Finance and inequality: the case of India.

• Author: Ang, James B.

1. Introduction

   Although the relationship between financial development and economic growth has been extensively studied in the literature (see, for example, King and Levine 1993; Demetriades and Hussein 1996; Arestis and Demetriades 1997; Levine, Loayza, and Beck 2000; Bell and Rousseau 2001; Ang and McKibbin 2007), little is known about how finance impacts income inequality. The importance of the finance-inequality relationship has recently been highlighted in an insightful survey article by Claessens and Perotti (2007). They indicate that while financial development can help reduce income inequality, financial liberalization captured by established interests may do the opposite.

   The theoretical predictions of the effects of finance on income inequality are controversial. Rajan and Zingales (2003b) argue that improvements in the formal financial sector primarily benefit the rich. Greenwood and Jovanovic (1990) predict a nonlinear relationship between financial development and income inequality, where it is hypothesized that income inequality first increases with the degree of sophistication in the financial systems, then stabilizes and eventually declines. Others propose that the presence of financial market imperfections deters the poor from borrowing adequately to invest in human and physical capital, implying that financial development helps alleviate income inequality (Banerjee and Newman 1993; Galor and Zeira 1993; Aghion and BoRon 1997; Mookherjee and Ray 2003, 2006). Given that theories provide ambiguous predictions regarding the effects of finance on the distribution of income, it is useful to approach the issue at the empirical level. This could facilitate our understanding of the relationship between finance and inequality, and help us to assess the validity of each theoretical model.

   Despite the important role of financial market frictions in the theories of poverty and income inequality, researchers so far have not adequately addressed whether financial development, and in particular financial sector policies, affect income inequality (Demirguc-Kunt and Levine 2007). In this connection, there are two novel studies that focus on examining the effect of financial development on income inequality. Using data for 83 countries over the period 1960-1995, Clarke, Xu, and Zou (2006) examine the effect of financial development on the level of the Gini coefficient--a measure of deviations from perfect income equality. Their results show that financial deepening is associated with lower income inequality. The finding of a non-linear effect of financial development is not robust. A more recent study by Beck, Demirguc-Kunt, and Levine (2007) attempts to assess the impact of financial development on changes in income distribution and income for the poor. Their main findings indicate that financial development is associated with a lower growth rate of the Gini coefficient and a higher growth rate of income for the poor. While these two studies have established that financial development helps reduce income inequality, studies examining the direct impact of financial liberalization on income inequality are particularly scant (Demirguc-Kunt and Levine 2007). The limited indirect empirical evidence, based on the survey by Arestis and Caner (2004), seems to suggest that financial liberalization has ambiguous effects on the poor and income distribution.

   This article attempts to contribute to this rather under-researched area by considering an important case study--that of India for the period 1951-2004. Specifically, I analyze the distributional impact of financial development and financial liberalization on the Gini coefficient. (1) The article aims to complement the above studies, and enrich the literature by providing further evidence on how development of financial systems and implementation of financial sector policies affect the evolution of income inequality, drawing on the experience of one of the most rapidly growing developing economies that has undergone significant financial sector reforms. I focus on India rather than a larger set of countries given that the effects of financial development and financial liberalization may be heterogeneous across countries at different stages of economic development. Moreover, case studies are particularly useful in disentangling the complexity of the financial environment and economic history of each country. By analyzing case studies, the econometric findings of this project can be related to the prevailing institutional structure (Bell and Rousseau 2001), and therefore inform academic as well as policy debate.

   The main contributions of this study include: (i) empirically testing the effect of financial development on income inequality by providing further evidence from a large and fast-growing developing country. Not only could this enhance our understanding of the finance-inequality relationship, but also fill the gap in the extant literature, which is dominated by cross-country analysis; (ii) contributing to the debate on the effectiveness of financial liberalization on the Indian economy--although various financial restructuring programs have been launched since the early 1990s, there is little empirical evidence informing policy makers of the effects of these reforms--and (iii) complementing the literature by assessing the impact of financial liberalization on income inequality. This policy factor has been somewhat neglected in the analysis of the finance-inequality nexus. The results show that income inequality decreases as the financial system deepens and broadens, consistent with the general findings in the literature. However, liberalization of the financial systems appears to have a harmful effect on income distribution, a finding that tends to support the political economy argument where captured financial sector reforms benefit only small elites.

   The remainder of the article is structured as follows. The next section describes the financial repression and liberalization experience of India. Section 3 discusses income inequality and the policies adopted to alleviate poverty. Section 4 briefly reviews the theoretical literature on the relationship between finance and inequality. The model and data are described in section 5. The estimation techniques employed in this study are explained in section 6. The results are presented and analyzed in section 7. Finally, section 8 summarizes the main findings and concludes.

2. Financial Sector Reforms in India

   There was little financial repression imposed on the Indian financial system in the 1950s. However, the Reserve Bank of India gradually imposed more controls over the financial system by introducing interest rate controls in the 1960s. The statutory liquidity ratio was raised from 25% in 1966 to 38% in 1989. The cash reserve rate increased considerably from 3% to 15% during the same period. These high liquidity and reserve requirements enabled the Bank to purchase government securities at low cost. The extent of directed credit programs has also increased significantly after the nationalization of the 14 largest private banks in 1969. A number of priority lending rates were set at levels well below those that would prevail in the free market. This process culminated in the late 1980s when directed lending accounted for more than 40% of total lending. Revenue from financial repression was estimated to be 22.4% of total central government revenue during the period 1980-1985 (see Giovannini and De Melo 1993).

   The major phase of financial liberalization was undertaken in 1991 as part of the broader economic reform in response to the balance-of-payments crisis of 1990. The objective was to restructure the entire orientation of India's financial development strategy from its position as a financially repressed system to one that was more open in order to provide a greater role for markets in price determination and resource allocation. Consequently, interest rates were gradually liberalized, and reserve and liquidity ratios were reduced significantly. The equity market was formally liberalized in 1992; although, the first country fund was set up earlier in 1986, allowing foreign investors to access the domestic equity market directly. There has also been a change in the capital account regime from a restricted one to a more open one. The regulatory framework was strengthened significantly in 1992. In addition, entry restrictions were relaxed in 1993, resulting in the establishment of more private and foreign banks. Regulations on portfolio and direct investment have since been eased. The exchange rate was unified in 1993-1994 and most restrictions on current account transactions were eliminated in 1994.

   However, despite this liberalization, the Indian financial system has continued to operate within the context of repressionist policies through the provision of subsidized credit to certain priority sectors. The bank nationalization program in 1969 has enabled the Reserve Bank of India to effectively implement its credit allocation policy. Although the government divested part of its equity position in some public banks in the 1990s, the banking sector has remained predominantly state-owned. (2) Liberalization of the directed credit programs is only limited to deregulation of priority lending rates while significant controls on the volume of directed lending remain in place. Furthermore, the Bank has tightened supervision and regulation in recent years to ensure that these priority sector requirements are met. With regard to capital controls, transactions related to capital outflows have remained heavily regulated in India. As such, it appears that repressionist measures coexist with a set of liberalization policies aimed at promoting free allocation of resources.

3. Macroeconomic Policy and Income Inequality in India

   Indian governments have accorded great importance to poverty eradication and rural...