Does Labor Market Informality Attract FDI? A Sectoral Analysis of Pakistan

Abstract

Informality and globalization are two distinct phenomena with significant links to less developed economies. In transitional economies, informal labor markets often operate alongside formal ones, with the informal markets characterized by lower labor costs and less regulation. Foreign Direct Investment (FDI) inflows depend on the presence of favorable location factors in the host country, including the structure of both the formal and informal labor markets. Countries with flexible labor market regulations offer investment-friendly environment for foreign investors. This study examines the relationship between informality and FDI using Pakistani sectoral panel data (i.e., manufacturing sectors) from 1996-2007. Employing the least square dummy variable (LSDV) approach, the study finds a significant positive relationship between informality and FDI in Pakistan, suggesting that informality in the labor markets play an important role in attracting foreign investment, especially in the manufacturing sectors. The study goes beyond mere correlation by exploring the potential mechanisms through which informality influences FDI flows. Using a range of econometric techniques and sectorspecific controls, our results are robust and insensitive. Analysis with lagged-informality also revealed a positive association between lagged-informality and FDI, which results however are not robust. While structural unemployment may persist in certain sectors, labor market flexibility is essential for attracting FDI, as it enables adaptation to industry needs and job creation, particularly in labor-intensive manufacturing industries.