Income Inequality and the Growth of Africa’s Financial Sector

Jan 16, 2011
In the 1980s and 1990s, most African countries embarked on a series of structural and policy reforms in the financial sector as part of overall economic reforms. The goal was to revive restart economic growth while improving economic and financial sector efficiency.
Initial reforms in the financial sector included the abolition of explicit controls on the pricing and allocation of credit, reducing direct government intervention in the financial sector. They also included a relaxation of controls on international capital flows and the determination of interest rates by the markets, rather than government. The second generation of financial sector reforms focused on structural and institutional constraints, such as improving the legal, regulatory, supervisory and judicial environment, restoring bank soundness, and rehabilitating financial infrastructure. The impact of these reforms on Africa’s financial sector was generally positive and a result is that financial depth on the continent has improved. A conductive business and investment environment as well as the improvement of

financial systems have now begun to attract foreign capital, although this is directed mainly at natural resources. The impact of the reforms on the reduction of financial inequality has, however, been questioned. For sub-Saharan Africa, the proportion of the poor surviving on less than $1.25 per day has hardly shifted between 1981 and 2005, falling from 53% to 51% between the two periods. In South Asia, which is a relatively comparable region with Africa, the poverty head count ratio fell from 59% to 40% between the two periods. Not only is poverty in Africa high but inequality, as measured by the Gini-coefficient, is also high. For the period 1992-2007, the Gini-coefficient for Africa averaged 0.44, while that for Latin America and the Caribbean averaged 0.51. But the figures for Africa also show a large variation in the Gini-coefficient between countries. Cote d’Ivoire and Tunisia have the lowest average Gini-coefficient (0.41) while Cameroon and Lesotho have the highest (0.54). In general, the level of income inequality in African countries has been very high and rather consistent over the period. A functional financial system fosters the accumulation of capital, improves economic efficiency and thus promotes long term growth. This, a number of writers have stated, has been the case in Africa. The impact of the development of financial systems on income distribution and poverty reduction, however, remains a matter of debate. Some argue that more developed and freer markets have widened the availability of credit, allowing the poor to invest in their human and physical capital, and also establish small businesses. By widening the financial opportunities available to the poor, the development of financial markets has helped reduce income disparities.
Indeed, most empirical research gives substantial support to the view that financial development reduces income inequality. One such study finds that when the financial sector is underdeveloped, inequality increases with financial markets development. However, as the economy, and the sector, develop and enters an intermediate and later a mature phase in which more people gain access to the financial sector, incomes rise while income disparities are reduced.

Others, however, argue that while this view may seem plausible, it is not based on any real evidence. They, indeed, go so far as to say that this ‘development’ of Africa’s financial sector may in fact have raised income inequalities on the continent. While the well-to-do have had the capacity to seize the opportunities created by this development of the financial markets, they argue, the poor have been left in a limbo as they have failed to obtain equal access to credit due to their lack of collateral and connections, among other factors.
This development of the financial markets may thus actually have worsened income inequality on the continent. Similarly, Banerjee and Newman (1993) and Galor and Zeira (1993), for instance, suggest a linear relationship between financial development and income inequality. Their view is that financial market imperfections such unaffordable transaction and contract enforcement costs; hold down the poor, who lack collateral, credit histories and contacts. As such, even when the poor may have projects from which high returns can be expected, they may still find it difficult to obtain appropriate levels of credit. This reduces the efficiency of capital allocation and limits the social mobility of the poor. Under such circumstances, income inequality rises with the development of financial markets. It is against this background that I and my two co-authors, Francesco Guidi of the Department of International Business at University of Greenwhich and Michael Enowbi Batou of University of East London, embarked on what we believed was the first study on the relationship between financial development and inequality based purely on Africa countries. In particular, we sought to investigate whether financial development in Africa has had an impact on income inequality, drawing on the experience of the continent’s financial reforms amid a very high and persistent level of inequality. Our purpose is to investigate whether the developments taking place in financial sector as a result of financial reforms can reduce the persistent level of inequality. The sample comprised of 22 out of 53 African countries for which we had data on inequality indices. We found this dataset sufficient for the analysis. The length of the dataset, covering the period 1980 to 2004, also allowed us to gather a good number of observations within each country. The findings of the study are in the paper titled Financial Development and Income Inequality: Evidence from African Countries.’ Our findings still showed that high levels of financial development tend to reduce financial inequality. Indeed, our results showed that a 1 percent rise in financial development is associated to a reduction of income inequality between the ranges of 0.02 to 0.05 per cent. However, we found no evidence supporting a direct relationship between financial sector development and the growth of income inequality. We also found that improved education was also a major contributor to the reduction of income inequality, suggesting that spending more on education and expanding coverage would have a substantial impact on the distribution of income. It is our belief that in trying to widen access to the financial markets, targeting especially those in the lower income cohort and the rural populations will help to reduce the persistent income inequality that exists in African countries.

From these findings, we believe it is important that financial policy designs take into account issues of poverty and inequality.

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