Financial Sector Development as an Essential Determinant for Achieving the MDGs: Increasing Private Credit Shown to Reduce Income Inequality

By Asli Demirguc-Kunt, Finance Research Manager, World Bank Whether or not one has access to private credit is a litmus test for wealth or poverty. If you're rich, you have it, and can use it to get richer. If you're poor, you don't have access to it, and you remain poor. Conventional wisdom suggests that building up the financial sector has little effect on this gap.

But new World Bank research reveals that a high level of financial development — that is, where private credit accounts for a high percentage of GDP-may well be a result of wealth, but it is also a powerful driver of poverty reduction.

Private Credit as a Share of GDP That a strong financial sector, with sound banks, lively stock and bond markets, established insurance companies, and multiple financial intermediaries, stimulates economic growth is to be expected. What's new is this: in countries with well-developed financial sectors, where private credit accounts for a bigger share of GDP, the poor get a bigger income boost from growth. Meanwhile, poor people living in countries with the same growth rate, but in which private credit accounts for a smaller share of GDP, stay poorer.

Microfinance schemes can help bridge part of the gap by providing loans to poor people, enabling them to launch small enterprises, which would otherwise never be created. Microfinance is important to the extremely poor, who have no access to other sources of credit. But it accounts, at best, for only a small share of all private credit, that is, the total amount of credit channeled from savers through banks and other financial intermediaries, to private firms.

New World Bank Studies Recent World Bank studies indicate that raising the proportion of private credit available triggers more rapid increases in the incomes of poor people, relatively speaking, as it stimulates growth for the whole economy.[1] In other words, financial development increases national income and reduces income inequality at the same time. It promotes what may be called "pro-poor growth".

This finding suggests that financial sector development is an essential determinant of a country's prospects for achieving the eight Millennium Development Goals (MDGs), which include reducing by half the proportion of people living on less than US$1 a day by 2015.

"Pro-poor" Finance This hitherto unnoticed "pro-poor" dimension of finance is due to two factors. First, as financial sectors deepen they also increase their reach, providing financial services directly to poorer clients. More evaluation studies are needed to measure the scale of their overall impact, but experience suggests that microfinance has made a big difference for those who have access to it.

The second - arguably more important - factor is that even when financial development does not touch poor people directly, it does improve overall economic performance in ways that deliver disproportionately increased incomes to the poor. More abundant private credit creates a rising tide that lifts all boats, but a bigger lift to the poorest ones.

Comparative analysis of average annual growth rates in poverty, private credit and GDP over 20 years shows that countries with higher levels of private credit reduced poverty more quickly. For example, in Chile, where private credit accounts for 54 percent of GDP, the percentage of people living on less than US$1 a day decreased by 14 percent a year between 1987 and 2000. But in neighboring Peru, where private credit amounts to just 13 percent of GDP, the proportion of extremely poor rose by 19 percent from 1985 to 2000. The new estimates, taken at face value, imply that, if Peru's financial sector had been as developed, or its private credit market as well-stocked as Chile's, the proportion of the population living on less than US$1 a day could be just two percent today, instead of 15 percent-a difference of 3.4 million people.

A similar calculation suggests that, average incomes of poor people in Brazil could have grown by more than 1.5 percent a year from 1960 to 1999 instead of zero percent, if Brazil's financial system had been as developed as Korea's; Korea's private credit amounts to 74 percent of its GDP, while Brazil's is just 28 percent of GDP.

Finance helps expand the range of firms and economic sectors that can get a foothold in the modern economy, and likely reduces concentrations of wealth that ultimately undermine prospects for overall economic growth. International survey evidence shows that small firms gain most in terms of access to finance where financial and legal systems are strengthened.

A vibrant financial sector can result in expanded banking and credit services to low-income households. But its biggest contribution is that it raises the amount of credit available to all entrepreneurs, which, in turn, increases the level of economic activity, generating more job opportunities and higher incomes among the poor.

Strengthening the financial sector thus emerges as a win-win pursuit, that promises faster growth and more income equality, without igniting often thorny debates over redistribution, and the tradeoffs that usually entails.

To learn more about this author, visit United Nations Capital Development Fund's Website.

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