Whether or not one has access to 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. The 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 (extended by financial institutions to households and private firms) accounts for a high percentage of GDP—may well be a result of wealth, but it is also a powerful driver of poverty reduction.
When private credit is a bigger share of GDP, poor people get more out of growth
It is to be expected that a strong financial sector, with sound banks, lively stock and bond markets, established insurance companies, and multiple financial intermediaries, stimulates economic growth.
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.
Micro-finance schemes can help bridge part of the gap by providing loans to the poor, enabling them to launch small enterprises which would otherwise never be created. Micro-finance 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.
Recent research by Beck, Demirguc-Kunt, and Levine indicate that raising the proportion of private credit available triggers more rapid increases in the incomes of the poor, relatively speaking, as it stimulates growth for the whole economy. 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”.
Financial sector development and achieving the Millennium Development Goals
“Our findings suggest that financial sector development is an essential determinant of a country’s prospects for achieving the eight Millennium Development Goals,” says Asli Demirguc-Kunt, research manager of the World Bank’s Development Economics Research Finance Team. “The foremost of these is to reduce by half the proportion of people living on less than $1 a day by 2015.”
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 micro-finance 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 the poor 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 gives a bigger lift to the poorest ones,” concludes Demirguc-Kunt.
This figure shows that - controlling for other country characteristics - greater financial development is associated with poverty alleviation. 'Growth in Headcount' is the average annual growth rate of the percentage of the population living on $1 a day or less over the period 1980-1999. 'Private credit' is the claims on private sector by deposit money banks and other financial institutions as a share of GDP. For a detailed discussion of the graph, see Beck, Demirguc-Kunt and Levine (2004).
Evidence from a comparative analysis of countries
Comparative analysis of average annual growth rates in poverty, private credit and GDP over 20 years show 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 $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 $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 the poor 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.
Strengthening the financial sector is a “win-win” pursuit
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 it usually entails.
Thorsten Beck is a Senior Financial Economist in the Finance Team of the Development Research Group of the World Bank. His recent research has focused on the effects of bank concentration and competitiveness, access to financial services, and the impediments to growth that SMEs face.
Patrick Honohan is a Senior Financial Sector Policy Advisor in the World Bank’s Financial Sector Vice Presidency and the Development Research Group. His current research focus is in the field of monetary and financial sector policy, including banking crises, financial liberalization and the taxation of financial intermediation.
Asli Demirguc-Kunt holds the joint appointment of Finance Research Manager, in the World Bank's Development Economics Research Group, and Adviser, Operations and Policy Department in the Bank's Financial Sector Vice Presidency. Her recent research has focused on banking crises, financial regulation, stock markets, corporate finance and the impact of financial structure on economic growth.
Ross Levine is the Harrison S. Kravis University Professor at Brown University and NBER Research Associate. His recent research has focused on financial structures and economic growth, as well as bank regulation and supervision.
To contact these researchers, send an e-mail to firstname.lastname@example.org
Beck, Thorsten, Asli Demirguc-Kunt and Ross Levine, 2004, “Finance, Inequality and Poverty: Cross-Country Evidence,” World Bank Policy Research Working Paper
Honohan, Patrick, “Financial Sector Policy and the Poor,” Working Paper No. 43. Washington D.C.: The World Bank.