Financial development and poverty alleviation

29-Jul-2010    Financial systems play a pivotal role in any country's economy. A well developed financial sector is thus pivotal to provide credit to the population of a country. This article attempts to examine the sources of financial development and its links with the poverty alleviation.

Financial systems play a pivotal role in any countriy's economy. They allow trading, diversifying and pooling of risk; they allocate resources, monitor loans and exert corporate control; they mobilize savings and facilitate the exchange of goods and services. The ability of the banking system and the financial sector to provide credit to the population of a country is measured by the level of financial development. This term assesses the extent to which the financial system of a country facilitates the mobilization and efficient allocation of capital by: a) adopting more transparency financial and credit instruments; b) dulling high transaction costs that may constrain credit access for those potential borrowers who lack collateral and credit histories (for example, the costs of monitoring loans).

This article attempts to examine the sources of financial development and its links with the poverty alleviation. Section 1 presents the determinants of a developing financial system and its relation with economic growth. Section 2 investigates the link between financial development and poverty reduction. Section 3 draws the conclusions.

1. Determinants of financial development and its role in economic growth

Huang (2005) and Honohan (2003) consider institutional, policy and geographic variables as the main determinants of financial system development across countries. Furthermore, the authors find that a financial regulation aimed at discipline rather than control of credit markets works better for promoting bank development, performance and stability. Indeed, a high degree of state-owned banks within a country's banking sector is often associated with lower financial sector development. These conclusions, however, have been dramatically challenged by the 2007-2009 financial crisis when many Governments had to heavily intervene in the ownership of financial institutions and in credit markets.

A strong link between financial development and economic growth has been proved by a rich literature. The first important work was published by Goldsmith in 1969, finding a parallelism between economic and financial development in several decades. King and Levine (1993) studied 80 countries over the period 1960-1989 and considered different measures of the level of financial development. The results were striking. According to one of the main findings, the increasing size of the banking sector help in raising the real per capita GDP, making individuals richer.

2. Financial Development and poverty reduction

The previous results suggest a close relationship between economic growth, financial development and poverty reduction. A high degree of financial development, lower transaction costs and higher transparency of the banking sector help to outweigh credit constraints that the poor suffer due to their lack of guarantees and credit histories. Further investigation concerning the impact of financial development on poverty reduction is thus necessary. The theory that financial development contributes to the reduction in global poverty is actually controversial. A stronger banking sector and a healthier financial system may imply high salaries paid to middle-men in financial markets, further deteriorating the distribution of income. On the other hand, Rajan and Zingales (2003) highlight the opportunities for poor households and small-scale producers that financial development may create by providing loans for new investments (both in physical capital and education), projects and ideas. Specifically, Li, Squire and Zou (1997) find that financial depth1 strongly and significantly contributes to lowering inequality and to raising the average income of the lower 80% of the population. Another research by Honohan (2003) shows that in 70 developing countries a 10 percentage points increase in the ratio of credit provided by the banking sector to the private sector would reduce the poverty ratio by 2.5 to 3 percentage points.

However, the results above do not necessarily imply that a deeper banking sector automatically implies a more fair income distribution. China, for example, has one of the deepest banking sector but also a GDP per capita equal to €5,800 per year in terms of Power Purchasing Parity2 in 2010 (while, in the same period, Dutch GDP per capita amounts to €32,600 per year in PPP, five times higher). This may be due to the fact that Chinese banks are owned by the State: the amount of money deposited by people is thus invested in state-controlled enterprises on the basis of a “public interests”. In other words, the Chinese people do not have full control over their own resources and cannot invest them in investment funds or pension schemes without control being exerted by the Government.3 Hence, banking depth cannot be a wholly reliable summary indicator of the role of financial development in poverty reduction. Poverty alleviation depends also on other factors: for example, to what extent banks can mobilize savings, allocate capital and monitor the use of loanable funds by entrepreneurs.

Another way to understand the role of the access to credit in reducing poverty is to study the effects of financial development on child labor. The amount of children forced to work is usually employed as an index of the poverty level prevailing in a country. Every family with a child in the world faces an inter-temporal trade-off: is it better to allow a child to work today, immediately contributing to the family earnings, or to invest in her/his human capital and schooling process? Investing in education of children has, in other words, an opportunity cost, that is the forgone income that they would earn if they did not go to school. This cost naturally depends on the alternatives to child labor, such as the kind and the quality of the degree provided by the educational system or “time spent in play (which is known to contribute to cognitive development)” (Dehejia and Gatti, 2002).

The final choice related to child's education relies on the extent to which one has access to credit in any specific country. In the presence of financial instruments that allow families to borrow against future returns to education (through study loans, for example), children would be able to study during their youth. As a consequence, the financial system would provide incentives to invest resources and children's time in learning skills in order to make their future work more productive (and more rewarding). To understand this fact, consider a low-income couple (with less than $1 per day), living in a rural community of a developing countries without a developed (not universal) pension schemes and financial markets. In the absence of access to credit, households resort to letting their children labour in order to cope with the above income shocks. In other words, children represent a “natural insurance”, since they also have to take care of their parents during their old age. On the other hand, having a large number of kids has two major consequences. Firstly, more children means more hungry mouths to feed. Most of the households' resources would thus be invested in food and less in physical or human capital (such as education). Furthermore, the lack of financial savings induces individuals to rely upon informal savings options (like animals or raw materials) which do not provide a combination of security of funds, liquidity, positive and convenient real return. Secondly, a high number of potential young workers in an economic environment that does not grow (and thus does not supply labor) would create a mass of young unemployed people which increases the probability of social clashes and civil wars.

The introduction of micro savings and micro pension plans would alleviate this situation by designing and tailoring savings plans. These would allow people to invest a fixed monthly amount of their revenues against old age or unforeseeable external shocks (like drought or flood) which make households income more volatile, freeing resources to be invested in education for children. The previous simple example demonstrates the positive and pivotal role that financial development has in increasing children education and in poverty alleviation in developing countries.

3. Conclusions

The lack of access to sustainable and secure financial services contributes directly to financial vulnerability and a lack of income security for poor workers, especially in the informal sector. Previous research by Honohan (2003) and Dehejia and Gatti (2002), has demonstrated that poverty levels and related child labor levels decline with financial development. The introduction of micro pensions may provide people with their own income during their retirement period; micro saving schemes and insurance products, instead, give access to financial services and protection against external shocks that make income highly volatile.

“A rapid modernization of the existing financial and legal structures will allow for the inclusion of poor people into the (formal) banking and financial system. This means more money in the economy, which can lead to overall economic growth and development, and increased stability in developing country.”4


1 to what extent financial services are provided to people.

2 the ability of any Chinese citizen to buy the same standardized good – for example a Big Mac – in China, USA, The Netherlands or Russia.

3 China's banking industry is still in the government's hands even though banks have gained more autonomy. Moreover, China's accession to WTO will lead to a significant opening of this industry to foreign participation.

4 Sterk, Boudewijn (2010), Power to the People - The House of Inclusive Finance for a New African Perspective, 10 Ideas for Africa, Unesco Call-for-Ideas (unpublished).


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