Financial Inclusion and Financial Deepening – An Effective Tool Against Income Inequality?

How efforts toward financial inclusion and deepening could offset the negative effects of inequality on growth.

By Henrieta Isufllari

As almost anyone who has walked into a bank to apply for a loan can confirm, the process of credit issuance is a complicated one. It often involves thorough background digging into one’s financial history, asset holdings, employment, and other factors that are considered indicators on the ability of the loan holder to pay back their obligation to the lender. From the banks’ point of view, this screening process is not entirely an exact science either, although the general consensus is that money attracts money - the fact that the rich have an easier time obtaining credit is well established and even backed up by literature in the field.

Until the last few decades, economic theory aimed at explaining the relationship between savings and income distribution advocated that inequality had a positive impact on economic growth, as it assigned wealth to that part of the society that was already predisposed to save more – the rich and the wealthy. This kind of reasoning, outdated as it may sound, relies on the fact that, for the longest time, economic growth was mainly fuelled by the accumulation of physical capital, like machinery and buildings. Viewed in this prism, wealth accumulation of such proportions would need an already established initial wealth base, which the rich already possessed.

As the industrial world started shifting towards more sophisticated methods of production, the definition of capital was expanded to include the value added to wealth from skilled labor and human capital. The new wave of literature paints a more complex relationship between inequality and economic growth, one in which a shift towards equality not only boosts investments in human capital, but it can also provide incentives for a more conflict-free socio-political environment – both important factors for growth.

With the recent economic slow down, Chile is also promoting policy scenarios focused at increasing human capital, as a way to keep up with the accelerating growth rates experienced during the previous two decades. However, the country has a hard task ahead: alleviating income inequality. The most recent OECD Economic Survey (2015) names Chile as the country with the highest income inequality coefficient among OECD countries: the top 10% receive 26.5 times the average income of the bottom 10%; while the OECD average is 9.6 times. Another indicator, wealth, is also highly skewed: the top 1% in Chile holds 21% of total income, while the bottom 40% only 1.65% (source here). 

“According to the World Bank’s World Development Indicators database, the number of adult borrowers from commercial banks in Chile was 438 per 1,000 adults (2015), while the ratio of domestic credit to the private sector, as percentage of GDP was 110%,” points out Patricio Valenzuela, MIPP researcher and Professor at the Universidad de Chile. “These numbers suggest that the effects of high inequality in Chile are being somewhat attenuated by access to credit, but that the most vulnerable sectors of the population still do not have access to credit in order to expand their economic opportunities,” he adds.

In making the right decisions on the income inequality problem, both economic theory and empirical data need to be carefully analyzed, and policy undertakings require a thorough understanding of the available research on the complex interactions between inequality, financial decision-making and economic growth. Professor Valenzuela’s recent academic paper, “Inequality, Finance, and Growth”, co-authored with Matías Braun and Francisco Parro, provides a model which explores the effects of income inequality on economic growth for different degrees of development of the domestic financial markets – both theoretically and empirically.

The first of the assumptions of the model is the distinction between physical and human capital. While productivity from physical capital is independent of its ownership distribution (whether it is concentrated in the hands of a very few producers or more evenly distributed), a highly concentrated distribution of human capital is prone to diminishing returns. The authors expand the meaning of human capital to include the opportunities that arise for investing in the development of those projects that yield high returns – defined as ideas. Not easily transferable from one producer to another, ideas are also a key factor in the production process of modern economies. Poor agents enter the market with a smaller initial endowment, so they would need to borrow from the capital markets in order to finance their ideas. The capital markets are ranked from less developed markets that offer low levels of credit to poor agents, to highly developed ones, which provide full an optimal access to indebtedness.

Valenzuela explains that the level of development of the financial markets serves as a production constraint, so efforts toward financial deepening would only offset the negative effects of inequality on growth, by expanding investment opportunities to include entrepreneurs who lack the initial endowment required for developing their ideas.

He finds that the effects of inequality on growth are more prevalent in countries with underdeveloped financial markets as opposed to countries with more developed ones. Valenzuela adds that consistent with the paper’s theoretical arguments, increases in income inequality lead to a smaller number of per capita patent applications by residents, but that this negative effect of inequality on patent applications vanishes in more financially developed countries.

To illustrate, in countries with an underdeveloped financial system (bottom 25%), a 1 standard deviation increase in income inequality, as measured by the Gini coefficient, resulted in a 65 basis points drop in growth of the real GDP per capita; for countries in the top 25%, the same increase in inequality caused a drop of only 7 basis points in the same GDP measure.

Another result is that, even though inequality in initial wealth has a negative effect on economic growth, a deepening of financial markets can help offset part of this negative effect, and in some cases even completely reverse it.  By providing a more inclusive service, financial markets act as a regulator to income inequality, as they redistribute investment to projects with high marginal return.

Looking forward, the model explores the extent to which the degree of development of a country’s financial system affects agents’ perceptions of inequality. Given that they constitute a majority, poor agents are the median voter. When poor agents have easier access to debt and can use it to finance their ideas, they stand a good chance of narrowing the income gap caused by differences in initial wealth. With this ex-ante information, poor agents would be more inclined to tolerate current inequality, and do not see a need to support policies that promote future redistribution, since they can foresee that this would already be a consequence of equal financing opportunities. The data also presents a positive significant effect of the impact that financial development has on tolerance to inequality.

Access to productive credit is an effective tool in attenuating income inequality, which is a persistent problem in Chile. One of the suggested sources of the lack of access to financial markets is the inability of financial institutions to recover their loans in case of a default. An effective course of action for the current administration, in their work to close the inequality gap, would be to couple their efforts of promoting financial education with a restructuring of the country’s financial markets. 

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