The effect of foreign direct investment on inequality: The case of

South Africa

Pumela Msweli

Research assignment presented in partial fulfilment

of the requirements for the degree of Master
of Philosophy in Development Finance
at Stellenbosch University

Supervisor: Professor Charles Adjasi

Degree of Confidentiality: A March 2015

 Stellenbosch University http://scholar.sun.ac.za

Declaration
I, Pumela Msweli, declare that the entire body of work contained in this research assignment is my
own, original work; that I am the sole author thereof, that reproduction and publication thereof by
Stellenbosch University will not infringe any third party rights and that I have not previously in its
entirety or in part submitted it for obtaining any qualification.

P Msweli

Copyright © 2015 Stellenbosch University

All rights reserved

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Acknow ledgements

I want to express my gratitude to everyone who has helped in making it possible to

accomplish this piece of work. A big thank you to Prof Azakiapono, Mr Marwa and Mr Tita
Fomum for encouragement and guidance.

I am most grateful to my supervisor, Prof Charles Adjasi, for all the help provided to make it possible
to complete this work. Thank you Debbie and Norma for your constant help when all seemed to go
wrong. I would also like to pay tribute to my late dad who continues to be a source of inspiration in my
life. To my mom, my brother Themba and his wife Nonhlanhla, and my sister Rachael, thank you for
being there for me.

Lastly, my deepest love and gratitude goes to my husband Enock, and our children - Lusanda, Bantu,
Unati, Lulu and our little puppy Kush - for your unconditional love, unwavering support and
encouragement. You are the fire that ignites my passion for new knowledge.

This work is dedicated to late Henry Mkhize who made sure, before he passed on, that I am registered
for the development finance programme.

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Abstract
This work empirically examines South African data covering the years 1956-2011 to look into the
relationship between FDI and inequality. By investigating how FDI is linked to inequality, policy makers
would be better poised to develop policies that optimise on the benefits of FDI without the dampening
effect of inequality. The benefits of FDI, particularly to the South African economy, are that it provides
capital to finance investment by bridging the savings gap in the country. In addition to that, FDI
facilitates transfer of technology and managerial skills from the source country. Moreover, FDI has a
positive impact on balance of payment not only because of the impact capital inflow has on balance of
payment, but because FDI also promotes exports of the country to world markets. Empirical evidence
presented in literature suggests that the FDI-inequality relationship is complex. In some locations, for
example in the US, Latin America and in some developing countries, FDI tends to raise income
inequality. In other locations evidence is inconclusive.

The results of this study showed that there is a negative relationship between inequality and foreign
direct investment for the period examined in the study. This finding is not consistent with the a priori
expectation that foreign direct investment increases inequality. Contrary to what has been predicted,
the findings show that foreign direct investment is likely to reduce inequality. The findings also show
that there is a statistically significant and positive relationship between GDP and inequality.

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Table of Contents

Declaration..................................................................................................................................ii
Acknowledgements ................................................................................................................ iii
Abstract ....................................................................................................................................... iv
CHAPTER 1: INTRODUCTION ................................................................................................ 1
1.1 BACKGROUND ............................................................................................................................ 1
1.2 PROBLEM STATEMENT ........................................................................................................... 2
1.3 RESEARCH OBJECTIVES .......................................................................................................... 2
1.4 RESEARCH HYPOTHESIS......................................................................................................... 2
1.5 CLARIFICATION OF KEY CONCEPTS.................................................................................... 3
1.5.1 Foreign Direct Investment (FDI) ............................................................................................. 3
1.5.2 Inequality ............................................................................................................................................ 3
1.6 RESEARCH DESIGN ................................................................................................................... 4
1.7 CHAPTER OUTLINE................................................................................................................... 4
1.8 SUMMARY .................................................................................................................................... 4
CHAPTER 2: LITERATURE REVIEW ..................................................................................... 5
2.1. INTRODUCTION ........................................................................................................................ 5
2.2. THEORETICAL FRAMEWORK ............................................................................................... 5
2.3. EMPIRICAL LITERATURE ...................................................................................................... 6
2.3 1 FDI , Economic Growth and Human Capital ....................................................................... 6
2.3.1 Inequality and FDI .............................................................................................................................. 8
2 . 4 . SUMMARY ............................................................................................................................. 10
CHAPTER 3: FOREIGN DIRECT INVESTMENT AND INEQUALITY TRENDS IN SOUTH AFRICA
...................................................................................................................................................... 11
3.1 INTRODUCTION ...................................................................................................................... 11
3.2 FOREIGN DIRECT INVESTMENT TRENDS....................................................................... 11
3.2.1 International and regional trends ............................................................................... 11
3.2.2 The South African context ............................................................................................... 13
3.3 INEQUALITY TRENDS ........................................................................................................... 14
3.3.1 International and regional context.............................................................................. 14
3.3.2 South African Context ....................................................................................................... 16
3.4 SUMMARY ................................................................................................................................. 19
CHAPTER 4: RESEARCH METHODOLOGY ...................................................................... 20
4.1 DATA DESCRIPTION .............................................................................................................. 20
4.2 VARIABLES AND A PRIORI EXPECTATIONS .................................................................. 20
4.3 MODEL SPECIFICATION ....................................................................................................... 20
4.4 MODEL ESTIMATION .............................................................................................................. 21
4.5 SUMMARY ................................................................................................................................. 22
CHAPTER 5: FINDINGS AND DISCUSSION....................................................................... 23
5.1 Unit Root Test Results.............................................................................................................. 23
5.2 Johansen Cointegration Results ........................................................................................... 23

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List of tables
Table 1: Female Share of Wage Income (thousands) excluding agriculture, 1996-2010 ..................................... 17
Table 2: Variables, Data Source and a priori expectations ................................................................................... 20
Table 3: Descriptive Statistics ............................................................................................................................... 22
Table 4: In Level and 1st Difference Series .......................................................................................................... 23
Table 5: Johansen Maximum Likelihood Cointegration ......................................................................................... 24
Table 6: Cointegration Regression Statistics......................................................................................................... 24

List of Figures
Figure 1: FDI Inflows by Region, 2010-2012 ........................................................... Error! Bookmark not defined.
Figure 2: FDI inflows (Billions of dollars) ................................................................. Error! Bookmark not defined.
Figure 3: South Africa - Direct Inflows ..................................................................... Error! Bookmark not defined.
Figure 4: South Africa's Growth National Savings in comparison to peer SADC region countries ................. Error!
Bookmark not defined.
Figure 5: Income share - top ten percent ................................................................ Error! Bookmark not defined.
Figure 6: Average Income per adulty for selected countries ................................................................................ 15
Figure 7: Gini Coefficient of South Africa in comparison to selected Southern African Countries ........................ 16
Figure 8: Gini Coefficient of South Africa from 1992-2008 .................................................................................... 16
Figure 9: GDP per capita (2010, R million) by Province ........................................................................................ 17
Figure 10: Gini Coefficient for non-income inequality for South Africa .................... Error! Bookmark not defined.
Figure 11:Actual, Fitted, Residual Graph ................................................................ Error! Bookmark not defined.

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CHAPTER 1

INTRODUCTION
1.1 BACKGROUND

This work looks at the effect of foreign direct investment on inequality in South Africa. South Africa is
chosen as a case study because of its unique political and economic experience. Firstly, South Africa
emerged out of a comprehensive apartheid system of institutionalised racial oppression where the
indigenous people were disposed of their land and its wealth. Secondly, when South Africa opened its
economy in the 1990’s an increase in inequality was registered. Gini Coefficient increased from 59,3
in 1992 to 63.13 in 2008 (World Bank 2013). As will be discussed later, this increase coincides with a
surge in foreign direct inflow in the country. While the impact of the apartheid system on inequality is
indisputable, it is not clear whether foreign direct investment has an effect on inequality or not.

Foreign direct investment (FDI) research in the context of Sub Saharan Africa has often been looked
at in relation to its determinants and economic impact (see for example Anynwu, 1998; Barthell, Busse
and Osei, 2008; Enu, Havi, and Attah-Obeng, 2013; Fredderke and Romm, 2006; Luiz and Stephan,
2011). There are hardly any studies that look at the relationship between FDI and income inequality
from the perspective of any of the subSaharan countries. This is rather surprising given the high
levels of inequality in the region. This study addresses this gap in knowledge by looking at how FDI is
associated with inequality in South Africa. The third reason why South Africa is chosen as a case
study is that it has the highest level of inequality in comparison to other countries in the SubSaharan
region (World Bank, 2013).

Previous studies that looked at the link between income inequality and FDI are based on data from
developing countries (see for example Basu and Guariglia, 2004). Herzer and Nunnenkamp (2011)
investigated issues related to FDI and inequality using data from Europe. Chintrakam, Herzer and
Nunnenkamp (2010) on the other hand looked at the same variables from the angle of the US. Along
the same line Bhandari (2007) looked at the Eastern Asian scenario. The dearth of literature in Africa
relating FDI to inequality is attributed to unavailability of household budget survey for most countries in
the Sub-Saharan region (Okojie and Shimeles, 2006). With the advent of scholarly works on
millennium development goals, inequality data relating to issues of poverty started to emerge in the
region in the past decade or so. By investigating how FDI is linked to inequality in South Africa, policy
makers would be better poised to develop policies that optimise on the benefits of FDI without the
dampening effect of inequality. The benefits of FDI, particularly to the South African economy, are that
it provides capital to finance investment by bridging the savings gap in the country. In addition to that,
FDI facilitates transfer of technology and managerial skills from the source country. Moreover, FDI has

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a positive impact on balance of payment not only because of the impact capital inflow has on balance
of payment, but because FDI also promotes exports of the country to world markets.

1.2 PROBLEM STATEMENT

The downside of the economic reform process that saw an upswing in DFI inflows in South Africa from
1996 to 2012 coincides with the jobless growth that entrenched the dualistic nature of the South
African economy. The question that arises is whether DFI inflows have a negative spill-over effect that
widens income inequality or not. While literature abounds with evidence of positive growth effects of
FDI arising from technology transfer or knowledge spillovers (Basu & Guarglia 2007; Blomstrom and
Kokko, 2007; Byraktar 2013; Nanda, 2009), there have not been sufficient studies that look at how FDI
is linked to income inequality in the context of economic reforms that took place in South Africa post
1994. Blomström and Kokko (2007) however recognised the possibility that FDI contributes to income
inequality. Their argument is based on the fact that, from a developing country perspective, the initial
human capital capacity does not usually match the technology requirements of foreign companies
investing in a host country. It is argued that this mismatch in human capital could further exercebate
the income inequality, as foreign investors introduce new technology in the host country. It is on that
basis that this study explores the relationship between FDI and income in the context of the
macroeconomic factors at play in South Africa. Conceptually and empirically, FDI has been positively
linked to inequality (see for Herzer and Nunnenkamp, 2011; Basu and Guariglia, 2007; Bhandari,
2007). This study seeks to determine whether the interaction between inequality and FDI holds in the
South African data.

1.3 RESEARCH OBJECTIVES

The objective of the study therefore is to establish the effect of FDI on income inequality using South
African data.

1.4 RESEARCH HYPOTHESIS

On the basis of conflicting evidence provided in literature (Basu & Guariglia, 2007; Bayraktar, 2013;
Bhandari, 2007; Mottalab and Kalirajan, 2010, Velde, 2003) on the relationship between FDI and
income inequality this study postulates that FDI inflow has a positive relationship with income
inequality:

H0: FDI has no effect on income inequality

H1: FDI has a positive relationship with income inequality

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1.5 CLARIFICATION OF KEY CONCEPTS

1.5.1 Foreign Direct Investment (FDI)

Foreign Direct Investment as defined by the United Nations Conference on Trade and Development is
a type of investment that reflects capital transaction(s) between the ‘direct investor’ and ‘investment
enterprise’ resident in an economy other than that of a foreign direct investor (UNCTAD, 2006).
According to the Organisation for Economic Cooperation and Development (OECD, 2013), a direct
investor may be an individual, an incorporated or unincorporated private or public enterprise, a
government, a group of related individuals, or a group of related incorporated and/or unincorporated
enterprises which have a direct investment enterprise. A ‘direct investment enterprise’ on the other
hand is an incorporated or unincorporated enterprise in which a foreign investor has economic
interests in the incorporated/unincorporated enterprise.

There are two categories of FDI: horizontal FDI and vertical FDI. Horizontal FDI is an investment
made for conducting similar business operations as already operated by the foreign investor in
different nations. Horizontal FDI is usually a market expansion strategy of the investing company into
economies that exhibit high growth potential. Vertical FDI on the other hand refers to those entities
that disintegrate the production process vertically by outsourcing some production stages with different
input requirements (for example capital and/or labour costs) for purposes of maximising profit margins.
In the case of vertical FDI, goods are not produced for sale to the country receiving FDI, but for export
purposes.

1.5.2 Inequality

Economists have a number of views on inequality. One school of thought is that inequality reflects
differences in talents and choices, as such, should not be viewed as a problem. According to
Friedman and Friedman the notion of reducing inequality would work against the market mechanism
to generate outputs efficiently, and would have a dampening effect on economic growth. Kuznets
(1955) puts forward a contention that there is a long-term relationship between income inequality and
the development process based on changes in the structure of different sectors in the economy.
According to Kuznets, in the early stages of industrialisation, inequality increases as productivity and
income increases in the cities following the migration from rural areas to cities. In the long-term, as
argued by Kuznets, inequality diminishes as agriculture becomes mechanised, as this results in a
declining proportion of the population engaged in the industrial sector.

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1.6 RESEARCH DESIGN

This study attempts to get a deeper understanding of the link between FDI and inequality and to clarify
the causality between the two variables. For this purpose the study develops a single error correction
equation model with the Engle–Granger (1987) two-step method. The error correction model (ECM) is
a time series regression model that is based on the behavioural assumption that two or more time
series exhibit an equilibrium relationship that determines both short-run and long-run behaviour
(Brooks, 2008). Engle and Granger (1987) demonstrated that cointegrated time series are well
represented by an error correction model (ECM).

1.7 CHAPTER OUTLINE

The rest of the dissertation is structured as follows. Chapter 2 presents the theoretical framework of
the study as well as literature that links FDI and inequality. Chapter three provides a context for this
study and looks at economic development as well as FDI and inequality trends in South Africa. The
methodological aspect of the study is covered in Chapter four. Chapter five deals with the empirical
analysis. Chapter 6 concludes the dissertation.

1.8 SUMMARY

This Chapter lays the foundation for this dissertation by first discussing the purpose of the dissertation,
followed by the exposition of the problem statement. The research objectives were presented together
with hypothesis that the study seeks to address. The key concepts, that is FDI and inequality, were
defined and the design of the study was presented. The study was justified and the structure of the
dissertation was outlined. On these foundations, the dissertation proceeds with the theoretical basis of
the study in the next Chapter.

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CHAPTER 2

LITERATURE REVIEW

2.1. INTRODUCTION

The purpose of this study as mentioned in the preceding chapter is to develop a single error correction
equation model with the Engle–Granger (1987) two-step method. This Chapter therefore, seeks to
build a theoretical foundation upon which the model is built. As such, the chapter is divided into parts.
Section 2.2 presents a brief description of the theoretical model. Empirical literature related to the
theoretical framework is covered in section 2.3.

2.2. THEORETICAL FRAMEWORK

Two key variables of concern in this study are inequality and foreign direct investment. As explained in
Chapter 1, FDI is heterogeneous, and is undertaken by investors either as a means of selling to
foreign markets (horizontal FDI) or to take advantage of inter-country differences such as labour costs
and/or capital costs that would maximise profit margins (vertical FDI). This study builds on previous
work that has looked at the relationship between foreign direct investment and inequality. For
example, Herze & Nunnenkamp, 2011 as well as Velde, 2003 found that FDI tends to increase
inequality in a host country. Notwithstanding the positive relationship between FDI and inequality as
observed by a number of authors (including Basu & Guariglia, 2007; Herzer & Nunnenkamp, 2011;
Feenstra and Hanson, 1997; Figini and Görg, 2006; Taylor & Driffield, 2005), there are theoretical
ambiguities. Bhandari (2007), as will be discussed later, found that there is no evidence of positive
effect of FDI on income inequality. Chintrakam, Herzer and Nunnenkamp (2010) on the other hand
found that FDI at the state level reduced income inequality.

Empirical studies that address the relationship between FDI and inequality in the context of
subSaharan Africa are scarce. In line with Bhandari (2006), Figini & Görg (2006), and Velde (2003),
this study puts forward the hypothesis that as foreign direct investment flows in a dualistic economy,
the demand for skilled labour increases, thus creating a surplus of unskilled workers in the economy.
This surplus has an impact on employment rates and invariably on income inequality. Although the
theoretical underpinnings of the relationship between inequality and FDI in this study are based on
Figini and Görg’s (2006) work, there are other contending views as will be discussed later. Figini and
Görg (2006) work is based on a production structure model in which output Y is produced using inputs
x and labour L as factors of production.

{∫ } 1/α (1)

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Output Y is produced using inputs x in country i, using labour as the only factor of production. The
parameter A represents production technology where A = 1, if old technology is used; and A increases
when new technology is adopted. This conceptualisation is based on the assumption that when the
economy uses old technology it uses unskilled workers. As the economy adopts new technology from
FDI related activities, the demand for skilled workers increases. Consequently, the economy shifts
from old to new technology. Figini and Görg (2006) postulate that the technology adoption leads to two
stages of development and inequality. In the first stage the economy is adopting change, as such
there is no difference in the wages paid to skilled and unskilled employees. In the second stage the
demand of skilled labour increases as economies successfully adopt new technology. Accordingly, the
demand for skilled labour increases resulting in a segmented labour market, in which skilled labour is
paid a higher wage, thus driving inequality.

This study also takes into account te Velde’s (2003) conceptualisation which identifies three
determinants of income inequality: (1) the distribution of factors of production; (2) the demand for
those factors and (3) the supply. Distribution of education in a dualistic economy such as South Africa
is characterised by the poor with low income and low levels of human capital and the wealthy with high
income and often with high levels of human capital. The demand for the factors of production in this
scenario is characterised by the demand for skilled workers.

2.3. EMPIRICAL LITERATURE

2.3 1 FDI, economic growth and human Capital

Fedderke and Romm (2006) used Vector Error Correction Model to estimate both the growth impact of
FDI and the determinants of FDI using annual series data from South Africa from 1960-2002. The
authors found that while the growth impact of FDI is positive for South Africa, there is a spill-over effect
of FDI on capital and labour which impact on output in the long run. The findings also showed that FDI
in South Africa is capital intensive suggesting that FDI has been horizontal rather than vertical (2006:
758). Using the Error Correction Model (ECM) Akinlo (2004) looked at how FDI is linked to economic
growth in Nigeria. The findings showed that FDI in Nigeria has a positive effect on growth after a
considerable lag. The results also show that extractive FDI might not be growth enhancing as
manufacturing FDI.

Noorbaksh, Paloni, and Youssef (2001) introduce a link between human capital development and FDI
inflow. Human capital reflects the accumulated skills, experience and education of the workforce in an
economy. The Organisation of Economic Co-operation and Development (OECD, 1998), also defines
human capital as “the knowledge, skills, competences and other attributes embodied in individual that
are relevant to economic activity”.

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Noorbaksh, Paloni, and Youssef (2001) established that FDI evolves in response to the acceleration in
the globalisation process. This line of argument is buttressed by Ogunade’s (2011) findings that link
economic development to human capital investment. In his work, Ogunande (2011:4) cites Levine,
Renelt & Esfahani’s study that showed a strong relationship between the increase in export/GDP
ration and economic growth. Noorbaksh, Paloni, and Youssef (2001) investigated the link between
human capital and the flow of FDI. Their study used data from 36 developing countries in Asia, Africa
and Latin America from 1980 to 1994. Their findings showed that Human Capital is significant
determinant of FDI inflows. It is on that basis that this study seeks to investigate how FDI inflow is
linked to human capital development. What is not clear from Noorbaksh et al’s findings is the causal
direction of the link between FDI inflow and human capital development.

A study conducted by Baldacci, Clements, Gupta, and Cui (2004) focused on the role of human capital
in fostering economic development in the context of millennium development goals. Baldacci,
Clements, Gupta, and Cui’s (2004) study looked into direct and indirect channels linking social
spending, human capital, and growth. The study showed that both education and health spending
have a positive and significant direct impact on the accumulation of education and health capital, and
thus can lead to higher economic growth. This, taken together with the OECD’s notion of human
capital development, means that one can expect human capital development to be positively linked
with economic growth. Such an argument is strengthened by a number of findings that support the
positive link between growth and FDI inflow (see for example Ljungberg and Nilsson 2005; Morisset,
1999; Fredderke and Romm, 2006). Similar to the link between human capital development and FDI,
literature does not provide conclusive evidence about the causal direction of human capital
development and growth. For example, Madariag and Poncent (2006) found that strong growth can
positively impact on FDI inflow but FDI inflow does not necessarily result in growth.

The relationship between growth and inequality is complex because while inequality has been found to
have a negative impact on growth it is built into the functioning of market economy and the incentives
needed for investment and economic growth. This complexity is manifested in myriad theoretical
strands that depict different nuances of the relationship between inequality and growth. For example
there are theoretical strands that show that inequality can cause political and economic instability,
consequently reducing the pace of growth (Berg and Ostry, 2011; Ostry, Berg, and Tsangarides,
2014). Ostry et al (2014) distinguish between market inequality (inequality before taxes and transfers)
and net inequality (inequality after taxes and transfers). The authors found that net inequality is
strongly correlated with faster growth. Another theoretical strand emerging from literature is that, when
wage income lags behind GDP per capita, income inequality widens (Van Zanden, Baten, Foldvari
and Van Leeuwen (2011). Following the same line of thought, if wage income grows faster than GDP

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per capita, income inequality is likely to decline. Milanovic (1995) on the other hand argues that initial
inequality can have a permanent effect on a country’s growth. Basu and Guarglia have the same view
as Milanovic although their focus is more on initial inequality of human capital. Building on Berg and
Ostry’s (2011) work that found that equality is associated with longer spells of growth, this study
predicts that inequality is negatively linked to growth.

2.3.1 Inequality and FDI

Literature provides different definitions and measures of inequality. For example Milanovic (2005)
identifies three types of inequality: (1) unweighted international inequality measured by GDP per
capita; (2) population weighted inequality also measured by GDP per capita; and (3) inequality across
all individuals in the world, where unit of analysis is not a country but an individual. Milanovic is of the
view that once inequality sets in a country as a result of globalisation and modernisation effects it
cannot be reversed. It is permanent. Okojoe and Shimeles (2006) on the other hand consider seven
levels of inequality including: (1) income/expenditure inequality; (2) asset inequality; (3) education
inequality; (4) inequality in health and nutrition; (5) inequality in use of public services; (6) labour
market inequalities; and (7) multidimensional inequality. The multidimensional inequality indicators as
pointed out by Okojoe and Shimeles (2006) include education, access to primary school, access to
secondary school, access to potable water, access to health services, nutrition variables, type of
habitation, energy and communication. The multidimensional construct converges with McKay’s
(2002) notion that inequality reflects the lifestyles across populations. The indicators of lifestyles and
living standards include public and private assets which literature also refers to as indicators of non-
income inequality (Bhorat, can der Westhuizen and Jacobs, 2009).

The measures of inequality are as divergent as the different conceptualisations of inequality captured
above. Gini coefficient is one of the several measures of inequality that is commonly used by scholars.
Gini coefficient captures income distribution across households. Wage inequality as well as access to
basic services and private assets has been used to measure inequality.

There is a growing body of literature that supports the contention that as much as FDI inflows have
significant benefits for host countries it has propensity to increase inequality (Herze & Nunnenkamp,
2011; Velde, 2003). For example Velde (2003) found that income inequality is persistently high in most
Latin American countries, labour, specifically the distribution of education and returns to skills seem to
the the driver of income inequality. This view is supported by a number of authors (Leibrandt, Woolard
and Woolard, 1996; Jensen, 1999; Jensen, 1999; and Jenkins and Thomas, 2000). Blomstrom and
Kokko (2007) as well as Basu & Guariglia (2007) account for the income inequality and FDI dynamic
by arguing that technology infusion in economies with high inequalities tends to advantage the rich
more than the poor who have limited or no access to technology. This happens, as explained by Basu

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and Guariglia (2007), because typical unequal societies are characterised by dualistic economies with
two types of agents – the poor with low initial human capital capacity to access technology and the
rich with sufficient initial human capital to access technology brought in through FDI. The tendency to
expand the level of inequality does not diminish the benefit derived from FDI inflows such as
employment creation, economic growth and technology innovation and knowledge spill-overs.

In Chintrakam, Herzer and Nunnenkamp’s (2010) study that looked at FDI and income inequality, the
authors found that there is heterogeneity in the long-run effects of FDI on income inequality across
states with 21 out of 48 states exhibiting a positive relationship between FDI and income inequality. In
a sample of 10 European countries, Herzer and Nunnenkamp (2011) found that FDI has a positive
short-run effect on income inequality. However, the long-run effect of FDI on inequality, unlike the US
sample, was negative. Herzer and Nunnenkamp (2011) found that the long-run causality runs in both
directions, implying that an increase in FDI reduces income inequality, while higher income inequality
leads to lower FDI inflows.

Using a panel of 119 developing countries, Basu and Guariglia (2007) found that FDI promotes both
inequality and growth. Basu and Guariglia (2007) also found a positive relationship between functional
inequality and GDP per capita, exchange rate and trade openness. A somewhat different finding is
observed in the case of Eastern Europe and Central Asia in a study conducted by Bhandari (2007).
Using fixed effects, Bhandari (2007) found that there is no evidence of positive effect of FDI on income
inequality, but when the effect was broken down into its components, FDI exacerbated income
inequality while reducing capital income inequality. Te Velde’ (2003) study that looked at FDI and
income inequality in Latin America found evidence to support the notion that labour income inequality
plays an important role in total income inequality. Te Velde’s (2003) conceptualisation is based on the
distinction between skilled and unskilled labour.

Most of the literature reviewed above provides evidence of the positive relationship between FDI and
inequality. There is also literature that shows that FDI can reduce inequality. For example Mundell
(1957) put forward a contention that an increase of FDI inflows in developing countries leads to
reduction in income inequality. As argued by Mundell, this is possible because FDI inflows increase
the amount of capital in the host country, thus leading to a rise in the marginal physical product of
labour which leads to a rise in both nominal and real wages. An increase in wages results in a decline
in income inequality. In line with Mundell’s (1957) findings, Feenstra and Hansom’s (1997) study that
looked at the effect of FDI on income inequality in Mexico over a period 1975-1988 found that FDI
accounts for a large portion of the increase in the skilled labour share of total wages.

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Mahler, Jesuit, & Roscoe (1999)’s findings on the other hand showed that there is no statistical
significant relationship between FDI and income. This illustrates the complex nature of the
relationship between inequality and FDI. Mah’s (2003) work that captures the Korean experience
also did not find a statistical relationship between FDI and income.

2.4. SUMMARY

The theoretical base of the relationship between inequality and foreign direct investment was
explained. Empirical evidence presented in this chapter suggests that the FDI-inequality relationship is
complex. In some locations, for example in the US, Latin America and in some developing countries,
FDI tends to raise income inequality. In other locations evidence is inconclusive. Other authors, for
example, Milanovic (2005) have strong views about the long-term effects of inequality in a country. In
the long run, FDI seem to exhibit a positive relationship with income inequality.

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CHAPTER 3

FOREIGN DIRECT INVESTMENT AND INEQUALITY TRENDS

IN SOUTH AFRICA

3.1 INTRODUCTION
To contextualise the foreign direct investment inequality debate, this chapter focuses on the key
global, regional and local trends. The first part of the chapter looks at international and regional FDI
trends, followed by the description of the FDI trajectory in South Africa. Along the same vein,
inequality is looked at in the last part of the chapter.

3.2 FOREIGN DIRECT INVESTMENT TRENDS

3.2.1 International and regional trends

The United Nations Conference on Trade and Development (UNCTAD) 2013 report showed that as
the global foreign direct investment fell by 18 percent, investment flows to the African continent
increased by 5 percent (see Figure 3.1).

2012 2011 2010

244
Latin America and the Caribbean 249
190
47
West Asia 49
59
34
South Asia 44
29
326
East and South-East Asia 343
313
407
Asia 436
401
50
Africa 48
44
703
Developing Economies 735
637
561
Developing Economies 820
696

Figure 1: FDI Inflows by Region, 2010-2012

Source: Adapted from the UNCTAD World Investment Report (2013)

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The growth as pointed out in the UNCTAD report, has been driven by FDI inflows in agriculture,
mining, quarrying and petroleum. Unlike FDI flows to agriculture and extractive industries in Sub-
Saharan Africa, the Investment Trends Monitor reported that most BRICS foreign direct investment
projects in Africa are in manufacturing and services (UNCTAD, 2013). FDI inflows to the five major
emerging national economies: Brazil, Russia, India, China and South Africa (BRICS) have also been
reported as having more than tripled to an estimated US$263 billion in 2012 (UNCTAD, 2013).
However, China and Brazil as illustrated in Figure 2, are in the top five host economies. South Africa
showed the largest share of intra BRICS investment.

Canada
Russian Federation
Singapore
Australia
United Kingdom
FDI Inflows (Billions of
British Virgin Islands dollars)
Brazil
Hong Kong, China
China
United States

0 50 100 150 200

Figure 2: FDI inflows (Billions of dollars)

Source: Adapted from World Investment Report (2013)

Pigato (2001, p5) identified six determinants of FDI inflows including: “(1) a favourable FDI
environment; (2) low transaction and business costs; (3) supplier networks and clusters; (4) support
institutions and technical services; (5) human capital; and (6) low cost infrastructure”. Pigato (2001,
p4) points out that the “ownership advantage” paradigm that attracted FDI in the past is being replaced
by “globalisation of production” paradigm. This shift saw China lowering its production and labour
costs, which made it highly attractive to foreign investors. Pigato’s (2001) study concurs with
Morisset’s (1999) study that showed that countries with a favourable and competitive business climate
are able to attract substantial FDI inflows. Using panel data regression, Morisset’s (1999) study found
that strong economic growth and aggressive trade liberalisation can be used to attract foreign
investment.

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3.2.2 The South African context

Macroeconomic factors and political instability in South Africa in the 1970’s and 1980’s resulted in a
decline in foreign direct investment as foreign owned companies were pressured by the host countries
to support the measures to oppose apartheid. A substantial number of foreign investors pulled out
their investments when sanctions were imposed in the 1970’s, to force the apartheid regime to change
the apartheid policies. The political instability in the country culminated in the June 16, 1976 Soweto
uprisings, which caused the UN Security Council to pass a resolution to institute an arms embargo
against South Africa (Kotz, 1995). The institution of arms embargo tipped the scale in favour of the
liberation movement as the apartheid regime felt the pinch of isolation from the international
community. During the same period (1970-1990), the South African economy entered a long-term
period of decline, with the average annual growth in real GDP per capita falling to zero between 1970
and 1979 and hovering around 3.4% between 1980 and 1989 (Tips, 2000). High levels of
unemployment, highly unequal distribution of income, and low levels of growth and investment
became deeply entrenched during this crisis.

FDI Inflows - (US Dollars Current Prices and current exchange rates in
millions)
9500
8500
7500
6500
5500
4500
3500
2500
1500
500
-500

Figure 3: South Africa - Direct Inflows

Source: Adapted from UNCTADSTAT Data Center - http://unctadstat.unctad.org/EN/Index.html

After the political changes that resulted in democratic elections in 1994 the country embarked on
economic reforms that focused on attracting foreign investments to lower the fiscal deficit that was
recorded in the 70’s and late 80s. The economic reforms took the form of trade liberalisation,
deregulations and privatisation of some public enterprises. As Figure 4 shows, South Africa’s gross
national savings lag behind that of its peers in the SADC region. With all the reforms and economic
policy changes post 1994, the country is still trapped in a low growth trajectory that is exercebated by
the industrial action in the platinum-mining subsector. Mining output in 2012 and in the first quarter of

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2014 has contracted with severe effects on GDP growth (South African Reserve Bank, 2014). The
mining obstruction in the face of high unemployment and low national savings signal a peculiar risk
pattern in the economy. This together with the exchange rate volatility post 1994 is enough to make
investors hesitate about committing significant resources to FDI, which explains the FDI volatility post
1994.

Gross National Savings (% of GDP) Botswana

Gross National Savings (% of GDP) Namibia
Gross National Savings (% of GDP) Zambia
Gross National Savings (% of GDP) Mozambique
Gross National Savings (% of GDP) South Africa
41.24 31.13
27.94
40.81
41.42 37.64
41.42 36.19 26.65
35.71
33.75
35.68 30.19 28.38
36.1
29.09
32.87 31.01
26.05 24.44
24.97 21.93 25.45 29.64 26.2
24
23.29 25.24
7.89 13.66 15.22 15.43 13.75
16.89
-0.72 10.81
9.95
-0.9 8.91 10.2 11.65
4.98 7.69 6.12 6.28 5.64 5.73 2.71
15.57 15.33 16.7 15.66 15.04 14.49 14.38 14.27 15.53 15.59 16.61 16.4

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Figure 4: South Africa's Growth National Savings in comparison to peer SADC region countries
Source: Adopted from World Bank Country Statistics (2001-2012)
As reported in the South African Reserve Bank Quarterly Bulleting (2014) FDI in 2014 is concentrated
in manufacturing and telecommunication.

3.3 INEQUALITY TRENDS

3.3.1 International and regional context

The top ten percent of income share was used to gauge how the countries in the list of the most
attractive FDI destination (see Figure 2) compared. As observed in Figure 4, although the US receives
the largest proportion of FDI, its top ten percent of income share is in the bottom of the list followed by
China. Interestingly, even though Canada appeared in the top of the list in Figure 4, it is in the bottom
of the list of the most attractive FDI host countries as observed in Figure 2.

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250

Canada, 39.67
200

Singapore, 41.36

150

Australia, 32.04

100 UK, 37.75

China, 27.94
50

US, 42.76

0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Figure 5: Income share - top ten percent

Source: Adapted from: Alvaredo F., Atkinson T., Piketty T., and Saez E (2014). The World Top
Incomes Database, http://topincomes.g-mond.parisschoolofeconomics.eu/#Database

Average income per adult figures show that Norway has the highest average income per adult
followed by Mauritius. Interestingly both Norway and Mauritius are not in the list of host countries that
attract the most FDI. South Africa has the highest average income per adult compared to Japan.
Singapore, Switzerland, New Zealand, Malaysia and Korea.

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350000
Italy
300000
Japan
250000 Korea
200000 M`l`ysia

150000 Mauritius
New Zealand
100000
Norway
50000
Singapore
0 South Africa
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

Figure 6: Average Income per adulty for selected countries

Adapted from: Alvaredo F., Atkinson T., Piketty T., and Saez E (2014). The World Top Incomes
Database, http://topincomes.g-mond.parisschoolofeconomics.eu/#Database

3.3.2 South African context

Not only does South Africa have the highest levels of inequality in Southern Africa (see Figure 6), the
country’s Gini coefficient increased significantly from 1992-2008 (see Figure 7).

Figure 1: Gini Coefficient of South Africa in comparison to selected Southern African Countries

Uganda (2009)
South Sudan (2009)
Senegal (2011)
Gini Coefficient
Nigeria (2011)
Mali (2010)
South Africa (2009)
0 10 20 30 40 50 60 70
Source: IMF country statistics

Figure 2: Gini Coefficient of South Africa from 1992-2008

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Figure 8: Gini Coefficient of South Africa from 1992-2008

Source: Trading Economics, http://www.tradingeconomics.com/south-africa/gini-
index-wb-data.html

The figures mask the gender, regional and non-income disparities. The Millennium Development Goal
(MDG) country report (2013) showed that while the female to male literacy ratio is one, gender
disparity is more prominent in wage employment income. As Table 1 shows, the wage income share
for females has ranged between 43% and 45% in the period 1996-2012.
Table 1: Female Share of Wage Income (thousands) excluding agriculture, 1996-2010
1996 1999 2005 2010 2012
Male 4191 5300 5509 5802 5929
Female 3227 3987 4216 4652 4929
Female Share 43% 43% 43% 44% 45%
Source: Republic of South Africa MDG Country Report (2013)

As illustrated in Figure 9, Eastern Cape is the poorest province in South Africa in terms of GDP per
capita, followed by Limpopo. While Gauteng is the smallest province in terms of geographical space, it
generates the largest amount of GDP and has the highest GDP per capita, closely followed by the
Western Cape.

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Western Cape

North West

Northen Cape

Mpumalanga

Limpopo
GDP per Capita
KwaZulu-Natal

Gauteng

Free State

Eastern Cape

,0.00 ,20.00 ,40.00 ,60.00 ,80.00 ,100.00

Figure 9: GDP per capita (2010, R million) by Province

Non-income inequality on the other hand is characterised by access to basic services and private
assets (Okojie and Shimeles (2006). In South Africa non-income inequality has been firmly
established in political and economic exclusion that took a colonial and racial form entrenched in the
apartheid system. The 1913 Natives Land Act was an important part of the apartheid system. The Act
was the most effective way of creating inequality as it created a system that deprived the majority of
South Africans the right to own their land. In 1936 the Black Trust and Land Act allocated 13% of
South Africa to Black people who formed 80% of the population. The extent of the impact of the 1913
Act and the 1936 Black Trust and Land is aptly described in the following statement made by de
Villiers (2003, p.46):

“the impact of this policy on the whole social, economic and political fabric of South African
society is impossible to measure; the resentment it caused is too deep to fathom, its scars too
sensitive to touch.”

The Apartheid policies were designed to restrict and severely control access to the economy by black
people. Such control and restriction took the form of job reservation policy that was reinforced by a
vastly inferior education system for black learners. The deliberate denial of access to technical and
scientific teaching and learning had devastating effects on skills of black people in South Africa. On
top of that, apartheid confined the majority of black people to homeland areas, which were not only the
poorest in terms of living conditions but also lacked infrastructure and business opportunities.

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Figure 8 below shows that although overall non-income inequality decreased in South Africa between
1993 and 2005, it was driven mainly by the decrease in income inequality of Blacks.

0.3
Gini Coefficient for non-

0.25
income inequality

0.2

0.15 1993
2005
0.1

0.05

0
African Coloured Asian White Overall

Figure 10: Gini Coefficient for non-income inequality for South Africa
Data sourced from Bhorat, Westhuizen and Jacobs (2009)

There was a marginal difference in non-income inequality amongst coloured people and no difference
registered for the White South Africans between 1993 and 2005.

3.4 SUMMARY

Five key FDI and inequality trends have been observed. Firstly, FDI inflows decreased in developed
countries while an increase was registered in the developing countries in 2012. Secondly, inflows to
the African continent increased by 5% in 2012, while inflows into the BRICS countries tripled in
quantity. Thirdly, while the US was in the top of the list of host countries receiving FDI in 2012, its
average income per adult is lower than a number of countries including South Africa. Fourthly, South
Africa shows a dynamic FDI inflow activity between 1994 and 2012, with a sharp decrease of inflows
registered in 2006. Lastly, gender disparities, geographic and non-income inequality were prevalent in
South Africa. It has been shown that females outnumber the boys with respect to primary school, high
school and tertiary education enrolment. While non-income inequality has decreased in 2005
compared to 2003, income inequality has risen during the same period.

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CHAPTER 4

RESE ARCH METHODOLOGY

4.1 DATA DESCRIPTION

The study empirically examines South African data covering the years 1956-2011 to test the
hypothesis that FDI has a positive relationship with inequality. Continuous and annual income
inequality data is scarce. Most authors use Gini Coefficient as a measure of income inequality. For
example Lachman and Bercuson (1992) had ten year and five year interval Gini coefficient measures
between 1960 and 1985. Using the available Gini Coefficient data would have limited the number of
observations for the econometric model tested in the study. To measure income inequality the share
of average household income in the top 5% average income sourced from the Top Incomes database,
generated by Alvaredo, Facundo and Atkinson, (2011) was used. To come up with the crude
inequality measure, the average adult income in South Africa from 1956-2011 (sourced from the Top
Incomes database), was divided by the average income of the top five (in the period 1956-2011).

4.2 VARIABLES AND A PRIORI EXPECTATIONS

FDI is predicted to have a positive relationship with income inequality in line with Basu and Guariglia’s
(2007) findings. This study adds growth as a control variable in the test.
Table 2: Variables, Data Source and a priori expectations
Variable Expected Measure
sign
FDI + FDI/GDP

Growth - Percentage change in GDP or log difference of

GDP

In line with the theoretical model, inequality is predicted to have a negative effect on growth because
high inequality could result in poor output as the economy depends on predominantly low-skilled
employees.

4.3 MODEL SPECIFICATION

In order to find out the effect of FDI inflows to South Africa on income inequality, the study uses the
Error Correction Model (ECM), a category of time series models that estimate the speed at which a
dependent variable Y returns to equilibrium after a change in an independent variable X. The basic
structure of an ECM is as follows:

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(1)

Where EC is the error correction component of the model, and measures the speed at which prior
deviations from equilibrium are correlated, and measures the error term (Brooks, 2008). In the
Engle and Granger Two-Step Method the EC component is derived from cointegrated time series as
Z.

ΔYt = b0ΔXt-1 - b1Zt-1 (2)

b0 captures the short term effects of X in the prior period on Y in the current period.

b1 captures the rate at which the system Y adjusts to the equilibrium state after a

shock. In other words, it captures the speed of error correction. To obtain Z, Y is regressed on X and
all the variables that are expected to be cointegrated are included. Secondly, the ΔY is regressed on
Zt-1 .

This study specifies the equation of this type

(3)
Where:

INEQUAL = inequality

FDI = foreign direct investment

GDP = gross domestic product

EC = error correction component

ε = error term
4.4 MODEL ESTIMATION

To prevent the use of non-stationary data Unit Root test (Augmented-Dickey-Fuller (ADF) test was
carried out to test for stationarity of the endogenous and exogenous variables. The ADF test is based
on the following regression:

∑ (4)

Where is the first difference operator, is the natural logarithm of the series δ1, δ2, and δi, to be
estimated; and is an error term. The null hypothesis of a unit root was tested against an alternative
hypothesis of no unit root. A stationary series has a finite root and variance that do not depend on
time.

(5)

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where | | is also stationary with a mean of zero and variance σ2

After checking for stationarity, the number of co-integration equations among the variables was
determined using the Johansen (1988) co-integration approach, to check whether an equilibrium
relationship exists. A necessary condition for equilibrium is that the data series for each variable
involved exhibit similar statistical properties. In other words, data series should be integrated to the
same order with evidence of some linear combination of the integrated series. An integrated series is
expressed as a function of all past disturbances at any point in time.

(6)

where is a constant drift,

Given that is a unit, X is said to have a unit root. If two time series are integrated of the same order
and some linear combination of them is stationary, then the two series are cointegrated. Cointegrated
series share a stochastic component and a long term

equilibrium relationship. If Xt is non-stationary, the variance may become infinite and any stochastic
shock may not return to a proper mean level. As shown by Engle and Granger (1987), such a non-
stationary series has no error-correction representation.

4.5 SUMMARY

Annual and continuous data covering the years 1956-2011 have been used to test the hypothesis that
FDI has a positive relationship with inequality. The a priori expectations of how the variables would be
linked is described and justified.
Table 3: Descriptive Statistics

Variable Mean Median Maximum Minimum Std Dev

Inequality 12.35 12.27 18.10 9.67 2.12
FDI 0.38 0.36 0.71 0.21 0.12
GDP 11.50 11.53 14.89 8.35 2.15
n= 56

The model was duly specified, and the measures as well as the analytical tools to analyse the data
were described. As Table 3 shows, the average share of income in the highest income observed (top
five percent income) is 12.35. The share of income of more than 50% of the observations is 12.27% of
the top five percent income. The standard deviation of the inequality measure also shows the large
variation in income inequality in South Africa. This is further shown in large difference between the
maximum value of inequality (18.10) and the mean value (12.35). Table 3 also shows that the
average share of FDI to GDP is 0.38. The next chapter proceeds with the analysis of the findings.

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CHAPTER 5

FINDINGS AND DISCUSSION

This chapter is divided into three parts. The first part reports the unit root test. The second part reports
the Johansen cointegration test. The third part reports on the Error Correction model.

5.1 UNIT ROOT TEST RESULTS

The results of the ADF for unit root for the variables are listed below. The null hypothesis is that the
exogenous variables have a unit root. The rejection of the null hypothesis for ADF test is based on the
Mackimon (1996) critical values and p-values 5% and 1%

Table 4: In Level and 1st Difference Series

st
In level series 1 difference Series
ADF P value ADF P value
Inequality -1.7801 0.0808 -7.1476 0.000
FDI -0.6037 0.5486 -6.8792 0.000
GDP -0.07505 0.9405 -3.599 0.007

The results in Table 4 show that the null hypothesis of unit root cannot be rejected. In other words in
level series yielded nonstationary variables. At first difference all variables were stationary.

5.2 JOHANSEN COINTEGRATION RESULTS

Trace test as illustrated in Table 5 indicate no cointegration at 0.1 level. Max-eigenvalue test indicates
no cointegration at level 1. Based on the Max-eigenvalue test we assume that there exists a long-
term relationship linking inequality with foreign direct investment as specified in the model.

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Table 5: Johansen Maximum Likelihood Cointegration

Unrestricted Cointegration Rank Test (Trace)

Hypothesised Trace 0.1
No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None 0.136636 8.432683 13.42878 0.4204

At most 1 0.009200 0.499086 2.705545 0.4799

Unrestricted Cointegration Rank Test (Maximum Eigenvalue)

Hypothesised Trace 0.1
No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None 0.136636 7.933597 12.29652 0.3855

At most 1 0.009200 0.499086 2.705545 0.0049

Table 6 shows the cointegration equation statistics. The long run equation is as follows
INEQUALITY = -11.0331527391*FDI_GDP + 0.909008654871*GDP + 6.13967184028
(7)
Table 6: Cointegration Regression Statistics

Variable Coefficient Std Error t-Statistic Prob

FDI/GDP -11.03315 1.735766 -6.356361 0.0000
Log GDP 0.102905 8.833446 0.0000
0.909009
C 1.156366 5.309454 0.0000
6.139672
R-squared 0.776626 Mean dependent var 12.40530
Adjusted R- 0.768035 S.D. dependent var 2.109203
squared
S.E. of 1.015851 Sum squared resid 53.66154
regression
Durbin-Watson 0.700615 Long-run variance 2.255556
stat

5.3 THE ERROR CORRECTION MODEL

Table 7: Error Correction Model (lags = 1)

Variable Coefficient Std Error t-Statistic Prob

FDI/GDP -11.09997 2.25029 -4.9326 0.0000
Log GDP 1.08034 0.133409 8.09793 0.0000
C 4.22023 1.499145 2.81509 0.0069
R-squared 0.731227 Mean dependent var 12.40530
Adjusted R-squared 0.720889 S.D. dependent var 2.109203
S.E. of regression 1.114312 Sum squared residual 64.56794
Durbin-Watson stat 0.586074 Long-run variance 3.790971

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The results show that there is a negative relationship between inequality and foreign direct investment
for the period examined in the study. The findings also show that there is a statistically significant and
positive relationship between GDP and inequality. This implies that as GDP increases inequality is
likely to increase.

Substituted coefficient:

INEQUALITY = -11.0999657028*FDI_GDP + 1.08034065144*GDP + 4.22022615346

(8)

Figure 11: Actual, Fitted, Residual Graph

The residual graph shows that the residuals are generally stable with the exception of some
instability between 1984 and 1985, as well as in 1996-2000. This could be accounted for by the major
changes in the political and economic landscape of the country as the period coincides with the time of
regime change.

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CHAPTER 6

CONCLUSION
Using annual data for the period of 1956 to 2011 for South Africa, this study examined the effect of
foreign direct investment on inequality. The ADF unit-root test indicates that all variables in the
cointegration equation at first difference are stationary. The cointegration test showed an equilibrium
relationship in the inequality/FDI model. The empirical results also show that there is a negative
relationship between inequality and foreign direct investment. This means that as foreign direct
investment inflows increase, income inequality decreases. While the findings are inconsistent with
findings in a study conducted by Herzer and Nunnenkamp in ten European countries, they are in line
with Mundell’s (1957) theory that FDI inflows in developing countries reduce income inequality.
Intuitively, one would expect physical and human capital to increase as FDI in a host country
increases, thus giving rise to the real and nominal return on capital and a decline on inequality. In line
with a number of studies (Fedderke and Romm, 2006; Akinlo, 2004; Madaria and Poncet, 2006) the
findings of this study showed that there is a statistically significant relationship between GDP and
inequality.
These results have important policy implications. Firstly, development that strategically focuses on
meeting the human capital needs of both local and foreign investors is likely to increase capital and
reduce inequality. Secondly, the empirical findings of the interaction between FDI and inequality
requires policy makers to think of a strategy to reduce inequality while addressing the need to
increase vertical FDI in South Africa. As mentioned earlier, South Africa tends to attract horizontal FDI.
There is a missed opportunity of growing the country exports and improving growth by not having a
country strategy to increase vertical FDI.

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