The Steinhoff Saga Management review - University of Stellenbosch Business School

January – June 2018

The great divide: Does foreign investment influence income inequality?

income inequality
  • Prof Charles Adjasi and Dr Theresia Kaulihowa
  • MAY 2018
  • Tags Insights, Finance
13 minutes to read

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Article written by Prof Charles Adjasi and Dr Theresia Kaulihowa

In Africa, statistics reveal that inequality has either remained unchanged or has increased for most countries over the past 30 years with significant negative consequences for social stability and peace. The current rise in inequality offsets the poverty-reducing effects of more than a decade’s worth of growth.

Yet there is a worldwide paradigm shift towards addressing socioeconomic concerns more adequately. Income inequality negatively affects progress towards the attainment of the United Nations Millennium Declaration, signed in September 2000, which commits world leaders to combatting poverty, hunger, disease, illiteracy, environmental degradation and discrimination against women.

High income inequality can be associated with a lack of income mobility and persistent implications for macroeconomic stability and broad-based development policies. In African countries characterised by higher than usual poverty and inequality rates, foreign direct investment (FDI) has become a complementary element to other development policies in closing the income divide. When assessing the impact of FDI, the approach cannot be one-dimensional as a number of factors, including underlying economics, play a role in outcomes.

The current rise in inequality offsets the poverty-reducing effects of more than a decade’s worth of
growth.

Growing debate on foreign direct investment
With the increase in the level of FDI to finance the growth ambitions of developing countries, the question arises about how these resources have affected income distribution.

Foreign resources have been found to influence the scope and rate of economic growth significantly in developing countries, and FDI from multinational corporations, governments, international trade and private organisations has become the pathway to globalisation in aiding broad-based development in Africa.

FDI has been heralded as being complementary in closing the income divide by increasing employment and wages, resulting in a reduction of poverty and inequality. However, literature is wreathed with extensive debates and mixed arguments on the efficacy of FDI as a policy instrument.

Empirical literature is filled with conflicting predictions about the impact of FDI. Mixed evidence emanates from many different schools of thought – from those that involve studies indicating how FDI worsens income inequality to those that support its inequality-reducing effects.

Other more recent critics find that, although FDI has been beneficial in promoting economic development, there are concerns that it is also responsible for widening income inequality. And there are several reasons for these theories. For instance, despite positive externalities associated with multinational enterprises, FDI is reputed to aggravate wage differentials in host economies. Furthermore, most of the FDI firms’ profit is repatriated back to the countries of origin.

Mind the gap
Most African countries are characterised by either high or a sluggish decline in income inequality. Using the Gini ratio and index – a measure of statistical dispersion representing the income or wealth distribution of a nation’s inhabitants and the most commonly used measurement of inequality – it can be seen that countries such as South Africa, Botswana and Zambia have recorded the highest Gini coefficient of about 0.6 while Tanzania, Tunisia, Nigeria and Morocco have a Gini of about 0.4. Mauritius has the lowest Gini of about 0.2, while Cameroon, Sierra Leone, Tanzania and Kenya exhibit a downward trend.

A country’s development processes occur in stages. It has been found that income inequality will increase during the early stage of development. However, income inequality can be expected to decrease once an optimal development stage has been attained, after which spill-over gains are eventually spread throughout the entire economy. This characterises a U-shaped curve between economic development and income inequality.

High income inequality can be associated with a lack of income mobility and persistent implications for
macroeconomic stability and broad-based development policies.

By regressing the FDI ratio to GDP on income inequality, the short-run parameter FDI seems to reduce income inequality by 10%. However, this effect is diminished in the long run where FDI is associated with widening income inequality. Even if FDI reduces income inequality in the short run, it is most likely that this will be eroded in the long run such that the net effect will not support inequality reduction theory.

In capturing the non-linear hypothesis and GDP per capita for economic activity, FDI does not have a significant impact on inequality in the short run. However, even though in the long run it reduces inequality, there is a turning point after which further increases in FDI will widen income inequality. This implies that when the inward FDI stock ratio to GDP rises beyond 2,8% it will worsen income inequality. When including education, a similar U-shaped relationship between FDI and inequality is found in the long run. The turning point is estimated at a ratio of 6,91% which implies that when the inward FDI stock ratio to GDP rises beyond 6,9% it will worsen income inequality. Education will reduce income inequality while GDP worsens it. However, after controlling financial development, education no longer decreases income inequality. This is not being pro-poor. Instead, it is rather an indication of movement towards growth and technologies. It is the exacerbation of income inequality that makes the poor worse off.

Considering financial sector development, the U-shaped relationship between FDI and inequality in the long run persists. Financial development seems to decrease income inequality while both education and GDP per capita are associated with increasing inequality. While education is theoretically expected to improve the distribution in any economy, there is no evidence that this holds true for Africa.

FDI may have resulted in skill-biased employment that further increases the gap between the rich and the poor. Furthermore, FDI may be dominated by resource-seeking FDI that is exploitative in nature and that creates limited linkages with the entire economy. Income inequality may further worsen if mergers and acquisitions – as opposed to green-field investment – dominate FDI activities. Therefore the type and nature of FDI activities can also influence the distribution effect of FDI. Although FDI may be beneficial to economic development, there is great concern that FDI may also widen skill inequality and exacerbate income inequality as a result. The findings of a U-shaped effect of FDI on income inequality are contrary to these a priori expectations, which could very well contribute to Africa’s inherent issues of capacity constraints and a weak industrial base.

FDI may have resulted in skill-biased employment that further increases the gap between the rich and
the poor.

When human capital augments FDI, it has the potential to improve the distribution of income and secondary education, which has a significant impact on income inequality. FDI tends to induce employment bias towards skilled labour. This implies that the poor are less likely to benefit from the resulting increase in employment.

A minimum threshold level of human capital is therefore required to realise technological transfers and certain spill-over gains. The reality is that Africa’s skills development, which allows the labour market to make use of new technologies, is weak.

It is therefore not surprising that FDI as a development policy instrument has worsened income distribution in Africa. Inequality will increase when the development process of developing countries is driven by highly industrialised multinational corporations. This will happen as long as African countries remain dependent on these activities that engage in capital-intensive production.

Furthermore, FDI may be dominated by resource-seeking FDI that is exploitative in nature and that
creates limited linkages with the entire economy.

Policy strategies that are geared towards investment in human capital could increase the supply of skilled labour and thereby improve the distribution effects of FDI. The resulting increase has the potential to invert the current U-shaped curve. By encouraging FDI to target both ends of the labour market, skilled and unskilled, the benefit would be the greatest in diminishing the gap in income inequality.

Charles Adjasi is a professor in Development Finance at the University of Stellenbosch Business School. His areas of expertise include the development of financial markets in Africa, international trade dynamics, economics, firm productivity and foreign direct investment.
Dr Theresia Kaulihowa is head of Economics at the University of Namibia, with expertise in the field of financial economics.

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