How does the difference between interest and economic growth rates mediate the impact of financial development on income inequality: Whither Africa?
Finance-income inequality nexus: Setting the Context
Calls to reduce income inequality have been well documented. The Sustainable Development Goal (SDG) 10 targets at reducing inequality within and across countries by 2030. Among the set policies to reducing income inequality, development of the financial sector remains paramount. This is because improved financial sectors deliver services to the poor which enhances their productivity, thus reducing inequality. Furthermore, financial sector development dampens income inequality through its effect on overall economic growth. For Africa, this is particularly important given the continent’s high inequality and endemic poverty.
The existing empirical studies on the impact of financial sector development on inequality in Africa suggest that, improved financial development spurs overall economic growth and given the inverse link between growth and inequality, increase in financial development lowers inequality by improving the per capita income of people including the poor. Indeed, these studies argue that financial frictions with regard to information and costly transactions constraint credit access by the poor since they lack collateral securities. In this endeavor, eliminating such binding constraints disproportionally benefits the poor, improves the efficiency of financial intermediation and dampens income inequality. While these arguments are valid, they have not addressed how external factors like the difference between interest and economic growth rates influences the impact of financial development on inequality.
Given the high interest rates and overall transaction costs related to participation in the financial markets, the poor and socially excluded are more likely to be credit rationed leading to imperfect allocation of capital. Consequently, income inequality may rise with the level of financial sector development thus threatening the achievement of the SDGs. By recognizing the importance of the financial sector, the MFW4A Partnership has over the years uniquely coordinated financial sector development interventions in Africa with the aim of maximizing the developmental impact of the financial sector.
However, on account of the financial market rigidities and asymmetric information in Africa, the poor may not be able to access credit products due to their inability to meet collateral requirements even though not all financial products require collateral. More recently, the Making Finance Work for Africa (MFW4A) in collaboration with the Development and Economic Growth Research Programme (DEGRP) at ODI organized a webinar on interbank markets in Africa. This webinar highlighted the high levels of perceived risk due to information asymmetry as one of the key barriers inhibiting the development of the continent’s financial sector.
Among others, the vision is that well-developed financial sector is a critical means to an end with reduction in income inequality being the end. Given this understanding, this blog, which is a product of a study available here contributes to the existing research efforts on the impact of financial sector development on income inequality by considering the significance of the spread between interest and growth rates of countries in Africa. In particular, it investigates whether the impact of financial development on income inequality is conditioned on the relative speed of growth in interest and growth rates of countries. The research concentrates on Africa because of the continent’s high-income inequality, nascent financial sectors, relatively higher interest rates and lower level of economic development.
Why is the difference between interest and growth rates important in finance-inequality nexus?
The gap between interest and growth rates is crucial in the fight against income inequality. While access to financial resources and participation in the financial sector partly hinge on the growth rate of an economy, the higher interest rates do not only inhibit access to these financial resources but also reduce borrowers’ ability to repay funds. The gap also signals if an agent can generate enough income to service the loans borrowed. Thus, whether financial deepening decreases or increases income inequality may depend on the relative speed of growth in interest rate and that of the economy. The precise impact of financial development on income inequality is conditioned on the threshold value of the gap where financial development influences income inequality depending on whether country’s gap is below or above a certain estimated threshold. In this case, how countries’ interest rates outstrip economic growth rates mediate the impact of financial development on income inequality.
The findings and implications for policy
The impact of financial development on inequality in Africa conditioned on the gap between interest and growth rates. This implication is that, how financial development supports in reducing inequality is dependent on how narrow or wide interest rates are away from the size of the GDP growth rate. There is a threshold value of the difference between interest and growth rates where the impact of financial development on income inequality changes. The threshold levels of the gap are estimated to range between 3.9% and 6.6%. These threshold values are critical in determining how financial development influences income inequality. Financial development significantly widens income inequality when the difference between countries’ interest and economic growth rates exceeds these thresholds.
Overall, the evidence suggests that, while the nascent Africa’s financial sector does not reduce income inequality, the income inequality–increasing effect is greater (lower) when the difference between the interest and growth rate is above (below) the estimated thresholds. This evidence holds irrespective of the measure of financial development and income inequality.
Indeed, the rising inequality as a result of higher financial development can be attributed to the nature of the relatively under–developed financial markets in Africa. In addition to information asymmetry, the higher interest (lending) rates coupled with restrictive collateral requirements in Africa do not allow the poor to fully participate in the financial sector. Thus, as the financial sectors improve, they tend to disproportionately benefit the rich exacerbating the already high inequality with GINI coefficient estimated at 0.541 relative to Western Europe (0.349), North America (0.456) and Asia (0.506).
Financial sector development is far from being inclusive if interest rates of countries far outstrip growth rates. While increases in interest rate raise the cost of borrowing thus burdening the poor, higher growth rate is expected to result in higher per capita income. In Africa where poverty, income inequality and interest rates are high, the rising interest rates exclude the poor from accessing financial resources since they lack the collateral required to access credit. However, higher growth rate which is inclusive enough may off-set the effect of the prohibitive interest rates since such growth rate spurs overall income per capita. Unfortunately, this is not the case in Africa since growth rates are lower relative to other emerging economies. Given this evidence, financial reforms that aim to deepen financial development in countries where interest rates outstrip growth rates may exacerbate income inequality. This is because those who are well-off relative to the poor are better equipped to access the new financial opportunities that the financial reforms push for.
A relatively under-developed financial system with a low number of bank branches and accounts breeds weak competition. As a result, high banks’ lending rates and low economic growth rates do not incentivize the poor to access credit for productive livelihood opportunities that can -potentially- increase their income and lower income inequality. What is observed is that income inequality-widening effect is lower as the gap between interest and growth rates is below the estimated threshold levels, and vice versa. Thus, the simultaneous reduction of interest rates and improvement in economic growth are critical for financial development to dampen income inequality.
Africa has relatively high interest rates and low growth rates. Given the sample evidence, this situation does not support financial development to reduce inequality in the continent. If the difference between countries’ lending rate and GDP growth rate is positive and exceedingly higher, policies that foster financial development may not lead to income inequality reduction. Improved financial development is a necessary but not a sufficient condition to reducing inequality. In addition to relaxing the collateral requirements for the poor by banks, it is also important for Central Banks in Africa to significantly reduce interest rates by using all instruments at their disposal. This is because the reduction of borrowing costs and allowing the poor to borrow are expected to spur their access to financial resources on the back of policies that foster financial development.
About the author
Muazu Ibrahim is the Research Officer of MFW4A. He is a numerate resource person with experience in development finance and economics, policy analysis, strategic planning and evidence-based research. Prior to joining MFW4A, he worked with the United Nations Economic Commission for Africa (UNECA) in Ethiopia. He has contributed to notable flagship reports including the Economic Report on Africa (ERA) and the Economic Governance Report (EGR). Muazu was a Lecturer with the School of Business and Law (SBL), University for Development Studies (UDS), Wa campus, Ghana, where he taught courses in development finance, international trade and finance, financial markets, financial crisis and bank regulation. Muazu obtained a PhD in Economics and Finance from Wits Business School, University of the Witwatersrand, South Africa where his research examined critical themes in financial sector development–economic growth nexus in sub-Saharan Africa.