For better or worse, the 2008 financial crisis has put the financial sector again at the centre of public debate. Several commentators have suggested that financial liberalisation contributed both to the financial crisis and to growing income inequality (e.g. Krugman 2009 and Moss 2009).  On a more general level and as in the case of other policy areas associated with the Washington consensus, financial liberalisation has been controversial among academics and policymakers, as it is not clear whom the benefits of expanded credit allocation accrue to.

Cross-country evidence has linked financial development both to lower levels and faster reductions in income inequality and poverty rates (Beck et al. 2007; Clarke et al. 2006). As is often the case with cross-country work, endogeneity concerns are manifold, exacerbated by measurement problems inherent to survey-based inequality and poverty measures. In addition, cross-country comparisons face limitations in identifying the channel through which financial deepening helps reduce poverty rates.

In recent work, we use annual household survey data across 15 Indian states over the period 1983 to 2005 to assess the effect of financial sector development on changes in rural and urban poverty (Ayyagari et al. 2013). Specifically, we exploit variation across states and over time in both financial depth and financial inclusion to explore:

  • The relationship between financial development and poverty levels.
  • The relative importance of financial depth and financial inclusion in this relationship.
  • The channels and mechanisms through which financial development alleviates poverty.

India is close to an ideal testing ground to ask these questions given not only its large sub-national variation in socio-economic and institutional development, but also significant policy changes it has experienced over the sample period (Besley et al. 2007). By focusing on a specific country, using data from a consistent data source and exploiting pre-determined cross-state variation in socio-economic conditions, we alleviate problems associated with cross-country studies, including measurement error, omitted variable and endogeneity biases.

Our data and methodology

To gauge the relationship between financial sector development and poverty levels and disentangle the mechanisms and channels through which this relationship works, we use household surveys from the National Sample Survey Office and exploit within-state and over-time variation across 15 Indian states over the period 1983 to 2005. We measure poverty using headcount (share of population living below the national poverty line) and poverty gap (average distance separating the population from the poverty line as a proportion of poverty line). We measure financial depth by commercial bank credit to state domestic product and financial breadth by bank branch penetration per capita.

We use a difference-in-differences regression set-up, controlling for state-fixed and year-fixed effects and controlling for time-variant state-level factors, such as the share of literate population, state domestic product per capita and state government expenditures to state domestic product. To alleviate biases of reverse causation and omitted variables, we employ instrumental variable approaches. Specifically, as an instrument for financial depth, we use the cross-state variation of per-capita circulation of English-language newspapers in 1991 multiplied by a time trend to capture the differential impact of the media across time after liberalisation in 1991. With the relatively free and independent press in India (Besley and Burgess 2002), a more informed public is better able to compare different financial services, resulting in more transparency and a higher degree of competition leading to greater financial sector development. Figure 1 shows the differential development of Credit to state domestic product in states with English language newspaper penetration above and below the median.

Figure 1. Bank credit and English newspaper circulation

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In addition, we follow Burgess and Pande (2005) and exploit the policy-driven nature of rural bank branch expansion across Indian states as an instrument for branch penetration and thus financial breadth. According to the Indian Central Bank’s 1:4 licensing policy instituted between 1977 and 1990, commercial banks in India had to open four branches in rural unbanked locations for every branch opening in an already banked location. Thus between 1977 and 1990, rural bank branch expansion was higher in financially less developed states while after 1990, the reverse was true (financially developed states offered more profitable locations and so attracted more branches outside of the program). Figure 2 documents these trend reversals.

Figure 2. Bank-branch penetration as function of initial financial development

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Our main findings

Relating annual state-level variation in poverty to variation in financial development, we find:

  • Financial depth, as measured by credit to state domestic product, has a negative and significant impact on rural poverty in India over the period 1983-2005. This finding is robust to using different measures of rural poverty, controlling for time-varying state characteristics, and conditioning on state and year fixed effects. On the other hand, we find no effect of financial depth on urban poverty rates.
  • The effect of financial depth on rural poverty reduction is also economically meaningful. One within-state, within-year standard deviation in credit to state domestic product, explains 18% of demeaned variation in the headcount and 30% of demeaned variation in the poverty gap over our sample period.
  • We also find that over the time period 1983-2005, financial depth has a more significant impact on poverty reduction than financial outreach. Our measure of financial breadth, rural branches per capita, has a negative but insignificant effect on rural poverty over this period, though a strong and negative effect over the longer period of 1965 to 2005, which includes the complete period of the social banking policy.

The channels

The household data also allow us to dig deeper into the channels through which financial deepening affected poverty rates across rural India.

  • We find evidence for the entrepreneurship channel, as the poverty-reducing impact of financial deepening falls primarily on self-employed in rural areas. On the other hand, we find no evidence that financial deepening has contributed to human capital accumulation.
  • We also identify migration from rural to urban areas as an important channel through which financial depth reduces rural poverty. In particular, we find that financial sector development is associated with inter-state migration of workers towards financially more developed states. The migration induced by financial deepening is motivated by search for employment, suggesting that poorer population segments in rural areas migrated to urban areas.
  • The rural primary and tertiary urban sectors benefitted most from this migration, consistent with evidence showing that the Indian growth experience has been led by the services sector rather than labour intensive manufacturing (Bosworth et al. 2007).
  • This last finding is also consistent with the finding that it is specifically the increase in bank credit to the tertiary sector that accounts for financial deepening post-1991 and its poverty-reducing effect.

Conclusions

Our findings suggest that financial deepening can have important structural effects, including through structural reallocation and migration, with consequences for poverty reduction. Our findings have important policy repercussions. The pro-poor effects of financial deepening do not necessarily come just through more inclusive financial systems, but can also come through more efficient and deeper financial systems. Critical, the poorest of the poor not only benefit from financial deepening by directly accessing financial services, but also through indirect structural effects of financial deepening. This is consistent with evidence from Thailand (Gine and Townsend 2004) and for the US (Beck et al. 2010) who document important labour-market and migration effects of financial liberalisation and deepening.

This article first appeared in voxeu.org

Authors: Meghana Ayyagari, Associate Professor at the School of Business and Elliott School of International Affairs, George Washington University. Thorsten Beck, Professor of Economics and Chairman of the European Banking Center at Tilburg University. Mohammad Hoseini, PhD student and junior fellow at the European Banking Center, Tilburg University.

Image: A customer hands a bundle of Rupee currency notes to a teller in Mumbai REUTERS/Vivek Prakash