Do types of foreign capital matter for income equality?

• Date: 01 December 2020
• Author: Inmee Baek,Andrew Chia
• DOI: http://doi.org/10.1111/twec.12984
• Published date: 01 December 2020

World Econ. 2020;43:3243–3261. wileyonlinelibrary.com/journal/twec

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3243

© 2020 John Wiley & Sons Ltd

Received: 10 June 2019

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Revised: 2 February 2020

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Accepted: 13 April 2020

DOI: 10.1111/twec.12984

ORIGINAL ARTICLE

Do types of foreign capital matter for income

equality?

InmeeBaek1

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AndrewChia2

1Department of Economics, Suffolk University, Boston, MA, USA

2School of Engineering and Applied Sciences, Harvard University, Cambridge, MA, USA

KEYWORDS

financial integration, foreign direct investment, globalisation, income inequality

1

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INTRODUCTION

Deeper financial integration and increased trade between economies over the last decades have co-

incided with an exacerbation of income inequality, and a concentration of wealth. The distributional

impact of economic globalisation is thus at the centre of debates around the world. Even though there

has been extensive research in identifying linkages between income inequality and trade, the role of

financial integration in influencing inequality is far less well-studied. In particular, studies on different

channels in financial integration are very limited. In this study, we attempt to answer the following

questions: in financial globalisation, do different types of foreign capital have different distributional

impact? If so, what type of capital exacerbates or reduces income inequality?

Analysis of economic globalisation is centred on trade openness and financial integration. This

paper examines how the degree of financial integration and composition of different types of foreign

capital shapes inequality. Previous studies on this issue have mostly used a composite measure of

financial openness and often suggest mixed findings on the link between financial globalisation and

income inequality. If different channels of financial integration have contrasting impact on income

inequality, then the failure to differentiate them will result in incomplete inferences on the re-distribu-

tional implications of cross-border capital integration.

The present study expands on the existing literature in the following ways. First, our empirical ex-

ercise focuses on the composition of cross-border capital, such as direct investment, portfolio invest-

ment and debt. Other studies have tended to include all the different types of foreign capital, expressed

as a fraction of GDP, together in the same specification.1 We depart from this by examining each type

of foreign capital individually and express them as a fraction of overall financial integration, which we

also separately control for. This allows us to differentiate the impact of changes in composition of

cross-border capital flows from a general increase in the degree of financial integration. Second, our

analysis classifies different types of foreign capital by their instrument—debt and equity—and by

1For example, see Jaumotte et al. (2013), Asteriou et al. (2014), and Gozgor and Ranjan (2017).

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BAEK And CHIA

function. Furthermore, we depart from the majority of existing literature by employing dynamic panel

data methods as opposed to a static panel, to capture the dynamic impact of financial globalisation on

income inequality.

The main finding of our empirical study is that different types of foreign capital have contrasting

distributional effects, and thus, the make-up of foreign capital matters in income inequality. For exam-

ple, financial integration through a greater share of debt-creating capital increases income inequality.

A higher dependency on direct investment in total financial integration has a significantly beneficial

impact on income distribution; the converse is true for loans and credit, while the share of portfolio

investment has no significant effect. This contrasting result could account for the ambiguous distribu-

tional effect of aggregated financial globalisation. Additionally, we find that trade openness increases

income inequality in advanced economies but reduces it in emerging economies. Moreover, domestic

factors such as education, technology intensity in production, economic structure, depth of financial

market and fiscal policy have a significant effect on income inequality.

The remainder of the paper proceeds as follows. Section 2 covers the literature review, followed by

the model and data in Section 3. Section 4 presents our empirical results. Section 5 concludes.

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LITERATURE REVIEW

Globalisation is multi-faceted, reflecting economic, social, cultural and political aspects.2 We focus

on the consequences of globalisation on income distribution primarily influenced by increased eco-

nomic integration. There has been extensive study of the distributional impact of economic integration

through increased trade openness, both empirically and theoretically. However, there is still contro-

versy surrounding the impact of trade openness on inequality across both advanced and developing

economies, with empirical findings conflicting with theoretical predictions.

Traditional theory assesses the impact of trade on income inequality through the framework of

comparative advantage analysis in the Heckscher–Ohlin model and the Stolper–Samuelson theorem.

Together, they predict that trade globalisation will see countries which have a comparative advantage

in low-skilled labour, such as emerging economies, experience growth in their low-skilled, labour in-

tensive industries. This will benefit workers in such industries, and thus, developing countries should

see a reduction in income inequality from increased trade. Conversely, countries with a comparative

advantage in high-skilled labour and capital such as advanced economies will experience a rising in-

come inequality in response to increasing trade globalisation. However, some empirical studies from

the 1990s conflict with the prediction that trade integration would lead to lower income inequality in

developing countries. During the period, trade integration and income inequality grew in tandem in

many developing countries. In response, a number of new theories have been developed to explain

why increased trade is associated with increased income inequality in developing countries. These

include theories on the skill premium, heterogeneous-firms monopolistic competition, skill-based

technology change and labour market frictions.3

2In developing ‘The KOF index of globalisation’, Dreher (2006) defines globalisation as the process of creating networks of

connections among actors at multi-continental distances, mediated through a variety of flows including people, information

and ideas, capital and goods. An extensive survey of the studies using the KOF index is included in Potrafke (2015). The

KOF index was revised by Gozgor (2018). Using the revised KOF index, the role of globalisation is examined in explaining a

wide range of economic issues such as economic growth (Gozgor, 2018), taxation (Jha & Gozgor, 2019) and social

expenditures (Potrafke, 2019).

3For a survey of the link between trade and income inequality, see Harrison et al. (2010).