilitates FDI in reduce wage differences.
In all three models examined, however, none of the coefficients of the control variables-
trade openness and education (indicated by ‘enroll’ in all tables) are statistically
significant, though in our first model, the signs of the coefficients of both openness and

2
Refer to table 3 in appendix.

11
education are negative, which is in line with our expectations 3. This might be the case
since more than half of the data of secondary enrolment ratios are not available, which
reduces the predictive performance.

7. Conclusion

We use a panel of 31 Asian developing countries for the period 1986 to 2005 to
analyze the relationship between foreign direct investment (FDI) and wage inequality,
particularly we focus on checking whether there is an inverted U-shape relationship
between FDI and wage inequality. We use Gini coefficient as a measure of wage
inequality as Gini coefficient is one of the common measures of income inequality.
Specifically, we develop three models step by step by first introducing our basic model
(1), which is inspired by the spillover arguments of FDI and Figini & Görg (2006)’s
theoretical framework underpinning their study of the effect of FDI on wage inequality.
According to the spillover arguments of FDI, we introduce a quadratic form of FDI in
model (1). Our statistical analysis exhibits significant results aligning with our inverted
U-shaped assumption. However, FDI will reduce wage bias only if local firms learn from
MNEs and receive the spillovers, as a result, we would expect it takes time for the
learning effect to be effective, and thus we introduce a dynamic effect of lagged FDI in
our second model, in which five years is a statistically significant lag as later
demonstrated in our empirical evidence in section 7. The lagged effect of FDI on wage
inequality is also verified in our empirical evidence section, which indicates that it takes
five year for FDI to be effective in reducing wage differences.
We further developed our second model by introducing an interaction term between
trade openness and FDI. As argued by authors such as Martens (2008), the majority of
FDI in developing countries are vertical, and thus there is a complementary relation
between FDI and trade openness. In our case where the countries we examine are
developing countries, we would also expect such kind of relationship exist. Indeed, our
findings provide us with a significantly negative coefficient of the interaction term, which
means when openness facilitates FDI, the effects of FDI on reducing wage differences

3
Refer to table 5.

12
can be more obvious. It is notable, however, that after introducing the interaction term the
lagged effects of FDI on reducing wage differences becomes insignificant. This might
happen since when non-linearity and lagged effects as well as an interaction effect are
tested at the same time in a single model, the model could be too complicated to provide
a strong predictive performance.

13
Appendix

Table 1

Variable Obs. Mean Std. Dev. Min Max

gini 126 38.93901 7.410471 16.83 74.00497

fdi 520 15.99033 18.41797 0 140.5003
openness 616 69.72178 46.36973 0 220.4073
enroll 260 65.47302 23.44789 13.03302 110.7591

* openness, enroll refers to trade openness and secondary enrolment ratio

respectively.

Table 2

gini Coef. t P>t

fdi .75707 2.84 0.008

fdi2 -.0083264 -2.73 0.011

openness -.0300005 -0.35 0.729

enroll -.1935857 -1.09 0.287

cons 43.90264 4.16 0.000

Observations 56
Countries 23
R-square 0.2301

* fdi2 refers to fdi2.

Table 3

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 gini Coef. t P>t

l5 .5428474 2.97 0.006

l5sq -.0080324 -3.21 0.004

openness -.0858836 -1.25 0.224

enroll .0002167 0.00 0.999

cons 40.31596 3.44 0.002

Observations 52
Countries 22
R-square 0.2987

* l5, l5sq refers to FDIit-5, FDI2it-5 respectively.

Table 4

gini Coef. t P>t

l5 .5556755 3.43 0.002

l5sq -.0040443 -1.55 0.135
openness .0168953 0.24 0.813
enroll .150562 0.95 0.352
l5op -.0034267 -2.86 0.008
_cons 23.43735 1.96 0.061

Observations 52
Countries 22
R-square 0.4715

15
Table 5

p-values
coef. Model (1) Model (2) Model (3)
openness -.0300005 0.729 -.0858836 0.224 .0168953 0.813
enroll(secondar -.1935857 0.287 .0002167 0.999 .150562 0.352
y enrollment
ratio)

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