FDI and Income Inequality—Evidence from Latin American Economies

• Author: Philipp Hühne,Dierk Herzer,Peter Nunnenkamp
• Date: 01 November 2014
• DOI: http://doi.org/10.1111/rode.12118
• Published date: 01 November 2014

FDI and Income Inequality—Evidence from Latin

American Economies

Dierk Herzer, Philipp Hühne, and Peter Nunnenkamp*

Abstract

This paper analyzes whether foreign direct investment (FDI) has contributed to the wide income gaps in

Latin America. Panel cointegration techniques as well as regression analysis are performed to assess the

impact of inward FDI stocks on income inequality among households in Latin American host countries.

The panel cointegration analysis typically reveals a significant and positive effect on income inequality.

There is no evidence for reverse causality. The findings are fairly robust to the choice of different estima-

tion methods, sample selection and the period of observation.

1. Introduction

Latin America stands out as “the most economically unequal region in the world.”1

Trends since the turn of the century reveal, however, that income inequality has

declined throughout the region—which is in striking contrast to widening income gaps

in Asia, notably in China and India (López-Calva and Lustig, 2010). At the same

time, Latin America reported a stronger increase in foreign direct investment (FDI)

than developing Asia since the 1990s. United Nations Conference on Trade and

Development (UNCTAD) data reveal that inward FDI stocks in Latin America were

less than one third of Asia’s inward FDI stocks in 1990. During the 2000–2011 period,

Latin America hosted FDI in the order of half the Asian FDI stock. Measuring FDI

as a percentage of GDP, Latin America became even more attractive than Asia.2

Conventional wisdom suggests that recent trends in inequality and FDI might

support economic growth in Latin America. Several studies have found that higher

inequality tends to retard growth in developing countries (Barro, 2000), even though

the empirical evidence is far from conclusive. FDI is widely believed to spur economic

growth in the host countries as it brings superior technologies and know-how in addi-

tion to foreign capital (e.g. OECD, 2002). Even globalization critics, including Stiglitz

(2000), find the case for FDI compelling.

Against this backdrop, it is not surprising that income redistribution (e.g. through

poverty reduction programs) as well as FDI promotion figure high on the agenda of

policymakers in Latin America. It has received only scant attention that this agenda

may involve a dilemma. Specifically, the promotion of inward FDI may undermine

efforts to narrow income gaps through redistribution if FDI leads to greater inequal-

ity in the host country.

The relationship between FDI and income inequality is theoretically ambiguous.

Moreover, previous empirical evidence for developed host countries, notably the

* Nunnenkamp: Kiel Institute for the World Economy, Kiellinie 66, 24105 Kiel, Germany. Tel: +49-431-

8814-209; Fax: +49-431-8814-500; E-mail: peter.nunnenkamp@ifw-kiel.de. Herzer: Helmut-Schmidt-

University, Holstenhofweg 85, 22043 Hamburg, Germany. Hühne: Helmut-Schmidt-University,

Holstenhofweg 85, 22043 Hamburg, Germany. The authors thank two anonymous reviewers for helpful

comments and suggestions.

Review of Development Economics, 18(4), 778–793, 2014

DOI:10.1111/rode.12118

© 2014 John Wiley & Sons Ltd

United States, does not necessarily hold for less advanced Latin American host coun-

tries. Therefore, we perform panel cointegration analyses to assess the distributional

effects of inward FDI in Latin American countries since the early 1980s. We find that

higher inward FDI stocks typically widen the income gaps in Latin American host

countries.

2. Theoretical Background and Previous Findings

The theoretical literature on inward FDI departs from the observation that multina-

tional enterprises (MNEs) possess firm-specific assets such as technological knowl-

edge and management skills, granting them a productivity advantage over domestic

firms in the host country. The heterogeneous firm model of Helpman et al. (2004) pre-

dicts that only the most productive firms engage in FDI to serve foreign markets.

Ownership advantages are required to overcome the “liability of foreignness”, i.e. the

lacking familiarity with conducting operations in the home market of local firms

(Markusen, 1995).

It is consistent with the productivity advantages of MNEs that they are generally

found to pay higher wages than local firms (Aitken et al., 1996; Lipsey, 2002). More

specifically, MNEs may pay higher wages to discourage worker turnover. Importantly,

a review of the empirical literature reveals that “almost all evidence shows that FDI

and foreign ownership are associated with higher wages for all types of workers”

(Overseas Development Institute, 2002, p. 2; emphasis added).

This evidence suggests that the fierce competition for FDI among potential host

countries in Latin America and elsewhere does not necessarily undermine efforts at

reducing income inequality. FDI would even support such efforts in a Heckscher–

Ohlin framework. In such a framework, FDI inflows resemble trade liberalization in

that the relatively abundant factor of production would benefit. Latin America is

often assumed to be abundant in less skilled labor (Robertson, 2000). By contrast,

more advanced countries with an abundant supply of skilled labor are the principal

sources of FDI in Latin America. Consequently, FDI from advanced countries in

Latin America would increase income inequality in the source countries and reduce

income inequality in the host countries.

Theoretical predictions become more complex when refining the ranking of skill

intensities. Sorting MNE activities by skill intensity, Markusen and Venables (1997)

consider headquarter (HQ) services to be more skill intensive than plant operations

by MNEs. Domestic firms producing for the local market are least skill intensive and

rank at the bottom of this classification. It has also to be taken into account that coun-

tries hosting plant operations by foreign MNEs may, at the same time, be home to

HQ services of domestic MNEs. The establishment of foreign plant operations

through FDI may then reduce the relative demand for skilled labor in the host

country. This is most likely to happen where the HQ services of various domestic

MNEs have traditionally shaped the demand for skilled labor. Inward FDI in the

USA may be the most obvious case in point (Blonigen and Slaughter, 2001). Low-

income countries lacking HQ services of domestic MNEs tend to be at the other end

of the spectrum of host countries; for them inward FDI is most likely to increase the

average skill intensity of production. Latin American host countries range in the

middle ground. Several countries in the region increasingly emerged as home bases of

domestic MNEs in the more recent past (e.g. Chudnovsky and López, 2000). Theo-

retical predictions on the distributional effects of inward FDI become more ambigu-

ous under such conditions.

FDI AND INCOME INEQUALITY 779

© 2014 John Wiley & Sons Ltd