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International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 21 (2008)


© EuroJournals Publishing, Inc. 2008
http://www.eurojournals.com/finance.htm

Direct Foreign Investment and Income Distribution: A Case


Study for Pakistan

Muhammad Shahbaz
Research Officer at Social Policy and Development Centre at Karachi, Pakistan

Naveed Aamir
Economist at Social Policy and Development Centre at Karachi, Pakistan

Abstract

Thus study is a valuable contribution in economic literature and differs from


previous research in a number of aspects. This study is a pioneering effort regarding
country case like Pakistan. Modern technique has been used in finding the order of
integration for running actors. ARDL bounds approach is for long run association among
said macroeconomic variables, which has never been employed in literature regarding
mentioned issue. Finally, gossip between dependent and explanatory variables for short
span of time is discussed through error correction method (ECM).
In empirical psychology, results reveal that increased FDI in Pakistan worsens
income distribution because it is focused towards capital intensive industrial and services
sectors of urban localities. Economic growth also makes income distribution more unequal
following upper echelon trend. Relation between income distribution and trade-openness
according to Leontief paradox i.e. more trade promotes rich class more. Inflation has
progressive impact on income inequality. Government size is associated negatively with
income distribution showing exploitation of poor segments through elite class.
Unemployment also raises income inequality but moderately. Finally, improvement in
agriculture activity decline income inequality and improves the incomes of rural class.

Keywords: FDI, Income inequality


JEL Classification Codes:

Note: Views are own of authors not representing SPDC.

Introduction
Foreign Direct Investment (FDI) is considered a vibrant tool for the growth of income and
employment, technological advancement, socio-economic development parallel to improve income
distribution or poverty reduction especially for the developing countries of the world like Pakistan.
Country’s economic policies should be attractive enough for FDI to have positive (negative) impact on
poverty alleviation (income inequality). Particularly for large agrarian economies claimed by Mason
and Baptist (1996), only the agriculture sector interventions serve to reduce poverty. Moreover, it
requires labor intensive economic growth in the host country so that FDI can contribute towards
productive employment generation.
International Research Journal of Finance and Economics - Issue 21 (2008) 8

As Moran (1998) highlights an important fact that exposure to foreign competition plays vital
role in skill upgradation. Therefore, a blend of policies comprising of feasible macro-economic
policies, sound investment climate, proper law and order situation, provision of infrastructure, etc. are
certain necessary conditions for FDI to work for the development of any country. FDI is considered as
an important agent in establishing link between trade liberalization and economic growth argued by
Taylor (1998), Blomstrom (1990), Levine and Renelt (1992), and Wacziarg (2001). Furthermore, they
asserted that trade benefits will not be realized if countries investment policies are poor and
discouraging. Liberalization in economies having weak domestic institutions creates domestic income
inequality indicated by Atkinson and Brandolini (2003). The impacts of FDI on poverty and other
social goals of development depend principally on many factors, such as host country policies and
institutions, the quality of investment, the nature of the regulatory framework, the flexibility of the
labor market, and many others (Mayne, 1997).
However, investment activities are often not conducive for employment generation because the
capital intensive nature of the production sector reduces demand for labor and hence, this retards
growth of an economy where labor is in abundance. This clearly indicates the fact that the most
appropriate route for transferring benefits of FDI to the disadvantaged segment of population is the
labor intensive economic growth. However, low investment results in low rates of job creation and
high investment has an accelerator effect on domestic investment and on economic growth as argued
by Jenkins and Thomas, (2002). As most of the developing countries have high rate of population
growth and lower investments means lower economic growth thereby adding more people in the
poverty bracket or making income distribution more worsen. Still according to Saravanamuttoo, (1999)
both domestic and foreign investors are potential sources for capital accumulation. This is just an
indirect way for reducing poverty and speeding up the growth across all sectors of the economy. Some
of the findings highlight the very fact that the role of FDI is important and crucial especially when it
comes to an increased economic growth in developing countries, Dollar and Kray (2001), Rama
(2001), and Kolstad and Tondel (2002).
Developing countries are able to get benefit from FDI if the country is oriented towards export
led growth of its economy. As FDI can exercise positive impact on country’s export growth on account
of trade liberalization phenomena and this process of globalization creates competition and improves
efficiency of the market forces in the host country as indicated by Cotton and Ramachandran, (2001).
Quite a number of industrialized economies as explained by Jenkins and Thomas (2002) have
multinational firms which are globally connected regarding their access to the financial markets and
consumer outlets, transportation networks. Even Balasubramanyam et al. (1996) argued that FDI raises
the level of efficiency among export promoting countries because it involves domestic capital and
labor. Thus FDI no doubt has a real spillover effect as it does not reduce poverty directly but creates an
enabling economic environment. If there is an export growth it will raise national income that will
benefit poor argued by Te Velde and Morrissey (2002).
The presence of multinational companies is positive sign for export growth of the host country
as highlighted by Blomstrom and Kokko (1996). However, situation varies across countries depending
upon the nature and focus of their economic policies. According to Thomsen (1999) who reviewed the
economic development case with respect to the role of FDI in Philippines, Malaysia, Thailand and
Indonesia as of a driving force behind growth in their export sector. Favorable investment climate and
trade openness in these countries helped foreign firms to expand their business. Even in China FDI
contributed to domestic capital formation and transferring technology as highlighted by Sun (1998).
Poverty reducing impact of FDI is also observed when foreign firms operate and domestic firms get in
contact with them, they get advantage through production subcontracting, competition, investment
opportunities and chances of expanding business parallel to employment generation activities.
Analyzing a study regarding the role of FDI in Indonesia in developing their manufacturing sector,
it is mentioned by Thee (1998) that for development of indigenous industrial technological capabilities
FDI and its related technology transfer were not much effective. This leads to another issue of wage
inequality as the phenomena if FDI is urban biased and capital intensive they involve less labor and
9 International Research Journal of Finance and Economics - Issue 21 (2008)

pay higher wages as they are mostly skilled and educated based in developed urban settlements. In case
of Mexico, Alarconand Mckinley (1998) pointed out that due to FDI increase in wages was
substantially lower for unskilled labor as compared to unskilled workers. There is a particular nature of
FDI flows as they are directed towards locations having developed infrastructure, efficient means of
communication available with a proper network of roads. The advantages of FDI especially for
economies like Pakistan can be seen if it is not directed towards agricultural sector, then at-least
towards agri-based labor intensive manufacturing sectors like textile, beverages, apparel, furniture,
toys, food items, etc which employees great degree of unskilled labor. It can be a possible option for
acquiring benefit from FDI. According to Saad (1995) it is observed in Indonesia that technology
transfer took place mainly through on-job training and was limited to basic technological capabilities.
In short, quite a number of previous studies analyzed the impact of various factors on income
inequality in Pakistan like the study by Shahbaz and Kalim (2007) shows that inflation is progressive
in case of Pakistan thereby creating improvement income distribution. Similarly, development of
financial sector which refers to more access of the poor individuals towards financial markets and
credit is a significant policy measure to decrease income inequality in the country not only in the long
run but also in short span of time, Shahbaz et.al. (2006). Furthermore, an increase in trade and
enhancement in economic growth both benefit the preferred and elite groups of the society as indicated
by Shahbaz et.al (2007) because Pakistan could not get benefits from the pace of openness due to low
degree of openness. The above literature shows that there is need to examine the impact of foreign
direct investment on income distribution regarding Pakistan.
In Pakistan the scenario is a bit different as our export sector lacks diversification and
concentrated in urban areas whereas country is still agrarian in nature with mostly people living in rural
areas. Rural population is mostly illiterate and prefers their traditional means of living. Although it has
been argued by Noorbaksh et al, (2001) and Borensztein at al, (1998) that good quality and appropriate
education leads to inclusion of the poorest part of workforce and it may help to attract and benefit from
FDI. Unfortunately, the rural population involved in agricultural activities is till unaware of the
benefits of FDI as they lack modern skills, rely mainly on indigenous technologies which are avoided
in the modern sectors and this hampers sustainable development process in some of the developing
countries like Pakistan.
Thus study is a good contribution in economic literature and differs from previous research in a
number of aspects. This study is a pioneering effort regarding country case like Pakistan. Modern
technique has been used in finding the order of integration for running actors. ARDL bounds approach
is for long run association among said macroeconomic variables, which has never been employed in
literature regarding said issue. Finally, gossip between dependent and explanatory variables for short
span of time is discussed through error correction method (ECM). Balance of paper is designed as
follows: part II & III is relevant to Modeling, Operational Definitions and Expecting Impacts
respectively. Methodological framework is discussed in section-IV while results are interpreted in part-
V. Finally, conclusion is drawn in section VI.

II. Modeling
Above huge discussion suggests utilizing log-linear functional form. It is believed that findings are
sensitive to functional form [Bowers and Pierce, (1975) & Ehrlich’s (1975). Originally, suggested by
Ehrlich (1977) and Layson (1983) was subsequently asserted that log linear form is superior to the
linear form. Both Cameron (1994) and Ehrlich (1996) claimed that a log-linear form is more likely to
find evidence of a deterrent effect than a linear form. To inquire the relationship between foreign direct
investment and income inequality in an open economy like Pakistan, the following equation is being
modeled;
Gini = α ° + α 1 FDI + α 2 CV + ε t ……………. (1)
International Research Journal of Finance and Economics - Issue 21 (2008) 10

Where income inequality indicated by Gini-Coefficient, FDI for foreign direct investment and
CV means control variables in the model. The main focus of analysis is foreign direct investment,
which, based upon the discussion of earlier theoretical work linking income distribution to foreign
direct investment, the above functional form is being assumed.

III. Operational Definitions and Expecting Impacts


Gini = Gini-Coefficient, Gini-coefficient ranges from 0 to 1 (0 indicates that all individuals have equal
things while 1 demonstrates that one person has all things).
FDI = Foreign Direct Investment as share of GDP may increase income inequality by
reinforcing the power of privileged groups and creating enclaves of well paid employees of the
multinational corporations surrounded by marginalized poor. Alternatively, increased competition in
domestic markets as a result of globalization could benefit consumers and less skilled workers in
developing countries and reduce rent-seeking, thereby contributing to greater equality (Bussmann rt al.,
2005 and Shahbaz et al., 2007).
GDPC = Real per capita GDP (economic growth) rises income inequality through its unequal
distribution according to upper-echelon phenomenon. Economic growth improves incomes of lower
segments of population through its distributional channels. If growth is labor absorbing then incomes
of poor sections of population will increase.
INF = Annual Inflation, inflation is having distributional impact on income distribution.
Erosion of real value of non-index public transfers like unemployment benefits and pensions slows
down by lower inflation. This channel would improve income distribution because such transfer
recipients belong to poor segments of the population. Low inflation slows down the erosion of real
value of private debt because private debt is set in nominal terms generally. If the poor class is net
nominal debtor then this tends to deteriorate the income distribution (Gali and Hoeven (2001).
TR = Trade-Openness (Exports + Imports/GDP) may lead to deteriorate situation of income
distribution in case of developing economies. The main reason is that exporting firms demand some
educated workers because trade does not benefit workers without education, who account for the bulk
of low-income households in most poor countries (Bensidoun and Jean, 2005).
AGR = Agriculture value added/GDP, Incomes are also expected to be more unequal when
agriculture’s share of national economic production is small. Inequality is relatively low within the
agricultural sector because the skills of farmers are more uniform compared to the diversity in industry;
hence, the larger the industrial sector, the greater is income inequality within a nation. Income
inequality is often thought to be affecting by the accessibility of education (Bussmann, Soysa and
Oneal, 2005).
GS = Size of Government (Government current consumption expenditures / GDP) may be
associated inversely with distribution of income. Often in developing economies, rich class uses their
connections to exploit poor segments of population.
UN = Unemployment rate increases income inequality through log term and harmful ways. As
it is argued that high unemployment – especially long-term unemployment makes poor segments of
population more vulnerable to fulfill their basic needs for their survival.
For data, three sources are used in present study. Data on Gini-coefficient has been obtained
from research report by Jamal Haroon (2006). Annual Inflation is collected from economic survey of
Pakistan (various issues). World Development Indicators (WDI, 2007) has used to accumulate data on
FDI, AGR, GS and Unemployment rate. Data on Trade has been assembled from International
Financial Statistics (IFS, 2007). This study covers data period 1971-2005.
11 International Research Journal of Finance and Economics - Issue 21 (2008)

IV. Methodological Framework


Appearance of 21 century has introduced new techniques for co-integration especially ARDL bounds
testing approach macroeconomic variables developed by Pesaran et al., (2001). Most studies in
literature widely used methods for co-integration such as residual based Engle-Granger (1987) test1,
and Maximum Likelihood based Johansen (1991; 1992) and Johansen-Juselius (1990) tests. All these
require that the variables in the system be of equal order integration. These methods do not include the
information on structural break in time series data and suffer from low predicting power2.
It is believed that ARDL has a numerous advantages over conventional Johansen Co-
integration technique. The first advantage is that it can be applied irrespective of whether underlying
regressors are purely I(0), purely I(1) or mutually co-integrated (Pesaran and Pesaran, 1999). The
second advantage of using the bounds testing approach to Co-integration is that Monte Carlo studies
that it performs better than Engle and Granger (1987), Johansen (1990) and Philips and Hansen (1990)
Co-integration test in small samples (see Haug, 2002). The third advantage of this approach is that, the
model takes sufficient number of lags to capture the data generating process in a general-to-specific
modeling framework (Laurenceson and Chai, 2003). However, Pesaran and Shin (1999) contented that,
“appropriate modification of the orders of the ARDL model is sufficient to simultaneously correct for
residual serial correlation and the problem of endogenous variables”. Moreover, a dynamic error
correction model (ECM) can be derived from ARDL through a simple linear transformation (Banerjee
et al. 1993). The ECM integrates the short-run dynamics with the long-run equilibrium without losing
long-run information. It is also argued that using the ARDL3 approach avoids problems resulting from
non-stationary time series data (Laurenceson and Chai 2003).
The error correction version of the ARDL model is given below for the above given Equation
no.1:
p p P p
ΔGINI t = α ° + ∑ β i ΔGINI t − i + ∑ δ i ΔFDI t − i + ∑ σ i ΔGDPCt − i + ∑ ω i ΔINFt − i
i =1 i =1 i =1 i =1
p p
+ ∑ ∂ i ΔTRt − i + ∑ ∂ i ΔUNPt − i + λ1GINI t − 1 + λ 2 FDI t − 1 + λ 3 GDPCt − 1 + λ 4 INFt − 1 (2)
i =1 i =1
+ λ 5 TRt − 1 + λ6 UNPt − 1 + μ t ........
Where GINI= Gini-Coefficient, FDI = Foreign direct Investment as share of GDP, GDPC
=Real GDP per capita, INF = Inflation, TR= Trade openness (Export + import/ GDP) & UNP =
Unemployment rate.
The first part of equation (2) with β , δ , σ ,ϖ and ∂ represent the short-run dynamics of the
model whereas the second part with λs show the long-run association. The null hypothesis in the
equation is λ1 = λ 2 = λ3 = λ 4 = λ5 = λ6 = 0 , which means the non-existence of the long run
relationship. While alternative hypothesis in the equation λ1 ≠ λ 2 ≠ λ3 ≠ λ 4 ≠ λ5 ≠ λ6 ≠ 0 shows the
existence of long-run rapport among variables.
The ARDL model testing procedure starts with conducting the bounds test for the null
hypothesis of no Co-integration. The calculated F-statistic is compared with the critical value tabulated
by Pesaran and Pesaran (1997) or Pesaran et al. (2001). If the F-test statistic exceeds the upper critical
value, the null hypothesis of no long-run relationship can be rejected regardless of whether the
underlying orders of integration of the variables are I(0) or I(1) . Similarly, if the F-test statistic falls
below the lower critical value, the null hypothesis is not rejected. However, if the sample F-test

1
The residual-based co-integration tests are inefficient and can lead to contradictory results, especially when there are more than two I(1) variables under
consideration.
2
It goes without saying that structural change is of considerable importance in the analysis of macroeconomic time series. Structural change occurs in
many time series for any number of reasons, including economic crises, changes in institutional arrangements, policy changes regime shift war. An
associated problem is the testing of the null hypothesis of structural stability against the alternative of a one-time structural break. If such structural
changes are present in the data generating process, but not allowed for in the specification of an econometric model, results may be biased towards the
erroneous non-rejection stationary hypothesis (Leybourne and Newbold, 2003).
3
The early discussion on ARDL Modeling approach can be found in Charemza and Deadman (1992).
International Research Journal of Finance and Economics - Issue 21 (2008) 12

statistic falls between these two bounds, the result is inconclusive. When the order of integration of the
variables is known and all the variables are I(1), the decision is made based on the upper bounds.
Similarly, if all the variables are I(0), then the decision is made based on the lower bounds.
The ARDL method estimates (p+1)k number of regressions in order to obtain optimal lag
length for each variable, where p is the maximum number of lags to be used and k is the number of
variables in the equation. The model can be selected using the model selection In the second step, the
long run relationship is estimated using the selected ARDL model. When there is a long run
relationship between variables, there exists an error correction representation. Therefore, in the third
step, the error correction model is estimated. The error correction model result indicates the speed of
adjustment back to the long run equilibrium after a short run shock. The equation of short run model is
being modeled as following below:
p P p p p
ΔGINI t = α ° + ∑ δ ΔFDI t − i + ∑ σ ΔGDPCt − i + ∑ ωΔINFt − i + ∑ ∂ΔTRt − i + ∑ ϕΔUNPt − i + η t − 1 ... (3)
i =0 i =0 i =0 i =0 i =0
Where η shows speed of adjustment towards long span of time from short run.

V. Interpretation of Empirical Results


For investigation of co-integration through employing ARDL technique there is no need for unit root
pre-testing. According to Ouattara (2004) in the presence of I(2) variables the computed F-statistics
provided by Pesaran, et., al (2001) become invalid because bounds test is based on the assumption
that the variables are I(0) or I(1). Therefore, the implementation of unit root tests in the ARDL
procedure might still be necessary in order to ensure that none of the variable is integrated of order I(2)
or beyond. For this purpose, DF-GLS (1999) test employed which is more powerful and reliable for
small sample data set. Table-1 shows that all running variables are stationary at 1st difference except
FDI. It is concluded that variables in concerned model are having mixed order of integration.

Table 1: Unit Root Test

DF-GLS with Intercept & Trend DF-GLS with Intercept & Trend
Variables
T. statistics T. statistics Inst.value
GINI -0.5512 0.2370 0.9974
FDI -4.2936* -6.6565 0.0000
GDPC -2.7483 -1.5545 0.7891
INF -2.6846 -2.9306 0.1664
TR -1.8134 -2.8503 0.1904
UNP -2.6311 -2.8229 0.1993
DF-GLS at 1st Difference
GINI -4.4660* -3.4508 0.0624
FDI -5.6014* -7.8184 0.0000
GDPC -7.3802* -5.2319 0.0009
INF -5.0456* -5.1420 0.0011
TR -4.7128* -4.1673 0.0126
UNP -4.4697* -4.4739 0.0060

After finding integrating order of all variables, the two-step ARDL Co-integration (See Pesaran
et al., 2001) procedure is implemented in the estimation of equation-(1). In the first stage, the order of
lag length on the first differenced estimating the conditional error correction version of the ARDL
model for equation-2 is usually obtained from unrestricted vector autoregression (VAR) by means of
Schwartz Bayesian Criteria and Akaike Information Criteria. Lag length is 1 based on the minimum
value (SBC) as shown in Table-2. In such small sample of observations we cannot take leg length more
than 1 lag order.
13 International Research Journal of Finance and Economics - Issue 21 (2008)
Table 2: Lag Length Criteria

Lag LR FPE SC
0 NA 2.57e-10 -4.785292
1 241.9475* 2.84e-13 -10.01251
2 45.63547 3.31e-13 -8.451839
Short run Diagnostic Tests
ARCH Test: 0.5237 (0.4745)
Serial Correlation LM Test = 1.5603 (0.2219)
Heteroscedisticity Test = 2.4483 (0.0351)
Ramsey RESET Test = 1.4740 (0.2348)
Jarque-Bera Test = 1.6562(0.4369)
* indicates lag order selected by the criterion
LR: sequential modified LR test statistic (each test at 5% level)
FPE: Final prediction error
SC: Schwarz information criterion

The total number of regressions estimated following the ARDL method in the equation No.2 is
6
(1+1) =64. The results of the bounds testing approach for Co-integration show that the calculated F-
statistics is 4.95 which is higher than the upper level of bounds critical value of 4.85 at the 5 percent
level of significance, implying that the null hypothesis of no Co-integration cannot be accepted and
that there is indeed a Co-integration among the variables in this model. Having found a long-run
relationship, we applied the ARDL method to estimate the long run and the short run elasticities
respectively.

Table 3: F-statistic of Co-integration Relationship

Bound Critical Values(restricted


Test-statistic Calculated-Value Lag-order Significance level
intercept and no trend)
F-statistic 4.95 1 I(0) I(1)
1% 5.25 6.36
5% 3.79 4.85
10% 3.17 4.14

Table-4 explains the long run marginal impacts of explanatory variables on dependent actor.
Increased foreign direct investment in Pakistan pushes income inequality upwards with high
significance. FDI is almost going in telecommunication and services sectors like banking etc. Jobs in
these sectors are being captured by high skilled labor class. This situation not only raising aggregate
income inequality but also enhancing the gap between rural and urban earnings (Shahbaz, et, al.,
2008)4. Economic growth is associated with more unequal distribution of income in the country. This
indicates the upper-echelon phenomenon in Pakistan. Major share of income (economic growth) is
capturing by elite class (top 10 % of population) on cost of deprived segments of population. This
channel promotes rich-class and increases the poverty in the case of small developing like Pakistan.

4
For more details see (Shahbaz, Naveed and Butt, 2008)
International Research Journal of Finance and Economics - Issue 21 (2008) 14
Table 4: ARDL Long Run Ordinary

Dependent Variable: GINI


Variable Coefficient (T. values) Coefficient (T. values)
Constant 2.0419 (6.747 a) 3.0105 (6.839 a)
FDIt-1 0.0230 (3.375 a) 0.0188 (3.804 a)
AGR - -0.1663 (-2.542 b)
GDPCt-1 0.1024 (3.855 a) 0.1025 (3.621 a)
UNP 0.0185 (4.041 a) 0.0157 (3.439 a)
TR 0.1654 (2.689 b) -
INF -0.0245 (-2.544 b) -
GS - 0.0500 (2.063 b)
R 2 = 0.9534 R 2 = 0.9743
Durban-Watson = 1.507 Durban- Watson = 1.386
F-stat = 118.60 F-stat = 220.217
Note: a (b) represent significant at 1 % (5%) level of significance.

Unemployment is also an important determinant of income inequality. Actually in developing


economies like Pakistan mostly population is living in rural areas. Illiteracy is high and there is an
abundance of unskilled labor. With the passage of time employment opportunities are generating only
in servicing sectors like telecommunication, banking sectors due to increased FDI. More FDI means
more employment calls for skilled personals and less for unskilled heads creating more income
inequality reflecting an urban phenomenon with rising poverty. Often downsizing starts from lower
staff which mostly belongs to poor segments of population. This situation makes them more vulnerable
to fulfill their basic necessities of life.
Trade-openness and unfavorable distribution of income are joined proportionately in case of
developing economy like Pakistan. Enhanced trade also worsens income inequality. This shows that
fruits from international are reaped up by elite or top 10 % segment of population. Poor class is waiting
with their empty chatic to receive benefits from international trade. The movement of income
inequality with trade-openness in same direction indicates existence of Leontief paradox. Inflation is
having progressive impact on income inequality according effective demand channel (Keynesian
Model)5 Government size and inequality are having same direction indicating positive and significant
relationship, meaning that government consumption causes to raise inequality by 0.050 percent, if there
is 1 percent increase in government spending. The major reason of this opposite result is that rich
households use their political powers or their connection to exploit the poor in the country (Shahbaz,
et, al., 2006). Agriculture sector is considered as backbone of an economy in developing countries like
Pakistan. Improving agriculture activity reduces income inequality. Enhanced share of agriculture
sector not only generates employment opportunities in rural economy but also reduces unemployment
in urban areas relevant to agri-based manufacturing sector or industrial sector. Short run phenomenon
is much different. Impact of independent variables is relevant according to theory as shown in Table-6.
Lag of differenced form of foreign direct investment worsens income distribution more in future.
Increased economic growth makes income distribution unequal while inflation declines income
inequality respectively with insignificance. Worse situation of unemployment in country makes income
distribution more unequal.
The ECM posited to be a force affecting the integrated variables to return their long-run relation
when they deviate from it and thus the longer the deviation; greeter would be force tending to correct
the deviation (Banerjee, et al, 1994). The equilibrium correction coefficients (ecmt-1) estimated value
of -0.2417, which is significant at 1 percent level of significance, has the correct sign and imply a fairly
high speed of adjustment to equilibrium level after a shock. Approximately 24.17% of dis-equilibrium
from the previous year’s shock converges back to the long run equilibrium in the current year.

5
See for more details Shahbaz & Kalim (2007)
15 International Research Journal of Finance and Economics - Issue 21 (2008)
Table 5: Short run Dynamics

Dependent Variable: ΔGINI


Variables Coefficient T-Statistics Inst-values
Constant 0.0080 6.6103 0.0000
ΔGDPC 0.0166 0.9003 0.3769
ΔFDI 0.0064 2.8238 0.0094
ΔFDI(-1) 0.0041 1.7652 0.0903
ΔINF -0.0014 -0.4924 0.6269
ΔINF(-1) -0.0017 -0.6949 0.4938
ΔTR 0.0029 0.1803 0.8584
ΔTR(-1) -0.0350 -1.9095 0.0682
ΔUNP 0.0038 2.3886 0.0251
ecmt-1 -0.2417 -3.2490 0.0034
R-squared = 0.4911 Adj-R-squared = 0.3003
Durban Watson = 1.258 F-statistic = 2.574 (0.031)

To ascertain the goodness of fit of the ARDL model, the diagnostic test and the stability test are
conducted. The diagnostic test examines the serial correlation, functional form, normality and
heteroscedasticity associated with the model. The stability test is conducted by employing the
cumulative sum of squares of recursive residuals (CUSUMsq). Examining the prediction error of the
model is another way of ascertaining the reliability of the ARDL model. If the error or the difference
between the real observation and the forecast is infinitesimal, then the model can be regarded as best
fitting. The short-run diagnostic test results are very satisfactory with an absence of 2nd order serial
correlation but prevalence of heteroscedisticity. Error term is normally distributed along-with no auto-
regressive conditional heteroscedisticity. Ramsey’s Reset test for functional form confirms that there is
no specification problem in the short run model.

VI. Conclusions
Foreign Direct Investment (FDI) is considered a vibrant tool for the growth of income and
employment, technological advancement, socio-economic development parallel to improve income
distribution or poverty reduction especially for the developing countries of the world like Pakistan.
Country’s economic policies should be attractive enough for FDI to have positive (negative) impact on
poverty alleviation (income inequality).
In empirical psychology, results reveal that increased FDI in Pakistan worsens income
distribution because it is focused towards capital intensive industrial and services sectors of urban
localities. Economic growth also makes income distribution more unequal following upper echelon
trend. Relation between income distribution and trade-openness according to Leontief paradox i.e.
more trade promotes rich class more. Inflation has progressive impact on income inequality.
Government size is associated negatively with income distribution showing exploitation of poor
segments through elite class. Unemployment also raises income inequality but moderately. Finally,
improvement in agriculture activity decline income inequality and improves the incomes of rural class.
Policy recommendation reveals that there is a need to revise macroeconomic policies to attract
more FDI in the country. Country can get more benefits from FDI if it is converted towards agri-based
industrial sector. This not only improves the incomes of skilled labor but also enhance the income
levels of unskilled personals. This shows that there is a huge need to train unskilled labor for its
absorption in various employment opportunities.
International Research Journal of Finance and Economics - Issue 21 (2008) 16

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Appendix
Figure 1: Plot of Cumulative Sum of Squares of Recursive Residuals

1.6

1.2

0.8

0.4

0.0

-0.4
78 80 82 84 86 88 90 92 94 96 98 00 02 04 06

CUSUM of Squares 5% Significance

The straight lines represent critical bounds at 5% significance level.

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