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Digital Subscriptions > Cities Today > The State of African Cities 2018 > Chapter 1 The Impact of FDI on Income Inequality in Africa

Chapter 1 The Impact of FDI on Income Inequality in Africa

Inequality tends to be higher in urban rather than in rural areas due in part to rural-urban migration
The Meskel festival in Lalibela. Ethiopia has the fastest growing economy in Africa and also the lowest level of income equality

FDI is an agent of global economic integration (Mah, 2003) and many developing economies have adopted FDI liberalisation policies to help facilitate its benefits. However, despite increasing investments in developing economies, poverty and income inequality persist and remain a major challenge. The relationship between FDI and income inequality is often divided into the Neoclassical and Dependency Theories. The former optimistically argues that FDI stimulates higher economic growth and, hence, lower inequality. The latter states that FDI has negative effects on economic growth and leads to higher income inequality (Firebaugh and Beck, 1994). Not many studies exist that have empirically established a link between FDI and inequality (Basu and Guariglia, 2007; Tsai, 1995; Wu and Hsu, 2012). Therefore, this study seeks to explore this relationship within the context of African countries. Given the persistent inequality in Africa, the Dependency Theory is the starting point and the current study seeks to identify the types of FDI that reduce income inequality in African countries so that policy recommendations can be made from its findings.

Neoclassical scholars have argued that FDI fosters economic growth and reduces inequality in host countries (Mundell, 1957). They theorize that, apart from filling the resources gap, FDI promotes higher economic growth and development through technology diffusion, development of human capital and management skills and access to export markets (Tsai, 1995; Li and Liu, 2004). Dependency scholars, on the other hand, argue that economic reliance on the advanced economies - implicit to many types of FDI - may have negative social and economic impacts on developing countries and can in the long run result in increasing inequality between highly skilled and lowskilled workers (Firebaugh and Beck, 1994).

Recent studies, however, have suggested that the impact of FDI on income inequality is determined by local conditions in the host (receiving) countries, particularly in terms of absorptive capacity, human capital, technology diffusion and the quality of its institutions (Schneider and Soskice, 2009; Wu and Hsu, 2012). In this study, absorptive capacity has been measured by the quality and production of electricity, air transport, mobile phone subscriptions and international internet bandwidth. Human capital is measured by the enrolment rate in tertiary education and the percentage of internet users. The indicators associated with local innovation and levels of technology are used as a proxy for technology diffusion. Lastly, institutional quality includes public and private institutions.

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About Cities Today

The State of African Cities 2018 is published by IHS-Erasmus University Rotterdam and UN-Habitat in partnership with the African Development Bank. The aim of the report is to contribute to development policies that can turn African cities into more attractive, competitive and resilient foreign direct investment (FDI) destinations. Attracting global FDI is highly competitive and crosses various geographic scales, therefore regional cooperation by cities and nations is critical. But FDI is not a panacea since it has both positive and negative effects and careful choices need to be made by cities in their pursuit of FDI, if it is to lead to inclusive economic growth. This report aims to provide guidance on these choices and to facilitate understanding of the complexity of global investment in Africa.