Trade, foreign investment, and wage inequality in developing countries

Is there a connection between trade and investment liberalization and wage inequality?

From a developing country perspective, wage inequality has two somewhat contrasting features.

• On the one hand, wage disparities are more worrisome in developing countries than in developed countries because the wage earners at the bottom of the wage distribution are closer to the subsistence level, and governments are less well equipped to shelter the weaker members of society through fiscal and welfare safety net measures.

• On the other hand, to the extent that wage disparities reflect differences in acquired skills, wage inequality constitutes an incentive to invest in children’s education. While the same incentive is at work in developed countries, the urgency may be greater in developing countries because the alternative to study is often child labor rather than leisure. The discussion in this section reviews the theoretical arguments and empirical evidence to the effect that trade liberalization raises wage inequality under certain initial conditions and lowers it under others.

Taking the skill premium as the ratio of non-production wages (supervisory and managerial) to production wages, a study finds that this form of inequality increased in about half the low- and middle-income developing countries during the 1980s and 1990s (countries with an annual per capita GDP below $14,000 in 1980) [2]. Other studies specify that the increase especially affected middle-income Latin American countries, but it also affected some low-income countries [3], [4], [5], [6]. Yet another study detects a positive correlation across developing countries between growth in wage inequality and an increase in the share of skill-intensive goods in those countries’ exports [7].

The relationship between wage inequality, skill endowments, and exposure to international trade is investigated in a very recent study using merged and matched data from the World Bank, the United Nations Industrial Development Organization, and the United Nations Educational, Scientific, and Cultural Organization [1]. The study used as a measure of the skill premium the ratio of the average wage rate in high or medium-high technology industries to the average wage in low technology industries. Trade exposure is measured by the ratio of exports plus imports to GDP. Skill endowments are measured by the share of the adult population with a primary education only and the share of the adult population with a secondary or higher education. The study finds that the effect of trade depends on the size of a country’s skill endowments. If these endowments are small, trade will reduce the skill premium (the ratio of skilled to unskilled wage rates). If they are sufficiently large, trade will raise the skill premium. For countries with very few adults educated to secondary school level (or higher), it is estimated that trade will raise the skill premium only if at least three quarters of the adult population have completed primary education.

What explains the connection between foreign trade and investment liberalization and wage inequality?

How should these statistical regularities be understood? According to economic theory, in an economy with no international trade (a closed economy), the larger the endowment of a particular factor of production, such as labor and capital, the lower the return to that factor relative to others. That may change if the country opens itself up to trade.

According to traditional (Heckscher–Ohlin) theory, countries specialize in the production of goods that make more intensive use of their comparatively more abundant non-tradable factors, and the returns to these factors are higher with international trade than without it. If the non-tradable factors are labor and capital, then in the standard model of trade between developed and developing countries, trade liberalization will induce labor-abundant developing countries to specialize in the production of goods requiring relatively more labor (labor-intensive goods) and induce the capital-abundant developed countries to specialize in the production of capital-intensive goods. Consequently, with trade, the wage rate will rise in developing countries and fall in developed countries (Stolper–Samuelson theorem).

If the non-tradable factors are skilled (more educated) and unskilled (less educated) labor, trade liberalization will induce the skill-abundant developed countries to specialize in the production of goods with a high level of skilled-labor inputs, and induce the skill-poor developing countries to specialize further in the production of goods with a low level of skilled-labor inputs. If countries then open up to trade, the skilled wage rate will rise relative to the unskilled wage rate in developed countries and fall in developing countries.

Is trade liberalization good or bad for developing countries?

To the extent that skill comes from formal education rather than work experience, an increase in the skilled to unskilled wage ratio raises the incentive to invest in children’s education, while a decrease in the ratio lowers the incentive. An adequate return to education, however, is not all that is needed for children to go to school rather than work. Parents must also be able to afford the investment (even if the tuition is paid for by the government, the family will still need to pay the cost of rearing the child and buying books and other school materials and will need to make up for the loss of the child’s income). Because of underdeveloped credit markets (liquidity constraints) in developing countries, this means that parents must be rich enough to finance their children’s educational investment out of their own resources.

In addition, while an increase in the ratio of skilled to unskilled wages raises the incentive to invest in education, it also redistributes income from less to more educated working parents and thus (assuming that the less educated parents are on average poorer and consequently more likely to be liquidity constrained than the more educated) makes it more difficult for the poor to finance their children’s education. Conversely, a fall in the skill premium reduces the incentive for parents to invest in their children’s education, but it also redistributes income from more to less educated parents. Therefore, theory cannot tell us in advance whether child labor will rise or fall in aggregate when the skill premium rises.

There is a further complication. By widening the range of production possibilities, and reducing the economic distortions generated by trade barriers, liberalization of foreign trade and investment reduces inefficiency and raises average income. Other things being equal, therefore, liberalization reduces the number of families that are too poor to invest in their children’s education and consequently the number of children who work instead of going to school.

With so many factors at play (trade-induced changes in skill premium, average income, and income distribution), it is an empirical question whether liberalization will result in more or less child labor. The study mentioned above in relation to the effect of trade on the skill premium also looks at the effect of trade on child labor. This study estimates that trade reduces child labor no matter whether it raises or lowers the skill premium [1]. An earlier study shows that not only actual trade, but also trade openness (measured by an index that rates a country as either open or closed according to whether it does or does not clear a number of obstacles to foreign trade and investment) reduces child labor [8].

It would thus seem that the income-enhancing effect of trade is strong enough to more than compensate for any adverse incentive effect (reduction in the skill premium) or distributional effect (redistribution from the poor to the rich).

An implication of these findings is that trade liberalization is good for developing countries because it raises average income and reduces child labor. But what does it do for these countries’ role in the international economy? While liberalization will raise the skill premium where the initial supply of qualified workers is sufficiently large and reduce it elsewhere, it will boost educational investment and thus, eventually, the supply of qualified workers everywhere. However, in the countries where the initial supply of skilled labor is sufficiently large, trade will attract production activities with high skill requirements from developed countries, so that the domestic skill premium will rise even as the supply of skilled workers rises. Elsewhere, by contrast, liberalization attracts production activities with low skill requirements, so that the domestic skill premium falls. Countries in the first group will gradually increase the share of skill-intensive goods in their output mix. Countries in the second group will specialize even further in the production of goods with a low skill content.

A different perspective on trade and development

The theoretical argument is made that liberalization of trade and investment lead not to an integrated world economy but to the emergence of a number of vertically integrated production systems consisting of countries that cooperate with each other because the education level of their workforces are not too dissimilar [9]. According to this theory, trade integration among such countries will lead, first, to greater wage disparities between more developed and less developed countries in the same integrated production system (and thus to a deterioration in the labor market position of the unskilled) and then to wage convergence between the countries and divergence within them. Developing countries that are unable to integrate with developed countries will be condemned to no international trade or to trading only among themselves.

On the face of it, this vision of the development process is somewhat reminiscent of Myrdal’s description in the 1950s of development as a virtuous circle triggered by a historical accident. However, empirical studies find that the developing countries that succeeded in integrating with developed countries had a sufficiently well-educated workforce when trade and investment was liberalized [1], [9]. Thus, because the number of educated workers is an outcome of earlier private or public education investments, and liberalization is the outcome of a political decision, the fact that the virtuous circle started in one place rather than in another is not a historical accident, but the result of deliberate action.

The economies referred to as the “Asian tigers” (Hong Kong, Singapore, South Korea, and Taiwan) are a good example of countries that took this kind of deliberate action. In the 1960s and 1970s, they invested massively in education (among other ways, by sending their brightest young people to study for higher degrees in Western Europe and North America) before liberalizing in both the economic and the political sense. That allowed Hong Kong and Singapore to become major exporters of financial services, and South Korea and Taiwan to become major exporters of information technology goods. Their example was followed, with a lag, by the “tiger cub” economies (Indonesia, Malaysia, Philippines, and Thailand). The Asian tigers and their cubs are now classified as emerging market economies or newly industrialized countries.

In contrast with the view that developing countries that are unable to integrate with developed countries in vertically integrated production systems are doomed to fall back into autarchy or to trade only with other countries in a similar position [9], the estimates reported above suggest that this is not necessarily the outcome for countries caught wrong-footed by trade liberalization [1]. These countries may still trade with and attract investment from developed countries, but this trade and investment will only accentuate their specialization in low-skill production activities and narrow (instead of amplifying) the domestic gap between skilled and unskilled wage rates, with all the positive and negative consequences this entails. African countries are a case in point. After waiting on the sidelines of the globalization process for several decades, these countries have recently started to engage in important regional trade agreements and to attract foreign investments.

During the 2000s, world trade fell as a share of global GDP. A recent International Monetary Fund paper attributes this decline to the exhaustion of the wave of information and communication technology innovations that led to a rapid expansion of global supply chains and consequent increase in back-and-forth trade in components during the 1990s. The participants in that boom are today’s emerging market economies and newly industrialized countries. The paper concludes that, although the first wave of vertical integrations across national borders has lost momentum, “there is still considerable scope to enhance the international division of labor by drawing in regions that have been at the margin of global supply chains, such as South Asia, Africa, and South America” [10]. In other words, the time may soon come for the participation of countries that were excluded from the first wave of vertical integration because their labor forces were not sufficiently well-educated.