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