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FDI & Domestic Income Inequality in 7 largest FDI recipient countries in Asia
Jan 2010
FINAL PAPER
FDI & D OMESTIC INCOME INEQU ALITY IN 7 LARGES T FDI RECIPIENT COUNTR IES IN
ASIA
SOFYAN, LURY
ソフヤン, ルリ
January 2010
Abstract
One aspect of Heckscher-Ohlin analysis - Samuelson Theorem & Factor Price Equalization Theorem -
agreed that trade would contribute to the increasing in wage level. This argument is also applied to
Foreign Direct Investment (Appleyard & Field, 2001, P.235). Having more significant role of FDI in
international economics, this paper tries to elaborate the role of FDI in increasing wage level issue to the
impact of income inequality. This paper emphasize on the impact of FDI towards domestic Income
Inequality. Focusing on 7 largest FDI recipient countries in Asia (China, Singapore, India, Singapore,
Malaysia, Indonesia, Philippine) this paper found that in short run FDI doesn’t have a significant effect
towards income inequality. However, in the longer run, it is found that FDI would contribute to wider
gap of income inequality. In the final part, this paper depicts this issue by focusing only on Indonesia.
The graph shows supportive finding that in the long run, FDI contributes to income inequality.
3. Social development.................................................................................................................8
Pros..........................................................................................................................................12
Cons .........................................................................................................................................12
Neutral .....................................................................................................................................13
E. Specific Study of FDI & Income Inequality ..................................................................................13
III. Empirical Study......................................................................................................................14
Methodology................................................................................................................................14
Result & Findings ..........................................................................................................................16
General.....................................................................................................................................16
since the role of FDI in international economics is becoming more and more significant. As it is shown
in the figure below, the amount of FDI, in particular, in Asia & Africa has increasing rapidly.
Figure 1
Knowing the important of FDI, it is interesting to study the effect of FDI. Having FDI in an economic will
eventually affect various factors both positively and negatively. In relation to the economic growth,
almost all studies agree that FDI can boost the growth; however, in accordance to other factors such as
environmental issue, income inequality issue, there still exist pros and cons.
particularly on large FDI recipient countries focusing on income inequality issue. This is important
because trade theories agreed that trade and FDI would increase wages rate. The important question
under this paper concern is that how about the role of FDI in increasing wage rate? Does it accelerate
In addition, this paper conducted an empirical study about the relationship between FDI and
income inequality
To answer those question above, In this part, the relationship between FDI & some prominent theories
will be elaborated to see reveal the issue of FDI and its impact on income inequality. Basically these
The figure below shows the huge amount of FDI compare to other source of money flows to developing
countries. In this case, the huge amount of FDI together with the fully support policy by the host
government could be considered as one of the Implementation of the big push theory. The theory of
Big Push was proposed by Paul Rosenstein – Rodan back in 1943 in which they emphasized on how a
country able to escape from the coordination failure. The big push model is a model of how the
presence of market failures can lead to a need to a concerted economywide and probably-policy-led
effort to let the long process if economic development under way or to accelerate it (Todaro, 2009).
(Billions of dollars)
The theory of Factor Price Equalization argued that when home & foreign trade, the relatives price of
goods is converge. This convergence, in turn, causes of the relative price of land & labor. Thus there is
clearly a tendency toward equalization of factor prices (Krugman, P. & Obstfeld, M. ;2003). In addition,
the existence of FDI allows pushing the economy to factor price equalization. The emergence of FDI
could bring industrialization and subsequently could lift the wage rate in the host country whi ch in the
end, it will accelerate the wage equalization between countries, or in other words, FDI it narrows
Stolper – Samuelson Theorem clearly stated that: with full employment both before and after trade take
place, the increase in the price of abundant factor and the fall in the price of the scarce factor because of
scarce factor will find their income decreasing. In this theorem, it is clear that for instance, in
developing country in which labor factor is abundant, trade will increase wages rate.
Furthermore, this theory also argued about the magnification effect, this is because the
percentage change in price of scarce factor is higher than the percentage change in price of abundant
factor. This argument is also in line with argument about the role of FDI in increasing wage rate.
In this part, I will elaborate a paper titled Foreign Direct Investment: A lead Driver for Sustainable
Development? (Gardiner.R; 2000). This paper showed some views about pros & cons of FDI. Basically,
FDI is thought to bring certain benefits to national economies. It can contribute to Gross Domestic
Product (GDP), Gross Fixed Capital Formation (total investment in a host economy) and balance of
payments. There have been empirical studies indicating a positive link between higher GDP and FDI
inflows (OECD a.), however the link does not hold for all regions, e.g. over the last ten years FDI has
increased in Central Europe whilst GDP has dropped. FDI can also contribute toward debt servi cing
repayments, stimulate export markets and produce foreign exchange revenue. Subsidiaries of Trans -
National Corporations (TNCs), which bring the vast portion of FDI, are estimated to produce around a
third of total global exports. However, levels of FDI do not necessarily give any indication of the
domestic gain (UNCTAD 1999). Corporate strategies e.g. protective tariffs and transfer pricing can
reduce the level of corporate tax received by host governments. Also, importation of intermediate
goods, management fees, royalties, profit repatriation, capital flight and interest repayments on loans
conditions of the host economy, e.g. the level of domestic investment/savings, the mode of entry
(merger & acquisitions or Greenfield (new) investments) and the sector involved, as well as a country’s
2. Stability of FDI
FDI inflows can be less affected by change in national exchange rates as compared to other private
sources (portfolio investments or loans). This is partly because currency devaluation means a drop in the
relative cost of production and assets (capital, goods and services) for foreign companies and thereby
increases the relative attraction of a “host” country. FDI can stimulate product diversification through
investments into new businesses, so reducing market reliance on a limited number of sectors/products
(UNCTAD 1999). However, if international flows of trade and investment fall globally and for lengthy
periods, then stability is less certain. New inflows of FDI are especially affected by these global trends,
because it is harder for a foreign company to de-invest or reverse from foreign affiliates as compared to
portfolio investment. Companies are therefore more likely to be careful to ensure they will accrue
benefits before making any new investments. Examples of regional stability are mixed, whilst FDI growth
continued in some Asian countries e.g. Korea and Thailand, during the 1996/97 crisis, it fell in others e.g.
Indonesia. During Latin America’s financial crisis in the 80’s many Latin American countries experienced
a sharp fall in FDI (UNGA 1999), suggesting that investment sensitivity varie s according to a country’s
particular circumstances.
3. Social development
FDI, where it generates and expands businesses, can help stimulate employment, raise wages and
replace declining market sectors. However, the benefits may only be felt by small portion of the
there is an urban emphasis, wage differentials (or dual economies) between income groups will be
exacerbated (OECD a). Cultural and social impacts may occur with investment directed at non-traditional
goods. For example, if financial resources are diverted away from food and subsistence production
towards more sophisticated products and encouraging a culture of consumerism can also have negative
environmental impacts. Within local economies, small scale and rural businesses of FDI host countries
there is less capacity to attract foreign investment and bank credit/loans, and as a result certain
domestic businesses may either be forced out of business or to use more informal sources of finance
(ECOSOC 2000).
Parent companies can support their foreign subsidiaries by ensuring adequate human resources and
infrastructure are in place. In particular “Greenfield” investments into new business sectors can
stimulate new infrastructure development and technologies to host economies. These developments
can also result in social and environmental benefits, but only where they “spill over” into host
communities and businesses (ECOSOC 2000). Investment in research & development (R&D) from parent
companies can stimulate innovation in production and processing techniques in the host country.
However, this assumes that in-house investment (in R&D, production, management, personnel training)
inappropriate to local needs, capital intensive and have a negative affect on local competitors, especially
smaller business that are less able to make equivalent adaptations. Similarly external changes in
suppliers, customers and other competing firms are not necessarily an improvement on the original
“Crowding in” occurs where FDI companies can stimulate growth in up/down stream domes tic
businesses within the national economies. Whilst “Crowding out” is a scenario where parent companies
dominate local markets, stifling local competition and entrepreneurship. One reason for crowding out is
“policy chilling” or “regulatory arbitrage” where government regulations, such as labour and
environmental standards, are kept artificially low to attract foreign investors, this is because lower
standards can reduce the short term operative costs for businesses in that country. Exclusive production
concessions and preferential treatment to TNCs by host governments can both restrict other foreign
investors and encourage oligopolistic (quasi-monopoly) market structure (ECOSOC 2000, UNCTAD 1999).
Empirical data for these scenarios is variable, but crowding out is thought to be more common in
specific sectors. For example, in industries where demand or supply for a product or service is highly
price elastic (market sensitive) and capital intensive. Hence regulation brings additional costs of
compliance and is therefore much more likely to influence a company’s decision to invest in that country
(OECD b).
It may be difficult for some governments, particularly low income countries, to regulate and absorb
rapid and large FDI inflows, with regard to regulating the negative impacts of large-scale production
growth on social and environment factors (WWF 1999). Also a high proportion of FDI inflows in
developing economies are commonly aimed at primary sectors, such as petroleum, mi ning, agriculture,
paper-production, chemicals and utilities. Primary sectors are typically capital and resource intensive,
with a greater threshold in economies of scale and therefore slower to produce positive economic “spill
over” effects (OECD a). Thus, in the short term, low income economies will have less capacity to mitigate
term, as well as potentially irreversible environmental losses (WWF 1999, OECD b).
7. Skewed distribution
FDI inflows are still highly concentrated in certain countries and regions. TNCs are the largest source of
FDI (about 95% of total inflows) and the majority of these are based in industrialised countries. The vast
proportion of FDI flows go to other developed countries, especially the “Triad” of USA, UK, Japan, but
Figure 2
Regional FDI inflows in 1998, as % of total global inflow US$ 644 billion
In 1998, 92% of total FDI outflows came from developed countries and 72% of the total inflows returned
to these economies (UNCTAD 1999). Of the proportion that went to low-middle income countries, the
East Asia, whilst only 6% was invested in Africa (World Bank 1999). Over half of the FDI that does reach
developing countries is concentrated in 5 countries. This is also true transitional countries, for example
in Eastern Europe 75 % of FDI inflows is directed toward 5 countries (WTO 1999, OECD b., ECOSOC 2000).
Inequality?
As it is elaborated above that trade theories support that the trade will have impacted on wage rate t
increase, and so does FDI, one positive impact of FDI is the increase of wage. In this part of this review
literature, to be more focus, I will the focus mainly on the effect of FDI towards income inequality. As
the increase of FDI, concern into the effect that would FDI brought into income inequality become
heightens. There are also pros and cons towards this issue and the following list are some relevant
Pros
1. FDI helps to reduce income inequality when implemented to utilize abundant low-income unskilled
2. FDI helps to reduce income inequality when capital, domestic or foreign, stimulates economic
growth and its benefits eventually spread throughout the whole economy (Tsai, 1995).
Cons
1. Inward FDI deteriorates income distribution by raising wages in the corresponding sectors in
comparison with traditional sectors (Girling, 1973; Rubinson, 1976; Bornschier and Chase-Dunn,
3. Mah (2002) investigated the impact of changes in trade values and FDI inflows on the Gini
coefficients in Korea and concluded that globalization tends to deteriorate the income distribution
there.
4. Taylor and Driffield (2004) also found that inward flows of FDI contributed to increasin g wage
inequality based on an empirical analysis with the three-digit industry level for UK manufacturing
5. Zhang and Zhang (2003) argued that foreign trade and FDI in China are important factors
6. D.W. Velde and O. Morrisey (2002) found that FDI has raised wage inequality in Thailand.
Neutral
1. Lindert and Williamson (2001) and Milanovic (2002) did not find any significant relationship
2. After comparing models with and without geographical dummies – such as Asia and Latin America –
over the period from 1967 to 1981, Tsai (1995) argued that the statistically significant correlation
between FDI and income inequality might capture more of the geographical difference in inequality
One of the most recent studies about FDI & income inequality is Chankyu Choi (2006) titled does foreign
direct investment affect domestic income inequality? Using a pooled ordinary least squares regression,
Note: Subscript i represents a country and subscript t represents year t. GINI represents the Gini
coefficient of a country. INTENSITY stands for foreign direct investment (FDI) stock as a percentage of
GDP. PGDP, GDP and PGDPR stand for country i’s per capita GDP, GDP and real per capita GDP growth
rates respectively. ASIA is a dummy variable set to one for countries in Asia and zero otherwise.1 LAC is
a dummy set to one for Latin American and Caribbean countries and zero otherwise. Dummy variable
YEARj is one if j=t and zero if j≠t.
This study concluded that the increase in the FDI intensity measured by inward, outward and total FDI
stock as a percentage of GDP proved to increase the income inequality. Especially outward FDI rather
than inward FDI has more detrimental effect on income distribution. Rich countries and fast growing
countries turned out to have a more even income distribution. Bigger countries tend to have a less equal
income distribution. Latin American and Caribbean countries have unequal income distribution.
Based on previous study above, this paper tries to give an empirical work contends the relationship
between FDI & income inequality. This paper examines 7 Asian countries which are Indonesia, Malaysia,
Singapore, Philippine, Thailand, China and India. The recent of choosing those countries is those
countries are mainly countries that attract most world FDI in Asia (FDI recipients).
Methodology
This paper uses multi regression analysis from panel data across from 1965 to 2007. The data is
obtained from various sources, mainly from World Development Index – World Bank. Since it is difficult
to obtain Gini Coefficient data annually for all those countries, the average five years data is calculated
so that the regression analysis can be run and tested statistically. Furthermore, putting some additional
model becomes:
*) The usage of 5 years lag is to make a consistent average data with the Gini Coefficient Data that
**) The criteria of crisis whether it refers to a world economic crisis or regional economic crisis are
General
After applying the proposed model above, the outcome mostly statistically insignificant in 5% level (see
appendix 2 for overall result). To give alternative models, this paper simulates 6 scenarios of model and
the Model 6 is chosen as the final model since all the independent variables are statistically significant.
UNEMPLOYi t (Unemployment, total (% of total labor force) are excluded since the data is quite small and
it decreased the total number of observation. Both dummy variables which are WORLDCRISIS & ASIAN
CRISIS are also excluded from the model since those variables are statistically insignificant for all the
scenarios.
Variable FDI
When including FDI variable into the model, the result is varied (Model 1 to Model 5), but basically the
result shows a negative correlation towards Gini Coefficient for all the models from 1 to 5 and
statistically insignificant. However, when adding the FDI lag variable into the model the result shows
differently. The correlation between FDI Lag is become positive towards Gini Coefficient and statistically
To have a supportive finding, focusing on Indonesia data, the following discussion will depict the
The figure above shows a positive correlation between FDI & Gini Coefficient. Although the
curve is not perfectly match one to another, however, in general this two variables show the tendency
of a positive correlation. Positive correlation means that the increasing of variable FDI will also affect
the variable Gini Coefficient to increase (Higher Gini coefficient refers to higher income inequality).
E. Conclusion
Foreign direct investment (FDI) has been played a significant role in boasting economic growth. It is no
doubt that every country in the world, especially developing countries, is racing to welcoming FDI. FDI
contributes positives effect such as: providing more employment opportunities, raising wage, allowing
debt servicing repayments, promoting export markets, stimulating product diversification, gaini ng more
and stimulating up/down stream domestic economy. However, FDI also contribute negative effects
such as: increasing income inequality, environmental damages, stimulating “Crowding out” and stifling
local competition and entrepreneurship, encouraging a culture of consumerism. Among Those pros and
cons, this paper found and interesting result toward FDI & Income Inequality.
Focusing on 7 ASIA FDI recipient countries (Indonesia, Malaysia, Singapore, Philippine, Thailand,
India & China), this paper found that FDI has a negative insignificant impact towards income inequality
in short term. But again, this relation is statistically insignificant. In longer term, it is found that FDI has
a positive significant impact towards income inequality. This is means that having more FDI inflow, it
could lead to more income inequality. This paper found that in 5 years time would be an av erage time
In addition, emphasizing in Indonesia case, this paper tries to have another perspective towards
the FDI role by depicting the relationship between FDI & income inequality (Gini Coefficient). From the
chart, it is clearly noticed that the increasing of FDI is always followed by the increasing of Gini
Coefficient. Therefore, it can be concluded that FDI has a positive impact toward Gini Coefficient. This
One important reason to justify this empirical finding is that FDI can promote raising wage that
consequently establishing gap wages. Another important thing is the present of FDI only in a certain
area; therefore, the positive effect of FDI could not be gained by other areas. This will bring the
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