The income inequality, financial depth and economic growth nexus in China

• Author: Eduard J. Bomhoff,Grace H. Y. Lee,Sharon G. M. Koh
• Published date: 01 February 2020
• DOI: http://doi.org/10.1111/twec.12825
• Date: 01 February 2020

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wileyonlinelibrary.com/journal/twec World Econ. 2020;43:412–427.

© 2019 John Wiley & Sons Ltd

Received: 15 February 2018

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Revised: 18 April 2019

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Accepted: 7 May 2019

DOI: 10.1111/twec.12825

ORIGINAL ARTICLE

The income inequality, financial depth and

economic growth nexus in China

Sharon G. M.Koh

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Grace H. Y.Lee

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Eduard J.Bomhoff

Monash University ‐ Malaysia Campus, Bandar Sunway, Selangor, Malaysia

KEYWORDS

ARDL Bounds, Granger causality, Income inequality, Financial Depth, Economic Growth

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INTRODUCTION

China has rapidly opened to the world since the onset of its economic reforms, resulting in accelerated

economic growth and development (Siebert, 2007). As the country experiences almost a double‐digit

growth rate, there is a noticeable, corresponding increase in the level of income inequality. Many

studies find rising inequality to impede future development and possibly a precursor to social tension

or political instability (Gu, Dong, & Huang, 2015; Jian, Sachs, & Warner, 1996; Kanbur & Zhang,

2005). In this view, the Chinese government has set out to reverse the rising inequality. The govern-

ment aims to build a more “harmonious socialist society” (11th five‐year plan) and reinforces the

concept of inclusive growth (12th and 13th five‐year plans) as one of its key development goals

(Kanbur, Rhee, & Zhuang, 2014). A wide range of government policies reflects this commitment,

such as the dibao1

system, subsidy to support compulsory education and elimination of agricultural

taxes to help rural farmers.

Additionally, greater financial reforms2

are observed in China. Regulation is passed to make the

financial system more competitive and stable. The increase in the availability of credit to public enter-

prises, firms and households further confirms t he development of the financial sector in China. Low‐

interest loans available from local banks or financial institutions have reduced poverty levels amongst

urban and rural households (Zhang & Loubere, 2015). While the exceptional growth rate for the past

1 “Dibao” or urban minimum living standard guarantee programme is an initiative by the Chinese government to help the poor

come out of poverty (Wang, 2007).

2 China also plays a pivotal role in developing the financial sector in the region and many countries have been benefitting

from China's economic growth (Koh & Kwok, 2017; Kwok & Koh, 2017). For instance, China continues to play a crucial

role in the Asian Infrastructure Investment Bank (AIIB), a multilateral development bank which aims to support infrastruc-

ture development in the Asia–Pacific region (Stiglitz, 2015). The Yuan has also been recognised as a major reserve currency

after it was added to the International Monetary Fund (IMF) basket of currencies which represents China's increasing status in

global financial markets (Tobin, 2013).

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few decades is evidence that China is moderately successful in its policies, it also prompts us to ques-

tion its impact on inequality. President Xi Jinping recently declared that the country needs a “crucial

rebalancing to embrace a new normal growth phrase” (Hu, 2015). This will ensure that benefits from

economic development are more evenly distributed, which is necessary as the country integrates fur-

ther with the world's economy.3

Our study differs from the existing literature in two ways. First, we expand the discussion of in-

equality‐growth‐financial depth using theoretical considerations from Kuznets (1955) and Greenwood

and Jovanovic (1990) using a two‐step procedure of the autoregressive distributed lag (ARDL) bounds

and Granger causality. In many instances, a time series analysis will provide deeper insights (Ang

& McKibbin, 2007; Arestis & Demetriades, 1997) into the relationship between the three variables

compared to cross‐country regressions in terms of policy implication. The ARDL is suitable here

since macroeconomic variables often reflect its past behaviour and should be seen as a dynamic and

autoregressive process (Narayan & Smyth, 2006).

Conceptually, a well‐developed financial sector leads to long‐run economic growth by easing the

ability of firms to access capital. Since capital is an essential input in the production function, higher

capital accessibility will lead to higher productivity and growth. As a result, economic growth and

financial depth may have an inequality‐widening effect temporarily since credit is often provided on

condition of available collateral. When the country achieves high economic growth, the benefits are

trickled down to other individuals in the society leading to an inequality‐narrowing effect (Kuznets,

1955). This argument is also in line with the theoretical stipulations of Greenwood and Jovanovic

(1990). Greenwood and Jovanovic (1990) hypothesised an inverted U‐shaped relationship between fi-

nancial sector development and inequality (resembling Kuznets' hypothesis). According to the authors,

the country's financial markets formalise with greater economic growth as the income gap widens.

The maturity stage is characterised by a well‐structured financial market and financial intermediaries.

Finally, the income gap will stabilise as the country's growth reaches a higher level. There is a possibil-

ity that this experience may not be evident in China and the country may move away from the inequal-

ity‐narrowing effect as predicted by the inverted U‐shape hypothesis (Kotarski, 2015). Earlier papers

such as Liu, Liu, and Zhang (2017) look at the different aspects of financial development to examine

the inequality‐financial structure relationship using a dynamic GMM approach. Nonetheless, the finan-

cial system often helps accelerate economic growth through the expansion of economic opportunities

(Beck, Demirgüç‐Kunt, & Levine, 2007). Furthermore, the literature on the direction of causality look-

ing at either income inequality‐finance, finance‐growth or inequality‐growth has so far provided mixed

evidence (Chang, 2002; Jalil & Feridun, 2011; Khalifa Al‐Yousif, 2002; Wan, Lu, & Chen, 2006).

Second, the paper contributes in terms of econometric strategy. The bounds approach developed in

Pesaran and Pesaran (1997) and subsequently expanded in Pesaran, Shin, and Smith (2001) offers

several advantages in comparison with other conventional cointegration techniques.4

The restrictive

assumption that all variables must be integrated in the same order is relaxed here. The bounds test can

be used irrespective of whether the variables are I(0) or I(1). This technique provides unbiased esti-

mates as it simultaneously corrects for residual serial correlation and problem of endogenous vari-

ables (Pesaran & Shin, 1999). Additionally, while the conventional cointegration techniques estimate

the long‐run relationships within the context of a system of equations, the ARDL method employs a

single reduced form equation.

3 “The Chinese century is not at the beginning of the end; it is at the end of the beginning” (Hu, 2015).

4 The Engle–Granger (1987) single equation model may be problematic when there are more than two variables, and the

number of cointegration vectors is unknown (Asteriou & Hall, 2007; Harris, 1995). The multivariate approach developed by

Johansen (1988), though widely used, is sensitive to lag length (Hjalmarsson & Österholm, 2010).