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Financial Sector Development Essay

ABSTRACT

This paper is an attempt to examine the relationship between financial development and income inequality. In doing so, we have used Bangladeshi data for the period 1985-2006. We have employed auto-regressive distributed lag (ARDL) methodology for cointegration. We have also carried out sensitivity analysis and stability tests. Our findings suggest that financial development increases income inequality. Economic growth seems to equalize income distribution. Inflation and trade openness also worsen income inequality. Finally, income inequality is being increased by social spending in the country over long run. This study provides new directions for policy makers to reduce income inequality to share the fruits of economic development among the wider spectrum of the society. Keywords: Financial sector, development, trade openness, income inequality, Bangladesh JEL Classifications: D14, D33, F1

INTRODUCTION

Economic growth and its correlates have been the focus of a large number of studies over the recent past. These studies primarily put emphasis on various aspects or sources of growth. One of the important correlates of economic growth that has been studied prominently is the extent of financial sector development. The positive and robust relationship between well-functioning financial system and economic growth is empirically a well established fact. Higher levels of financial development are significantly and robustly correlated with current and future rates of economic growth, physical capital accumulation, and improvements in economic efficiency (see, Khan, 2000; Goldsmith, 1969; McKinnon, 1973; Roubini and Sala-i-Martin, 1992; King and Levine, 1993; Easterly, 1993; Pagano and Volpin, 2001; Beck, Levine and Loayza, 2000; Khan and Senhadji, 2000; Christopoulos and Tsionas, 2004; Iqbal, et al., 2006; Khan, Qayyum and Skiekh, 2005 and Shahbaz, 2009).

It is argued that capital market improvements benefit the rich more than the poor and hence contribute to increase income inequality. The main reason is that rich individuals have more potential than the poor ones to exploit new opportunities. It is also believed that the access of the poor to bank credits may be impeded because of the high cost involved therein, and, as such, financial development may be regressive for the poor, particularly at the initial stages of development (Greenwood and Jovanovic, 1990). The financial sector charges high set up cost against financial services during early periods of development to gain advantages from the screening and risk pooling.

This cost is beyond the affordability of the poor people. As they are not in a position to use their savings for this outlay which pushes them further below in the income inequality trap (Clarke et al., 2003; Dollar and Kraay, 2003; Beck, Demirguc-Kunt and Levine, 2004). Financial market imperfections such as financial asymmetries, transaction costs, and contract enforcement costs may be especially binding for poor entrepreneurs who lack collateral, credit histories, and connections. These credit constraints will impede the flow of capital to poor individuals with high-return projects (Banerjee and Newman, 1993; Galor and Zeira, 1993), thereby reducing the efficiency of capital allocation and intensifying income distribution (Greenwood and Jovanovic, 1990; Banerjee and Newman, 1993 and, Aghion and Bolton, 1998).

The relationship between financial development and reductions in income inequality is not only a correlation, but also a causal relationship. The positive relationship between private credit and economic growth for the poor might be driven by higher demand for financial services as the poor constitute a larger share in national income. Similarly, reduction in income inequality might lead to political pressure to create a more efficient financial system that allocates the funds to the projects based on market criteria, not on political considerations.

No particular study has determined whether financial sector development benefits the whole population, primarily benefits the rich, or disproportionately helps the poor (Honohan, 2004; Beck et al. 2004; Claessens and Perotti, 2007 and Bittencourt, 2006). But in the case of Pakistan, Shahbaz (2009) documents that financial development, improves agriculture and manufacturing sectors and investment activities improve the incomes of bottom 20% of the population. The rest variables such as economic growth, financial instability, increase in prices, and overall high income inequality lower the income share of the poor from national income.

The issue on the nature of relationship between financial development and income inequality has been discussed in many studies using few control variables with traditional estimation techniques such as Ordinary Least Squares (OLS). For instance, Dollar and Kraay, (2003) found that more trade would lead to improve income distribution, whereas higher inflation, higher government consumption and financial development would lead to higher income inequality. The specification of Li and Zou, (2002) is similar to the one in Barro, (2000) with the level of the gini coefficient as a dependant variable and control variables including inflation, financial development, government spending and openness.

Their results suggest that higher inflation leads to lower income inequality, whereas higher government spending, an improved financial sector and better education abate it. Calderón and Serven, (2003) find that financial depth increases income inequality while better education decreases it. Finally, the findings of Lopez, (2004) are based on the estimation of a dynamic panel with fixed effects for the change in the gini coefficient. The results suggest that improvements in education and lower inflation rates reduces the levels of income inequality, while financial development, trade openness, and reduction in government size will be associated with an increase in income inequality.

Lopez also finds that economic policies are likely to be pro-poor in the long-run (i.e., the growth effects offset the increase in inequality) but might also lead to a temporary short-run increase in income inequality in the absence of compensatory measures. The effect of financial development is, however, not very large and is dominated by agricultural factors and other sectoral factors (Kakwani and Pernia, 2000; Khan and Senhadji, 2000; Christopoulos and Tsionas, 2004).

With the development of a financial system, the capacity to bear the high costs of small credits (Rajan and Zingales 2003) increases. Moreover, the growth of a formal financial system makes poor people more accessible to informal credit that offers opportunities for profitable investments. Finally, in a framework of competitive markets of goods and production factors, credit may improve the well-being of the poor, even if they do not directly receive the loans from financial institutions (Beck et al. 2004)[1].. Finally, Ang (2008, 2009) scrutinizes the link between growth in financial sector and income distribution for the case of India. This paper indicates the important role of financial sector to decrease income disparity. It is documented that connection between financial development and income inequality exists and is significant.

The results of this study show that financial development and increased banking density seem to improve income distribution by raising the income of the bottom 20 percent or the poor segments of the population. This study again provides support for linear relationship between finance and inequality. There is no space to validate Greenwood and Jovanovic (1990) hypothesis. Moreover, Ang (2009) probes an active link between financial liberalization and income disparity over the period of 1951 upto 2004 for the case of India. It may be noted on the basis of empirical evidence that financial reforms do not seem to provide any equal access to financial services and hence income discrimination has intensified in India.

For the case of Brazil, Bittencourt (2006, 2009), has checked the effects of financial development on income disparity for the periods of 1980s and 1990s. The study uses time series and panel data approaches to examine the said nexus. The econometrical exercise indicates that financial development declines income inequality because easy access to financial services seems to increase income share of the bottom 20 percent of the population. Shahbaz (2009) also seems to investigate the impact of financial development, financial instability on the income of poor segments of population with the battery of other control variables such as economic growth, inflation, agriculture, and manufacturing shares to GDP for the case of a small emerging economy like Pakistan.

The evidence proves the validation of McKinnon Conduit Effect in Pakistan. But, financial instability weakens the beneficial impact financial development on income share of the bottom 20 percent of the population. The main reason is that financial crisis seems to increase credit constraints for poor individuals. Furthermore, developments in agriculture and manufacturing sectors enhance the welfare of poor people by raising their incomes. Finally, study conducted by Shahbaz, (2010) indicates that financial development is associated significantly with equal income distribution. The estimate of economic growth is linked with high income inequality. The trade openness worsens income distribution and this provides the support to accept the Leontief Paradox for Pakistan. The income inequality is positively correlated with financial instability.

The main objective of this endeavour is to investigate the relationship between financial development and income inequality in an Autoregressive Distributive Lag (ARDL) framework for Bangladesh utilising data over the period of 1985-2006. This attempt is the first of its kind for Bangladesh.


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