Finance, Inequality and Poverty: Cross-Country Evidence

Thorsten Beck, Asli Demirguc-Kunt and Ross Levine

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Motivation

• High levels of income inequality and poverty around the world– In 2001, 1.1 billion lived on less than one dollar a day– In Thailand, poverty dropped by 90% from 1981 to 2000,

while it doubled in Venezuela• While growth helps reduce poverty, it is not enough!• Growth-enhancing policies can have distributional

effects:– Raise everyone’s income– Raise primarily incomes of the rich– Raise primarily incomes of the poor

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Motivation

• Negative relationship between inequality and growth often explained with financial market constraints; suggesting redistributive policies

• Alternative: financial sector reform that reduces market frictions, lowers income inequality and boosts growth without incentive problems of redistributive policies

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Our Contribution

• Finance is pro-(average) growth …• … but is it also pro-poor?

... Does it boost the growth of the poor more than growth of the average person?

• Using a cross-country regressions, we analyze the effect of financial development on:– Income growth of the poor– Changes in income inequality– Changes in Headcount

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Finance – pro-rich or pro-poor?

• Pro-poor– Credit constraints are particularly binding for the

poor (Banerjee and Newman,1993; Galor and Zeira, 1993; Aghion and Bolton, 1997)

– Finance helps overcome barriers of indivisible investment (McKinnon, 1973)

– Finance foster economy-wide openness and competition by facilitating entry (Rajan and Zingales, 2003)

• Pro-rich:– Credit is channeled to incumbent and connected and

not to entrepreneurs with best opportunities (Lamoreaux, 1986; Haber, 1991)

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Data – Financial development

• Private Credit

– Value of credit by financial intermediaries to the private sector divided by GDP

– Data averaged over 1960-99 (1980-2000)

– Countries with higher levels of Private Credit grow faster• Beck, Levine and Loayza (2000)

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Data – Dependent variables

• Average annual growth rate of the real income of lowest income quintile over 1960-99 for 52 countries

• Average annual growth rate of Gini coefficient over 1960-99 for 52 countries

• Average annual growth rate in Headcount (share of population with less than $1 a day) over 1980-2000 for 58 countries

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Methodology

,/)( ,,,,,, iiintpintpitpi XFDynyy

,/)(/)( ,,,,,,,, iintitintpintpitpi FDnyyynyy

,/)(/)( ,,,,, intiintitintiti GFDnyynGG

,/)(/)( ,,,,, intiintitintiti PFDnyynPP

Finance and income growth of the poor

Finance and changes in income inequality

Finance and poverty alleviation

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Finance and income growth of the poor

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Finance and the Poor – the economic effect

• Income of the poor in Brazil would have grown 4% instead of 0% per year over the period 1960-99, had Brazil had the same level of Private Credit as Korea

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Finance and changes in Gini

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Finance and changes in Headcount

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Finance and Poverty Alleviation – the economic effect

• Headcount in Peru would have increased only by 5% instead of the actual 19% per year, had it had the level of financial development of Chile; this would have resulted in a Headcount of 2% in 2000 rather than the actual 15%.

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Robustness tests

Results hold controlling for:

• Trade Openness

• Inflation

• Schooling 1960

• Age dependency ratio

• Population growth

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Simultaneity Bias

• Control for reverse causation and simultaneity bias by instrumenting for Private Credit

– Legal origin

– Latitude

– Religion

• Tests:

– Test of overidentifying restrictions

– F-test and adjusted R-squared for first stage

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Conclusions

• Finance is pro-growth and pro-poor! • In countries with better developed financial

intermediaries,– income of the poor grows faster– income inequality decreases at faster rate– poverty falls at faster rate

• How to foster financial intermediary development?

• How to broaden access to financial services?