Financial Development, Financial Structure and Income Inequality in China

• Published date: 01 September 2017
• Date: 01 September 2017
• Author: Chengsi Zhang,Yuanyuan Liu,Guanchun Liu
• DOI: http://doi.org/10.1111/twec.12430

Financial Development, Financial

Structure and Income Inequality in China

Guanchun Liu

1

, Yuanyuan Liu

1

and Chengsi Zhang

2

1

School of Economics & China Center for Economic Studies, Fudan University, Shanghai, China and

2

School of Finance & China Financial Policy Research Center, Renmin University of China, Beijing,

China

1. INTRODUCTION

FOR the past few decades, China has experienced a persistent and impressive growth rate

globally. Meanwhile, this rapid growth has been accompanied by remarkable increases in

income inequality, which have become a fundamental issue of concern in China. According

to the National Bureau of Statistics in 2004, the share of the incomes of the poorest 20 per

cent is only 4.7 per cent, while that of the richest 20 per cent is as high as 50 per cent. That

is, the ratio of the upper and lower 20 per cent is nearly 10.6, which is much higher than that

in developing countries. Furthermore, the 2010 Blue Book of China’s Society by the Chinese

Academy of Social Science shows that the Gini coefficient of China has been worsening and

was about 0.5 in 2009, exceeding the commonly recognised warning threshold of 0.4. These

findings reveal that the distribution of income in China is very uneven.

To alleviate the persistent inequality and poverty, many economic policies have been imple-

mented by the Chinese Government. In 1994, the policy of nine-year compulsory education was

introduced, and the standard of personal income tax was adjusted to 3,500 RMB from the previ-

ous 2,000 RMB in 2011. Among these macroeconomic reforms, the expansion and liberation of

the financial sectors to escape the state of ‘financial repression’ have been prominent. As an

important means of resource allocation, except for promoting social investment and economic

growth, financial development can have some direct impacts on income distribution by affecting

the economic opportunities of individuals, such as investing in human capital to attain a good

job and start a new business (Greenwood and Jovanovic, 1990; Banerjee and Newman, 1993;

Galor and Zeira, 1993; Beck et al., 2007). Meanwhile, it also exerts some indirect impacts on

income inequality by promoting economic growth and the allocation of credit to chosen indus-

trial sectors, which alters the relative demands of high-skilled and low-skilled workers (Gine and

Townsend, 2004; Townsend and Ueda, 2006; Demirg€

ucß-Kunt and Levine, 2009).

While a large body of research has investigated the existence of a strong relationship

between financial development and economic growth, some recent studies have started to

address the way in which finance can have an effect on income inequality. However, the impact

of financial development on income inequality is far from settled in the literature, since previ-

ous studies obtain a series of conflicting theoretical and empirical results. In general, the exist-

ing literature on the relationship between financial development and income inequality can be

classified into two different viewpoints: one is linear, while the other is nonlinear. In particular,

the former includes two opposite views –positive and negative –and the latter is a combination

of the linear hypothesis at different stages of economic development.

Chengsi Zhang is the corresponding author. The research was supported by the Fundamental Research

Funds for the Central Universities (Grant No. 15XNI001).

©2016 John Wiley & Sons Ltd

1890

The World Economy (2017)

doi: 10.1111/twec.12430

The World Economy

At the theoretical level, some researchers argue that financial development has a positive

impact on income distribution (Banerjee and Newman, 1993; Galor and Zeira, 1993). In the

condition of lacking enough collateral and having scant credit histories, the poor may be the

group that is most affected by financial market imperfections (e.g. information asymmetries,

contract enforcement and transaction costs), and therefore, they cannot obtain sufficient fund-

ing to satisfy their demands. To some extent, the development of the financial system espe-

cially relaxes the credit constraints on the poor and provides them with more access to

financing. They can invest to build their human and physical capital and start a new business,

even for their children, and then their income will increase. Furthermore, the rich and well-

connected group is more likely to benefit from financial development as well due to its power

to prevent small firms from gaining external finance and to reduce the ability of the poor to

improve their economic state (Rajan and Zingales, 2003). Therefore, by widening the avail-

ability of credit for the poor, financial development can help to reduce income inequality.

In contrast, other theories deem that financial development should have a negative impact

on income inequality (Banerjee and Newman, 1993; Galor and Zeira, 1993; Bourguignon and

Verdier, 2000). Due to their deficiency in collateral and social connections, the poor rely more

on informal networks of credit, such as family connections of capital. As financial institutions

develop, the groups that are relatively well-off receive more funds for their physical capital

and investment with high expected returns. In other words, the rich are better equipped to

exploit the new financial opportunities. Thus, the income of the rich increases more than that

of the poor, and the income distribution becomes more unequal. Hence, the inherent advan-

tages of the rich over the poor make the impact of financial development on income inequal-

ity negative.

Different from the previous two separate views, the mathematical model of Greenwood and

Jovanovic (1990) predicts a non-linear relationship between financial depth and income

inequality. At the early stages of economic development, the distribution of income tends to be

more uneven because only the rich can afford to access and benefit directly from the developed

financial system. As the economy develops to higher stages, the poor can also gain access to

credit and then the gap between the groups narrows. In fact, the differences in access of indi-

viduals in different income categories to financial services determine the trend of income

inequality. Moreover, Oechslin (2009) states briefly that whether the rich have incentives to

divert financial sources from the poor is determined by the development level of the financial

system. The powerful group makes efforts to push such distortions only at the early stages,

when credit is scarce, while they have no incentives to do so at more advanced stages, when

the capital is sufficient or at least their demands can be satisfied. Thus, the monopoly power

and desire of the rich for credit tend to weaken as the economy develops, and the impact of

financial development on income distribution manifests an inverse ‘U-shape’ pattern.

Furthermore, some researchers point out that financial development plays positive roles in

accelerating economic growth and thus has significant impacts on the labour market demands

of different types (Gine and Townsend, 2004; Townsend and Ueda, 2006; Demirg€

ucß-Kunt and

Levine, 2009). According to the supply–demand theory, if financial development increases the

demand of low-skilled workers more than that of high-skilled workers, the distribution of

income will be more equal. In addition, there is a ‘trickle-down’ effect of the development of

the financial system on income distribution via the promotion of aggregate growth and the

expansion of economic opportunities (Aghion and Bolton, 1997), suggesting that the signifi-

cantly positive roles of financial development in the real economy benefit the poor more.

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