Financial Liberalisation

So far we have discussed the impacts of financial development on inequality from the perspective of financial deepening, concentrating on the indirect effects of financial intermediary development, and on the direct effects of financial broadening. However, financial broadening can have strong implications on inequality affecting households indirectly through the growth of enterprises creating employment. In fact, households are not the only ones facing credit constraints. In many developing countries, the emergence and growth of small and medium sized enterprises is highly conditional to the availability of external financing. Removing entrepreneurial credit constraints in order to support entrepreneurship, regarded as an engine of growth for developing economies, is seen as an effective strategy for creating demand for low-skilled labour and smoothing income inequalities. Can this assumption be backed up by empirical evidence?

As discussed earlier, many of the obstacles facing entrepreneurial activity arise from stiff regulative structures characteristic to developing countries that generally lag behind in the implementation of financial reform. Demirguc-Kunt and Levine (2009) criticise the existing economic literature of neglecting the impact of financial sector policies on inequality. They argue that while the majority of researchers take capital market imperfections as given, financial sector policies, such as bank regulations, shape the financial system in a way that deserves closer attention when studying links between finance and inequality.

Financial sector reforms have been a debated topic in the public arena as the distributional effects of such reforms are obscure and the mechanisms through which the benefits would reach the poor remain somewhat unexplored. Giné and Townsend (2004) evaluate the growth and distributional outcomes of financial liberalisation and globalisation with a general equilibrium occupational choice model calibrated to data from Thailand during the period 1976-1996. The authors chose Thailand for its convenience to the methodology employed. It serves as a good example of an emerging market characterised by rising inequality, which experienced liberalisation from a rather restrictive credit system during the period of study, accompanied by a clear occupational shift.

The focus of the study is on reforms increasing outreach by policies such as less restricted licensing requirements for financial institutions, the reduction of insufficiently high capitalisation requirements and an increased ability for institutions to expand by opening new branches. All of them are treated as domestic reforms enabling deposit mobilisation and access to credit at market interest rates for groups that would otherwise be excluded from access to savings and credit at the formal sector. (Giné & Townsend 2004, 270.)

Giné and Townsend (2004) extend a model developed by Lloyd-Ellis and Bernhardt (2000) built on an interaction of wealth distribution with credit constraints and distribution of entrepreneurial efficiency leading the development process. According to Lloyd-Ellis and Bernhardt (2000, 147) a development path resembling the Kuznets inverted U emerges if a sufficient amount of efficient entrepreneurs exist in the economy, whereas the lack of efficient entrepreneurs leads to a cyclical distributional process driven by an endogenous interaction between credit constraints, efficiency and wages. Giné and Townsend (2004) adapt the model into a two-sector general equilibrium incorporating a subsistence sector and an intermediated sector to fit the framework of financial liberalisation. The sectoral structure is based on the view of Banerjee and Newman (1993) relating growth and inequality to imperfect financial markets. In the other sector, financial intermediation does not exist, whereas in the other one, borrowing and lending is possible at a market interest rate, and exogenous expansion of the sector is allowed. Exogeneity permits policy analysis as it enables experimentation with the data in a scenario where financial expansion would not have occurred.

The study shows considerable net welfare gains due to financial liberalisation, yet the resulting welfare effects do not spread out evenly. This is mainly due to differences in wealth and talent. The rich benefit from increased interest on savings, however, the greatest benefit goes to individuals

with low wealth and entrepreneurial talent or to existing entrepreneurs lacking sufficient capital, enabling them to set up their business or to scale up an existing one. Furthermore, due to higher wages in the intermediated sector, benefits spread out to those remaining as workers in the intermediated sector. The authors estimate welfare gains of 17–34 per cent, average of household income. However, the cost of improved access to finance is borne by existing entrepreneurs facing increased competition and higher wages to pay, resulting in a very high welfare loss for this group.

(Giné & Townsend 2004, 270-273.) All in all, as the highest gains go to the low-wealth talented few who benefit from the opportunity of becoming entrepreneurs in the intermediated sector, inequality can increase. However, in the long run this effect is offset by the labour market mechanism as benefits spread out to a wider share of the population.

The study avoids drawing generalising conclusions in terms of mere numbers, as figures are dependent on the data set utilized, but emphasise the directions and magnitude of distributional impacts credit liberalisations can have on an economy. Due to this magnitude the authors call for certain important refinements concerning the model. One of them is the fact that the model ignores differences in wages and thus does not account for productivity differences and investments in human capital. (Giné & Townsend 2004, 298-299.) Thus, although the study provides valuable insights on the distributional impacts of liberalisation, calibration cannot avoid a certain level of disharmony between a set of simplifying assumptions and historical data.

The findings on the Thai example lead us nonetheless to conclude that financial sector policies can have considerable distributional impacts, benefitting primarily talented low-wealth individuals setting up enterprises, and secondarily low-skilled workers representing the low end of the income distribution. Despite the gains in welfare, many developing economies are still relatively far behind with the implementation of liberalising financial policies. We have seen in the case of Thailand that the welfare losses were experienced by existing enterprises facing increased competition and higher wages to pay for employees. Consequently, the groups being better off before liberalisation have a great incentive to prevent such reform, and in many cases also the power to do so. The political economy factors of financial reform will be discussed in the final section of this paper, dealing with policy implications of the theory and pieces of evidence presented.

On the basis of all the empirical evidence reviewed in this section, we have seen how all studies, whether measuring the impact of financial deepening or broadening, suffer from certain methodological shortcomings. Furthermore, we admit that we have merely been able to scratch the

surface of financial sector development research. Nevertheless, in the light of the studies reviewed, we draw three prudently generalising conclusions that are more based on speculation than solid fact:

(i) Financial deepening reduces inequality, however, the magnitude of this effect may depend on the structure of the economy.

(ii) Microfinance as a financial broadening strategy seems to increase inequality in the short run, but it could reduce inequality in the long run.

(iii) Financial liberalisation seems to increase net welfare, increase short-term inequality but lead to reductions in inequality in the long run.

We reject the inverted U-hypothesis in explaining the distributional effects of financial deepening due to the lack of empirical support. We rely on the modern theories of Banerjee and Newman (1993) and Galor and Zeira (1993) suggesting that capital market imperfections prevent economies from attaining more equal distributions of income. The positive net effects of financial deepening on income distribution can be explained by the trickle-down effect.

The implications of microfinance on inequality are somewhat inconclusive. The empirical evidence suggests that microfinance can increase the incomes of successful participants. However, a short-term rise in inequality could be offset by an increased demand for low-skilled employment, which could in the long run come to reduce inequality. A similar reasoning applies for the case of financial liberalisation broadening access to credit-constraint firms. Hence, financial sector development strategies targeting to broaden access on the extensive margin could support the idea on the inverted U. However, country-specific political economy factors can result in very different distributional patterns of financial liberalisation that cannot be measured by quantitative means. In the final section of this paper we discuss the implications of the reviewed theory and evidence from a development policy perspective.