Like every Friday, from Raj Nallari and Breda Griffith's lecture notes.
Macroeconomic Fundamentals and Financial Development
The development of a financial system will necessarily be affected by both endogenous and exogenous factors and the particular country context in terms of its socio-political development. Endogenous factors refer to indicators of health of individual financial institutions. A commonly used framework for assessing this health is the so-called CAMELS framework, i.e. capital adequacy, asset quality, management soundness, earnings and profitability, liquidity, sensitivity to market risk. Exogenous factors refer to macroeconomic developments that can in turn affect financial system depth.
Imbalances in economic growth rates may have a negative impact on the financial system of a country in at least two respects. First, low or declining aggregate growth rates often weaken the debt servicing capacity of domestic borrowers and contribute to increasing credit risk. Second, if an economy is overly dependent on one or two sectors for its economic growth and financial institutions are overly exposed in those sectors, an adverse real sector shock may have an immediate impact on the financial system. The system is even more vulnerable if these sectors are affected by exogenous forces such as climatic conditions. The pattern and trend of inflation has a direct bearing on the stability and health of the financial system. High and volatile inflation makes it more difficult to assess accurately credit and market risk with associated risks for a financial institutions portfolio and its ability to manage and plan for the future.
Financial Development and Poverty Reduction
Although the relationship between financial development and growth is well-established, the same cannot be said for the direct link between financial development and income inequality, beyond the growth relationship itself. Beck, Demirguc-Kunt and Levine (2004) provide a recent comprehensive analysis of this important question.
As the authors note, theory is ambiguous when it comes to the relationship between financial development and changes in poverty and income distribution. Some models imply that financial development enhances growth and reduces inequality. According to these models, financial market imperfections, such as information problems, transactions costs, and contract enforcement costs, may be especially binding on 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, thereby reducing the efficiency of capital allocation and worsening income inequality. Viewed from this angle, financial development reduces poverty by (i) disproportionately relaxing credit constraints on the poor and reducing income inequality, and (ii) improving the allocation of capital and accelerating growth.
Other theories, however, question whether financial development reduces poverty. Some research suggests that the poor primarily rely on informal, family connections for capital, so that improvements in the formal financial sector primarily help the rich, rather than the poor. For instance, Greenwood and Jovanovic (1990) develop a model that predicts a nonlinear relationship between financial development and income inequality during the process of economic development. At the early stages of development, only the rich can afford to access and profit from financial markets so that financial development intensifies income inequality. At higher levels of economic development, financial development helps an increasing proportion of society. Other models imply that if financial development reduces income inequality, this could slow aggregate growth and increase poverty. For instance, if the rich save more than the poor, and financial development reduces income inequality, this could reduce aggregate savings and slow growth with adverse implications for poverty. Accordingly, empirical evidence is needed to distinguish among competing theoretical predictions.
Beck et al. do this by assessing the relationship between financial development, poverty alleviation, and changes in the distribution of income using broad cross-country comparisons. They find that financial development alleviates poverty and reduces income inequality. Their findings also indicate that financial development exerts a disproportionately positive influence on the poor.
More specifically, their paper has three key findings: (i) even when controlling for real per capital GDP growth, financial development reduces income inequality beyond the growth effects themselves; (ii) financial development induces a drop in the Gini coefficient measure of income inequality; and (iii) financial development reduces the fraction of the population living on less than $1 or $2 a day and lowers the Poverty Gap.
In another recent paper, Jalilian and Kirkpatrick also find that financial development reduces income inequality, but only beyond certain income levels, in line with the Greenwood and Jovanovic predictions of an inverted U-type relationship. They find that at particularly low levels of development, financial development is likely to be positively related with income distribution but that once a threshold level of development is achieved, then financial development reduces inequality.
Next Friday: Policy Measures to Increase Access to Financial Services