Does Financial Development Contribute

to Poverty Reduction?

HOSSEIN JALILIAN and COLIN KIRKPATRICK

The article examines the contribution of financial development to

poverty reduction in developing countries. Building on earlier
research which has established links between financial development
and economic growth, and between economic growth and poverty
reduction, the article tests for a causal process linking financial
sector growth and poverty reduction. The empirical results indicate
that, up to a threshold level of economic development, financial
sector growth contributes to poverty reduction through the growth-
enhancing effect. The impact of financial development on poverty
reduction will be affected, however, by any change in income
inequality resulting from financial development.

I. INTRODUCTION

An extensive literature has developed in recent years on how an economy’s

financial system affects its growth, and vice versa. There is also a substantial
body of research on the linkages between economic growth, income
distribution, and poverty reduction. There has been very little empirical
investigation, however, of the impact of financial development on poverty
reduction which allows for the complex set of inter-dependencies between
financial development, economic growth, income inequality and poverty
reduction.

Hossein Jalilian, Bradford Centre for International Development, University of Bradford. Colin
Kirkpatrick (corresponding author), Institute for Development Policy and Management,
University of Manchester, Manchester, M13 9QH. E-mail: Colin.Kirkpatrick@man.ac.uk.
Earlier versions of the article were presented at Nanyang Business School, Nanyang
Technological University, Singapore, December 2001, the Conference on Finance for Growth
and Poverty Reduction: Experience, Policy and Practice, University of Manchester, April 2002,
and at the ESRC Finance and Poverty Reduction Seminar, University of Birmingham, March
2003. We are grateful to participants at these presentations, in particular, Subrata Ghatak, for
helpful comments. We have also benefited from the suggestions of the journal’s referees. Colin
Kirkpatrick’s contribution was supported by the DFID-funded Finance and Development
Research Programme.
The Journal of Development Studies, Vol.41, No.4, May 2005, pp.636 – 656
ISSN 0022-0388 print/1743-9140 online
DOI: 10.1080/00220380500092754 # 2005 Taylor & Francis Group Ltd
FINANCIAL DEVELOPMENT AND POVERTY REDUCTION 637

The aim of this article is to estimate the causal relationships which link
financial development to poverty reduction in developing countries. Section
II reviews the financial development and growth literature and identifies
financial market failures and imperfections as key factors which weaken the
potential impact of financial sector development on economic growth and
development. The literature relating to economic growth and poverty is also
reviewed in this section. Section III formulates the functional relations
between financial development, income inequality, economic growth and
poverty reduction to allow for empirical testing. The next two sections
discuss the data used in the empirical analysis, summarise the diagnostic
statistics and preliminary analysis, and present the econometric results. The
final section provides a summary and conclusion to the article.

II. FINANCIAL DEVELOPMENT, ECONOMIC GROWTH AND

POVERTY REDUCTION

There is a large body of theoretical and empirical literature to support the

proposition that an efficient, well-functioning financial system is a necessary
condition for long-term economic growth. Almost a century ago, Schumpeter
[1911] argued that financial intermediation through the banking system
played a pivotal role in economic development by affecting the allocation of
savings and, thereby improving productivity, technical change and economic
growth. Modern financial theory emphasises the intermediation role
performed by financial institutions in bridging the information asymmetries
between borrowers and savers, thereby performing the functions of savings
mobilisation, capital fund allocation, monitoring of the use of funds, and
managing risk, which together support the economic growth process [Levine,
1997].
Empirical investigation of the financial development and economic growth
relationship has relied heavily on cross-country econometric analysis [King
and Levine, 1993 a, b; Arestis and Demetriades 1997; Levine 1997; Rajan
and Zingales, 1998; World Bank, 2001b]. The findings of King and Levine
[1993a] are representative of this body of literature: ‘higher levels of
financial development are significantly and robustly correlated with faster
current and future rates of economic growth, physical capital accumulation
and economic efficiency improvements’ (717–18); and ‘finance does not only
follow growth; finance seems importantly to lead to economic growth’ (730).
Recent advances in econometric techniques allow for the pooling of cross-
country and time-series data, and by correcting for simultaneity provide a
more robust procedure for testing for causality. The study by Levine, Loayza
and Beck [2000] uses dynamic panel data techniques to analyse the causal
relationship between banking sector development and economic growth.
638 THE JOURNAL OF DEVELOPMENT STUDIES

Using data for 63 countries averaged over the period 1960–95, and after
controlling for potential endogeneity bias, the authors find that, ‘ the data
suggest a strong, positive link between financial intermediary development
and economic growth’ (54). In a separate study [Beck, Levine and Loayza,
2000], the same data set and techniques are used to assess the impact of
financial development on the separate factors contributing to economic
growth, including private savings, capital accumulation and productivity. The
results show that the impact of financial intermediation on economic growth
occurs mainly through total factor productivity growth, rather than through
savings or physical capital accumulation.
A second inherent problem with cross-section analysis is the assumption of
structural homogeneity. Ram [1999] splits an all-country sample into three
sub-groups classified by average growth performance, and finds significant
variation in the financial development growth correlations. Andersen and
Tarp [2003] perform a similar procedure, by re-estimating the Levine et al.
[2000] model with the data split by regions. Their results again confirm
structural heterogeneity: as regions are progressively taken out of the data set,
the financial development indicators become insignificant. Individual country
studies also show a positive relationship between financial development and
economic growth, but indicate that the functional form varies between
countries [Demetriades and Hussein, 1996; Luintel and Klan, 1999;
Demetriades, Devereux and Luintel, 1998].
To summarise, there is a substantial body of empirical evidence that
confirms a positive causal link from financial development to economic
growth, while at the same time showing cross-country heterogeneity in the
relationship. Such heterogeneity in the impact of financial development on
economic growth may reflect structural, institutional and policy differences in
the economies included in the sample, and may, in turn, allow us to identify
appropriate policy interventions for strengthening the growth-promoting
effects of financial sector development.
Where there are significant imperfections in the financial market, resulting,
for example, from asymmetric information, then the contribution which the
financial sector makes to economic growth is impaired [Stiglitz, 1998, 2000].
The impact of market imperfections will be compounded by a weak financial
regulatory and supervisory framework [Brownbridge and Kirkpatrick, 2000,
2002]. These problems are often pronounced in low-income countries, where
institutional capacity and regulatory skills are limited, and where political
pressure to induce regulatory forebearance further weakens the effectiveness
of the regulation process [Jalilian, Kirkpatrick, Parker, 2003].
With the international commitment to the goal of poverty reduction in the
developing world, attention has been focused in recent years on the
relationship between economic growth and poverty reduction and on
FINANCIAL DEVELOPMENT AND POVERTY REDUCTION 639

achieving ‘pro-poor growth’. There are different definitions, however, of pro-

poor growth. One definition is a situation in which incomes of the poor grow
at a higher rate than the non-poor. With this definition, the absolute living
standards of the poor may rise even when there are ‘anti-poor’ shifts in the
relative income distribution. Other observers define pro-poor growth as
growth that reduces poverty by some agreed measure [Ravallion and Chen,
2003]. This measure does not allow for the impact of growth on income
distribution, and hence on poverty. Analysis of the link between economic
growth and poverty reduction needs, therefore, to incorporate the distribu-
tional effects, which may make the overall growth process more or less pro-
poor over time [Goudie and Ladd, 1999; McKay, 2002]. ‘For a given rate of
growth, the extent of poverty reduction depends on how the distribution of
income changes with changes in growth and on initial inequalities in income,
assets and access to opportunities to allow the poor to share in growth’
[World Bank, 2001a: 52].
There are a number of arguments as to why inequality may retard the
growth of an economy. Inequalities in wealth imply significant inequalities in
access to productive assets resulting in under-utilisation of the productive
potential of the poor [Ferreira, 1999]. Credit market failures will mean that
people are unable to exploit growth-promoting opportunities for investment
in physical and human capital. With declining marginal products of capital,
the output loss from the market failure will be greater for the poor, so that the
higher the proportion of poor people in the economy, the lower the rate of
growth [Ravallion, 2001:1808]. The existing evidence using cross-country
growth regressions is generally supportive of the view that a high initial level
of inequality can lower the rate of growth, after controlling for other factors
such as the initial level of income [Birdsall and Londono, 1997; Deininger
and Squire, 1998].
The impact of economic growth on inequality is likely to be related to the
initial conditions in the economy. Early theoretical contributions stressed the
structural characteristics of an economy as important determinants of the
growth–inequality relationship [Lewis, 1954, 1955, 1983; Kuznets, 1955].
Both Lewis and Kuznets proposed that the link between inequality and
growth would take an inverted U-form, with inequality increasing with
economic growth at low income per capita levels, and then decreasing once a
threshold or turning point income per capita level is passed. Lewis [1983]
provided an intuitive explanation for increasing inequality at the early stages
of development: ‘development must be in-egalitarian because it does not start
in every part of an economy at the same time’. An initial unequal distribution
of wealth and lack of access to various forms of productive assets may
contribute therefore, to a worsening in the distribution of income with
economic growth in low-income economies. Initially, those who are in
640 THE JOURNAL OF DEVELOPMENT STUDIES

possession of physical, financial and human capital assets are likely to benefit
most from economic growth. However, as the economy develops and market
imperfections lessen, access to capital in its various forms may be expected to
widen, and inequality will begin to lessen with continued economic growth.
This lessening of the trade-off between growth and inequality may be
reinforced by political economy considerations, where rising income per
capita levels are associated with widening participation and politicalisation
[Alesina and Rodrik, 1994; Alesina and Perotti, 1996].
Empirical studies of the growth and inequality relationship have used a
growth accounting framework approach to test for an augmented Kuznets
curve relationship [Barro, 1991, 2000].
While the results are less robust than the evidence on the impact of
inequality on growth, they do provide empirical verification of a negative
relationship between an income per capita regressor (level, change in level
and squared to allow for a u-shaped relationship), and an inequality
dependent variable.
To summarise, the distribution of wealth is an integral part of the economic
growth and poverty reduction relationship. Both theory and empirical
evidence suggest that inequality both affects and is affected by economic
growth. As low-income economies grow, poverty is likely to be reduced, but
the rate at which poverty falls could be lowered by an increase in inequality.
Depending on the magnitude of the poverty reduction elasticities with respect
to growth and inequality, the net effect of growth on poverty reduction could
be positive or negative. As Bourguignon [1996–97] points out:

The view that inequality is mostly determined by the current level of

development and the view that it determines the rate of growth are
perhaps not contradictory but complementary. They can be seen as
partial views of a general equilibrium mechanism in which the
characteristics of an economic system determine the current distribu-
tion of income along with other current economic indicators, which in
turn determine the growth rate and the new characteristics of the
economy.

Figure 1 summarises the possible links between growth, inequality and

poverty. Starting from an income profile as shown by curve A, if GDP growth
is equally shared by all income classes, a possible outcome would be as
shown by income profile B: the vertical gap between A and B shows income
growth for each income class. As a result of equi-proportional growth in
income, income distribution has not changed and the level of poverty has
declined from Po to P1. If, however, GDP growth is not equally shared, the
distribution of income will be changed and the impact on poverty reduction
FINANCIAL DEVELOPMENT AND POVERTY REDUCTION 641
FIGURE 1
GR O W T H , IN E Q U A L IT Y A N D P O VE R T Y

will also be affected. Profile C shows a situation where the main beneficiaries
of growth are those at higher levels of income. Although poverty is reduced,
this reduction is smaller than in the previous case (P2 – Po as against P1 – Po).
There are also shifts within the poverty segment of the distribution, with
those below P3 experiencing an increase in poverty.

III. FINANCIAL DEVELOPMENT AND POVERTY REDUCTION

Market failures resulting from problems of moral hazard and adverse

selection are a characteristic feature of capital markets [Stiglitz and Weiss,
1981; Stiglitz, 1998]. These market imperfections result in unequal access to
credit, whereby a group of people are unable to invest productively, simply
because they do not have sufficient wealth for collateral, or because imperfect
information limits efficient intermediation by the financial institutions.
Credit market imperfections are likely to be linked to inequality in wealth
and income distribution which means that those who are in possession of
financial, physical and human capital resources are likely to benefit most
from any general growth in financial markets.
Market behaviour will allocate credit to those who can provide collateral
and to those with whom the financial institutions have an established
relationship. This can be expected to enhance the economy’s growth rate
through improved productivity of endowed resources and increased
642 THE JOURNAL OF DEVELOPMENT STUDIES

accumulation [Beck et al. 2000], but given the unequal distribution of

income, the gap between those who have access to the formal financial
system and those who do not, can be expected to widen, particularly if there
are fixed costs of monitoring [Banerjee, 2001: 27].
Several recent models have provided a formal explanation of how
capital market imperfections might affect income inequality during the
economic development process. The Greenwood and Jovanovic [1990]
model predicts an inverted u-shaped relationship between income
inequality and financial sector development. At the initial stages of
development credit market failures result in high transaction costs which
mean that only those individuals who have command over a certain level
of assets are likely to be engaged with the financial system and to benefit
from it. Assuming that the poor save less and thus accumulate wealth
more slowly, income differences widen, resulting in an increase in income
inequality. Over time, as the financial system matures, the transaction
costs of using financial services decline and there is improved access to its
use for a wider section of society. The gradual growth of the financial
system can be expected, therefore, to weaken the link between asset
ownership and investment resulting in an eventual reversal in the upward
trend of income inequality.
The links between financial development, economic growth, inequality and
poverty reduction are represented in Figure 2. In the remainder of this section
we formulate these linkages for empirical testing of the impact of financial
development on poverty reduction.
As in King and Levine [1993a], we assume that economic growth is
directly related to financial development as well as to other explanatory
variables, that is:
g ¼ a0 þ a1 FD þ ai Wi i ¼ 2...m ð1Þ
where g is income per capita growth rate, FD is a proxy for financial
development and WI, i = 1 to m, stand for other explanatory variables, both
quantitative and qualitative, that have an impact on growth.1 Adding a
stochastic error term to equation (1) gives us a generic econometric model
which can then be used to measure the magnitude of various growth
determinants. Appropriate dummies can also be introduced in equation (1) to
allow for country specific characteristics and differences.
To analyse the link between financial development and inequality we
use a reduced form model which explains inequality by the level of GDP
per capita as well as its square, controlling for other variables and special
characteristics or conditions in different countries [Barro, 2000] Equation
(2) below is a generic model that is used to test the inverted ‘U’
hypothesis.
FINANCIAL DEVELOPMENT AND POVERTY REDUCTION 643
FIGURE 2
I N T E R A C T I O N OF F I N A N C I A L DE V E L O P M E N T W I T H G R O W T H , I NE Q U A L I T Y A N D
P O VE RT Y

X
G ¼ a þ b1 y þ b2 y2 þ bi Vi i ¼ 3...m ð2Þ
i¼3

where G stands for Gini coefficient, y for the level of per capita income and V
for a number of control and other independent variables that affect the
distribution of income.
The third relation to be investigated is the link between economic growth
and poverty. Here, we follow Dollar and Kraay [2002]2 among others, in
using the following explicit log-linear functional form as a base model for our
analysis:
X
m
Inðyp Þ ¼ m1 Iny þ mi Xi i ¼ 2...m ð3Þ
i¼2

where yP denotes per capita income in the poorest segment of the population,
y stands for average per capita income for the entire population, and X is a
vector of other determinants of mean income of the poor. Vector X also
includes a number of control variables. It was established earlier that the
relationship between aggregate growth and poverty will depend upon
distributional changes during the process of growth and on the initial level
of inequality. A measure of inequality is included therefore, as one of the
control variables applied in equation (3).
First differencing of equation (3) gives a relationship between growth of
income of the poor, gP and growth of average income, g:
644 THE JOURNAL OF DEVELOPMENT STUDIES

X
m
g p ¼ m1 g þ mi DXi ð4Þ
i¼2

Adding an intercept and a stochastic error term to equation (4) gives us an

econometric model of poverty determinants, the parameter estimates of
which give the magnitude of the elasticity of poverty reduction with respect
to growth in the economy and other determinants of poverty.
In principle, one could combine equations (1), (2) and (4) in order to get a
direct relationship between growth of income of the poor and determinants of
average income, including financial development. This implies substituting
income growth from the accounting analysis given by (1) in place of the
growth term in the first difference of the poverty determinants given in (4),
resulting in the following relationship:
X X
gP ¼ f1 FDþ f2i Wi þ f3i DXi ð5Þ
i i

where j1 = a1m1, j2i = aim1, j3i = mi, and i = 2. . .m. However, in general, this
substitution is inappropriate on the grounds of the stochastic properties of the
relationship specified by the two equations, as well as technical considera-
tions that are explained below.
The interaction of the independent variables in the case of growth may
differ from their interaction in the case of poverty, in which case the
reduced form suggested by equation (5) may at best, give an estimate of
the net effects of the various common variables. Equation (5) gives an
estimate of j rather than of a and mwhich we are interested in, since they
capture the indirect and direct poverty effects of various variables,
respectively. Furthermore, if there is high correlation between dependent
variables in different specifications, this generates a multicollinearity
problem as a result of which the precision of parameter estimates will be
affected. A more serious problem however, is likely to arise due to the
stochastic nature of relationships specified by equations (1) and (4). Using
equation (5) as a base regression model implies that the error term is
composed of those which are associated with (1) and (4). This problem
will be exacerbated if, as is likely to be the case, error terms associated
with specifications (1) and (4) behave differently. In that case the
regression is unlikely to produce statistically robust results. An alternative
method of estimation would be to set up a system of equations and use a
technique such as two stage least squares regression (2SLS). But
insufficient number of lagged observations and appropriate instruments
rules out the use of these techniques. We therefore estimate each
specification separately and independently.
FINANCIAL DEVELOPMENT AND POVERTY REDUCTION 645

The chosen method of capturing the role that financial development plays
in poverty reduction, based on our discussion above, is as follows:
dgp =dFD ¼ @gp =@g  @g=@FD þ @gp =@FD þ dgp =dG  @G=@FD ð6Þ
This derivative is based on equations (1) and (4). The relationship shown by
equation (6) captures the overall impact of financial development on the
growth of income of the poor. The first term on the right hand side of
equation (6) captures the indirect (trickle-down) impact of financial
development on growth of income of the poor. The second term captures
its direct impact. The third term captures the effect of financial development
on poverty via a change in inequality. From equation (4), @gg/@g = m1is the
rate of change of growth of income of the poor with respect to change in
average growth of income of population. Based on equation (1), @g/@fd = a1
captures change in average growth of income with respect to a unit change in
financial development. Therefore the overall impact is equal to:
dgp =dFD ¼ a1  m1 þ l1 þ l2 ð7Þ
where l1 = @g /@FD captures the direct poverty reduction effect of financial
g

market development and l2 = dgg /dG*@G/@FD captures the effect of FD on

poverty via inequality.

IV. DATA SOURCES AND PRELIMINARY ANALYSIS

Data on macro variables are taken from the World Bank’s World
Development Indicators. Data on various indicators of financial development
were extracted from the IMF’s International Financial Statistics.3 We are
pressed, however, for a reliable and up-to-date series on poverty and
inequality for most countries, and particularly for developing countries. The
data set most researchers have used in recent empirical research is based on
Deninger and Squire [1996] and Lundberg and Squire [1998], which give
both income and headcount data for the poor, as well as Gini coefficients.
Dollar and Kraay [2002] have extended the series both with respect to
countries and time period and we use their data for income for the bottom
quintile. There is also an extensive Theil inequality index series prepared by
the University of Texas Inequality Project [Galbraith and Lu 2000]. In some
regressions we experiment with the use of this index as an alternative to the
Gini coefficient.
For all our analyses we use a pooled-panel data approach with both a time
series and cross section dimension.4 All of the data sets generated were
unbalanced panels. For the growth accounting exercise, the largest data set
that we were able to construct included 285 observations covering 42
countries, including 26 developing and 16 developed countries. Available
646 THE JOURNAL OF DEVELOPMENT STUDIES

TABLE 1
C O R R E L A T I O N C OE F F IC I E N T M A T R I X , 1 9 6 0 – 95

Variables 1 2 3 4 5 6 7 8
1 Gini coefficient 1.00
2 Private credit 7 0.38 1.00
3 GDP growth 7 0.08 0.12 1.00
4 GDP per capita 7 0.55 0.74 0.01 1.00
5 Government expenditure 7 0.40 0.32 7 0.11 0.57 1.00
6 Openness 0.03 0.01 0.05 0.03 0.13 1.00
7 Inflation 0.32 7 0.27 7 0.25 7 0.21 7 0.19 7 0.18 1.00
8 Secondary schooling 0.41 0.61 0.02 0.74 0.42 0.05 7 0.12 1.00

TABLE 2
S U M M A R Y S T A T I S T I C S , 19 6 0 – 9 5

Variable 1 2 3 4 5 6 7 8
Maximum 62.87 2.06 0.10 18273 0.28 1.80 2.22 5.15
Minimum 23.05 0.03 7 0.04 437 0.06 0.10 6.00 0.10
Mean 39.56 0.48 0.02 6514 0.15 0.52 0.14 1.54
Standard deviation 9.89 0.36 0.02 4777 0.05 0.29 0.27 1.03
Skewness 0.52 1.27 0.14 0.47 0.45 1.27 5.85 0.94
Kurtosis 7 0.80 1.72 0.80 7 1.09 7 0.56 2.37 34.25 0.40
Coefficient of variation 0.25 0.74 1.07 0.73 0.35 0.55 2.74 0.67

information on inequality and particularly income of the poor is more

limiting, and our data set for analysis of inequality and poverty included 225
and 147 observations respectively, again covering developing as well as
developed countries. A list of the countries included in the regressions is
given in Appendix 1.
Table 1 provides a correlation coefficient matrix and Table 2 shows the
summary statistics, for the key variables we have used in this study. Most
correlation coefficients have the expected sign. In particular, those between
various indicators of financial development and index of inequality have the
expected negative sign, while those between FD and growth are positive.
Before proceeding with the formal test of the models we attempted to carry
out some preliminary investigation of the data in terms of stationarity. Formal
testing would require a long length of lags for the variables of interest.
Unfortunately, none of the data sets we were able to construct had sufficient
lags and for this reason we were unable to carry out the formal tests.
However, graphical inspection of the residuals did not suggest any serious
problem as far as non-stationarity is concerned. Given that we are using first
difference models and that most economic series are I(1), we are sufficiently
FINANCIAL DEVELOPMENT AND POVERTY REDUCTION 647

confident that the first difference series are I(0) and that we are not capturing
a spurious relationship. A further issue that we were concerned with in our
empirical analysis is that of spatial correlation. Again, limitations in the data
set precluded carrying out a formal test on this, but graphical inspection of
residuals does not seem to suggest that this is a problem.

V. RESULTS

We now seek to test empirically the various relationships shown in Figure 2,

with the objective of confirming the contribution that financial development
makes to poverty reduction. We proceed by estimating each link separately,
before combining the results to provide a more complete analysis of the
linkages between financial development, income distribution, economic
growth and poverty reduction.

Financial Market Development and Growth

In estimating the contribution of financial development to economic growth
we include a number of control variables, following the growth empirics
literature [Barro, 1991, 2000; Mankiw et al., 1992; Islam, 1995]. Among the
variables commonly included in empirical research are initial conditions, in
terms of the level of development (proxied by GDP per capita) as well as
human capital (proxied by an education variable). Most also include proxies
for the macro economic environment, trade openness and structural
characteristics.
Table 3 provides the results for the growth regression as specified by
equation (1). Our preferred proxy for financial market development is the
ratio of private credit to GDP. Private credit equals the value of credits by
financial intermediaries to the private sector, and therefore isolates credit
issued to the private sector, as opposed to credit issued to government,
government agencies and public enterprises. It also excludes credits issued by
the central bank. Higher levels of private credit can therefore be interpreted
as higher levels of financial services and therefore greater financial
intermediary development [Levine el al., 2000: 39].
Regression 1 includes the initial level of income per capita and a proxy for
education, as control variables. The lagged dependent variable is also used to
correct for serial correlation.5 All variables have the expected sign, and are
statistically significant with the exception of education. In regression 2 we
introduce a number of additional variables based on the recent empirical
growth and financial development literature [Levine et al., 2000; Beck et al.,
2000]. These include an inflation variable, a proxy for the trade policy
regime, and economic structure measures. The statistical significance of the
financial development variable is maintained, at the 10 per cent, and all other
648 THE JOURNAL OF DEVELOPMENT STUDIES

TABLE 3
R E L A T I O N S H I P B E T W E E N F I N A N C I A L D E V E L O P M E NT A N D G R O W T H ( a )

Variables 1 2 3
Explanatory constant 7 2.55 7 2.21 7 10.1
(0.28) (0.26) (1.10)
Lag of dependent variable 0.40 0.38 0.36
(7.74) (7.49) (6.98)
(b)
Financial development 0.24 0.17
(2.44) (1.87)
(c)
Education 2.74 2.91 3.78
(1.49) (1.67) (2.13)
Initial income (d)
7 1.03 7 1.23 7 0.77
(4.09) (4.23) (2.32)
(e)
Trade regime 1.00 1.14
(2.23) (2.57)
Change in inflation (f)
7 0.02 7 0.02
(2.73) (2.84)
(g)
Change in trade share 0.18 0.17
(3.59) (3.50)
(h)
Change in manufacturing share 0.45 0.44
(2.86) (2.67)
(i)
Interactive term 0.32
(2.57)
Number of observations 285 285 285
Adjusted R2 0.32 0.41 0.41
Notes:
Figures in brackets are absolute value of ‘t’ ratios; tabulated ‘t’ for degrees of freedom
in excess of 120 at 1% , 5% and 10% significance level is 2.58 and 1.96 and 1.65.
(a)
Dependent variable is GDP per capita growth rate.
(b)
Logarithm of Private credit – GDP ratio.
(c)
Logarithm of percentage of primary school enrolment (gross).
(d)
Log of initial real income per capita.
(e)
A dummy variable which is one if the economy is considered closed in terms of trade regime or
zero if it is open. This is based on criteria used in Sachs and Warner [1995].
(f)
Change in the rate of inflation between two consecutive periods.
(g)
Change in the share of trade (exports plus imports) in GDP between two consecutive periods.
(h)
Change in manufacturing value added over GDP between two consecutive periods.
(i)
An interactive term between developing country dummy and financial development Proxy
constructed as (Developing Countries Dummy * Financial development proxy).

variables, with the exception of education, are also statistically significant.

The signs for the independent variables are consistent with the economic
growth hypothesis.
In regression 3 we replace the financial development proxy with an
interactive variable constructed by combining the financial development
measure with a developing country dummy. Our purpose is to test the
hypothesis that the impact of financial development on economic growth is
confined to lower income economies. Interestingly, the parameter estimate
for the interactive terms is positive and highly significant, suggesting that it is
FINANCIAL DEVELOPMENT AND POVERTY REDUCTION 649

developing countries that derive most benefit, in terms of economic growth,

from financial sector development.6 All the other parameter estimates in
regression 3 have their expected sign and are highly significant.7 The results
for the interactive term are suggestive of a threshold effect for financial
development, where the impact of financial development on economic
growth declines at higher income levels.8

Financial Development and Inequality

Table 4 reports the estimates for equation (2). The aim is to estimate the
various determinants of income inequality, including the impact of financial
development on distribution. Regression 1 tests for the inverted-U relation-
ship between income inequality, measured by the Gini coefficient, and the
level of economic development, measured by GDP per capita. The results
confirm the U-shaped relationship, with both explanatory variables (GDP per
capita and squared GDP per capita) displaying the expected sign and
statistical significance.
The second regression (2) reports the results based on a fuller specification
of the determinants of income inequality, in conformity with similar studies
in this area, and in particular Barro [2000]. The variables include a measure
of trade openness, a proxy for human capital, and various regional dummy
variables. The inverted-U relationship remains statistically significant and the
additional explanatory variables display the predicted signs, with statistical
significance.
Financial development is expected to impact indirectly on income
inequality, through its effect on economic growth. To test for the indirect
effect that financial development has on inequality, we construct an
instrumental variable for GDP per capita growth, which excludes any
contribution that financial development makes to growth. We first regress
GDP per capita on the measure of financial development (ratio of private
credit to GDP) and then save the residuals from the auxiliary regression. The
residuals are used as a proxy for all factors that affect GDP per capita growth,
except financial development. The residuals variable is then substituted for
GDP per capita as an explanatory variable in estimating the determinants of
income inequality.9
The results of using this alternative income variable are shown in
regression (3) in Table 4. The sign and statistical significance of the other
variables remain unchanged, with the exception of the human capital
interactive variable which becomes statistically insignificant. However, with
the introduction of the residuals variable in place of GDP per capita, the
inverted-U relationship is not replicated. The sign on the adjusted income per
capita variable is reversed, and both the level and squared income variables
become statistically insignificant. We interpret this result as being consistent
650 THE JOURNAL OF DEVELOPMENT STUDIES

TABLE 4
D E T E R M I N A NT S O F I N E Q U A L I T Y ( a )

Variables 1 2 3
Constant 7 3.09 7 0.72 3.61
(2.82) (0.66) (0.92)
GDPPC (b)
1.79 1.02 7 0.02
(6.66) (3.18) (1.02)
GDPPCsq (c)
7 0.12 7 0.06 7 0.03
(7.12) (3.58) (1.40)
(d)
Openness 1.38 0.83
(4.19) (3.07)
Interactive term I (e)
7 0.16 7 0.09
(4.08) (2.91)
(f)
Africa 0.13 0.09
(2.99) (2.09)
(f)
Latin America 0.23 0.29
(7.18) (8.60)
Advanced countries (f)
7 0.21 7 0.13
(4.63) (2.86)
Interactive term II (g)
7 0.06 7 0.02
(2.59) (1.00)
Number of observations 225 225 225
2
Adjusted- R 0.60 0.63 0.60
Notes:
(a)
Dependent variable is Gini coefficient.
(b)
GDP per capita. In regression 3, residuals variable is used, formed from the auxiliary regression
in which the impact of financial development on GDP per capita is removed.
(c)
GDP per capita squared. In regression 3, the squared residuals variable is used.
(d)
Ratio of exports and imports in total GDP.
(e)
Interactive variable, generated as openness xGDP per capita.
(f)
Africa, Latin America and advanced countries are dummy variables for the respective regions,
with Asia as the control group.
(g)
Interactive variable, generated as product of human capital proxy (average years of secondary
schooling) and a dummy representing developing countries in the sample.
Figures in parentheses are t ratios. The tabulated 1%, 5% and 10% significance level values are
2.58, 1.96 and 1.65.

with the argument made in the preceding section, that financial development
has a significant impact on the pattern of income distribution over time, as
income growth occurs. When this influence is excluded, the evidence to
support the inverted U-relationship is difficult to detect [Deininger and
Squire, 1998; Bruno, et al., 1998].

Poverty and Growth

Our basic regression for the study of the link between poverty and growth is
specified by equation (4). Variables included in the regressions follow those
suggested by research in this area, as summarised in previous sections of the
FINANCIAL DEVELOPMENT AND POVERTY REDUCTION 651

article. The growth of income, and changes in the distribution of income are
both included as explanatory variables. In addition, initial income level,
inflation and public expenditure are used as poverty reduction determinants.
The results reported in Table 5 are based on OLS regressions. The
parameter estimates for growth and income distribution are correctly signed
and statistically significant. A change in inflation also seems to be
significantly and negatively related to the growth of income of the poor. A
change in government expenditure is marginally significant and positively
related to the growth of income of the poor. Surprisingly, the dummy variable
for developing countries is not statistically significant.

The Effect of Financial Development on Poverty Reduction

Equation (7) can, in principle, be used to calculate the overall effect of
financial development on poverty. Estimates of the coefficient of growth in
poverty reduction given in Table 5 give an average value of m1 which is unity.
The coefficient of the interactive term in Table 3 gives us a measure of a1 for

TABLE 5
P O V E R T Y R E D U C T I O N R E GR E S S I O N ( a )

Variables 1 2 3
Constant 7 1.97 7 10.84 7 8.44
(1.74) (1.48) (1.36)
Growth of GDP 1.09 1.18 1.16
(5.41) (5.20) (5.80)
Change in Gini (b)
7 4.22 7 4.26 7 4.20
(7.46) (7.50) (7.57)
Change in inflation(c) 7 0.09 7 0.10 7 0.09
(2.46) (2.54) (2.72)
Change in public expenditure(d) 1.74 1.73 1.67
(1.57) (1.60) (1.61)
Initial income(e) 1.01 0.75
(1.24) (1.05)
Developing countries dummy(f) 7 2.12
(0.66)

Number of observations 147 147 147

Adjusted R2 0.56 0.56 0.56
Notes:
(a)
The dependent variable is growth of income of the bottom quintile.
(b)
Change in Gini Coefficient between two consecutive periods.
(c)
Change in the rate of inflation between two consecutive periods.
(d)
Change in general government expenditure between two consecutive periods.
(e)
Logarithm of initial real income per capita.
(f)
A dummy variable set to one for developing countries, zero otherwise.
652 THE JOURNAL OF DEVELOPMENT STUDIES

developing countries, which averages 0.3. Therefore, our results suggest that
a unit change in financial development improves the growth prospects of
income of the poor in developing countries by almost 0.3 per cent. However,
since the measure for financial development in our data set is correlated with
the growth of GDP it is not possible to include it separately in our poverty
regressions as a test of whether there is any additional direct link between
financial development and poverty that is separate from its indirect trickle-
down influence which is captured through the growth effect: therefore l1 = 0.
Nor can l2 be easily measured based on any of the specifications above,
although as was discussed, financial development does appear to have a
quadratic relationship with inequality. For developing countries at a low level
of income per capita, financial development is expected, ceteris paribus, to
accentuate inequality, which in turn will reduce the poverty reduction impact
that is associated with the growth enhancing effect of financial development.

VI. CONCLUSIONS

The purpose of this article has been to examine the linkages between financial
development, economic growth, inequality and poverty reduction. More
precisely, the article has sought to generate empirical evidence to help answer
the policy question of whether financial sector development can contribute to
the goal of poverty reduction in developing countries. Although individually
each of these linkages is covered relatively fully in the literature, we are not
aware of any study which attempts to integrate the links between financial
development, inequality and poverty which we have shown in Figure 2. There
are limitations, however, in the data available for empirical investigation of
these issues, and the results that are produced are likely to disguise significant
differences between countries in how the poor benefit from financial
development and growth [Ravallion, 2001]. Equally the link between
financial development and inequality is still controversial and merits further
research.
In addressing the link between financial development and poverty
reduction, we have tried to incorporate three distinct research strands; one
linking financial development with growth; the second linking poverty to
growth; and the third establishing a possible relationship between financial
development and inequality. Our contribution here is to attempt to unify these
strands in order to get a fuller picture of the possible impact that financial
development may have on poverty. Equation (6) above summarises these
linkages.
The results reported in this article on the link between financial
development and growth are in conformity with most of the recent empirical
work in this area, suggesting that financial development improves growth
FINANCIAL DEVELOPMENT AND POVERTY REDUCTION 653

prospects, with the causal link running from financial development to

economic growth. Our analysis goes further, however, by suggesting that the
impact of financial development on economic growth is most pronounced at
lower income levels, so that poorer developing countries will gain most from
the growth and development of the financial sector.10
Our analysis linking poverty to financial development is indirect and
follows a similar approach to the one used in Dollar and Kraay [2002]. In the
absence of access to a suitable proxy to capture any direct effect that financial
development may have on growth, we have attempted to capture the poverty
effects of financial development indirectly from its impact on growth. Our
results show that the impact is positive. There is no indication in our analysis
that the growth effect of financial development is unequally shared; more
specifically, as a result of financial development the income of the poor
changes as much as average income.
We have also attempted to investigate the possible link between financial
development and inequality using the reduced form model as used in Barro
[2000]. Results reported here suggest that the link is quadratic; at a low level
of development, financial development is likely to be positively related to
inequality, but once a threshold level of development is achieved, then the
link between the two becomes negative.
Theoretically, the specification in equation (6) captures the full effect of
financial development on poverty and represents the direct and indirect effect
of financial development on poverty as well as on income distribution. We
faced data availability constraints however, in empirically capturing the full
effects. Nevertheless, given the current emphasis on poverty reduction
objectives and the importance attached to financial sector reform by the major
development agencies, our article serves to highlight the complexities of the
finance, growth, inequality and poverty linkages. At the same time, the results
reported in this article are consistent in showing that financial development
does contribute to poverty reduction, and they therefore provide firm
empirical evidence on which to proceed with more detailed investigation of
how specific financial sector policies and interventions can be deployed as
effective instruments for achieving poverty reduction in low income
countries.

NOTES
1. The same formulation of the finance–growth relationship is used in Levine et al. [2000] and
Beck et al. [2000].
2. The Dollar and Kraay [2002] study has attracted considerable critical attention. See, for
example, Lubker et al. [2002].
3. In a number of cases, the NBER Penn World Tables on purchasing power parity income
figures, were used to complement the World Bank data set.
654 THE JOURNAL OF DEVELOPMENT STUDIES

4. This is generally recognised to be the best-practise procedure to account for the diversity of
experience between and within countries [Hsiao, 1986, Baltagi, 1995].
5. Parameter values shown in Table 3 give the short-term impact of the variables concerned. In
the long run, the magnitude of these estimates increases by over a third, given the average
estimate of the lag dependent variable which is around 0.35.
6. Using a different estimation technique, Anderson and Tarp [2003] do not find evidence of a
statistically significant relationship between growth and financial development indicators, in
developing countries. Ram [1999] also fails to find a significant relationship between
financial development and growth in a low and mid-growth sample of countries.
7. We also experimented with an alternative financial development proxy, measured as the ratio
of net foreign assets to GDP. The rationale for using this alternative measure was based on
the empirical observation that the flow of foreign resources, particularly to developing
countries, is directed towards those economies with more developed financial markets. In
addition, this proxy may also act as a proxy for direct foreign investment which has a strong
growth enhancing effect. A number of regression were performed using this alternative
financial development variable in the growth equation. The results showed a positive sign,
but were never statistically significant.
8. Greenwood and Jovanovic [1990] provide a theoretical explanation for this relationship.
9. In so far as the measure of financial development is correlated with other excluded variables,
the residuals from the auxiliary regression will not fully capture the effect of the excluded
variables.
10. An important issue pertinent to this discussion, which is not considered here, is the
complementary role of supporting institutions to regulate and support the development of the
financial sector in developing countries. For discussion of this point, see Stiglitz [1998];
Brownbridge and Kirkpatrick [2002].

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APPENDIX: LIST OF COUNTRIES USED IN REGRESSIONS

Countries used include in financial development nd inequality regressions: Australia, Austria,
Belgium, Bolivia, Brazil, Central African Republic, Canada, Chile, Colombia, Costa Rica,
Germany, Denmark, Dominican Republic, Algeria, Ecuador, Spain, Finland, France, United
Kingdom, Ghana, Gambia, Greece, Guatemala, Honduras, Indonesia, India, Ireland, Iran, Israel,
Italy, Jamaica, Japan, Kenya, Republic of Korea, Sri Lanka, Lesotho, Mexico, Mauritius,
Malawi, Malaysia, Niger, Netherlands, Norway, Nepal, New Zealand, Pakistan, Panama, Peru,
Philippines, Portugal, Paraguay, Rwanda, Sudan, Senegal, Sierra Leone, El Salvador, Sweden,
Thailand, Trinidad and Tobago, United States, Venezuela, South Africa and Zimbabwe.
Countries used in poverty regressions: Australia, Bulgaria, Brazil, Canada, China, Spain,
Finland, Great Britain, Indonesia, India, Italy, Jamaica, Japan, Sri Lanka, Malaysia, Netherlands,
Norway, New Zealand, Philippines, Poland, Portugal, Singapore, Sweden, Thailand, United
States and Venezuela.