New Directions in Welfare A conference for economists and policy makers Dynamic of Finance-Inequality nexus: A Dynamic Panel Analysis on Developing Countries HUI-BOON TAN  The University of Nottingham (Malaysia Campus) & SIONG-HOOK LAW Universiti Putra Malaysia

I. Introduction Does income inequality matter? Can financial factors contribute to income inequality narrowing in developing countries?

Income Inequality Signs of injustice, insider privilege, unequal opportunity, and social instability. destructive and problematic to society and economy. The inequality combined with underdeveloped markets and ineffective government programs can be a huge resistance to economic growth.

Financial Deepening A huge literature on financial deepening and economic growth but studies on financial deepening and income distribution remain scarce.

II. Literature Review The finance-inequality theoretical framework is well developed in the 1900’s. The deficiency of data in income inequality hindered empirical work on the subject matter. The empirical work only began when the data set of income inequalities was made available by Deininger and Squire (1996). Empirical studies on the relationship remain scarce until current.

Literature Review (cont) Among the very few: Clarke et al. (2006) examined the relationship between finance and income inequality for 83 countries both developed and developing countries between 1960 and 1995 Their result indicated linear finance-narrowing hypothesis. Income inequality is reduced when financial sector is deepened in the long run.

Literature Review (cont) Liang (2006) examines the relationship in China, using the Chinese provincial data over the period of 1991 – 2000. Financial development contributes significantly in stabilizing the income distribution in China. Empirical evidence for linear finance-inequality (narrowing) relationship Not evidence provided for nonlinear relationship.

III. Objectives of the Study This study intends to extend the literature in three dimensions: To investigate the whether there is a nonlinear finance-inequalities nexus in developing countries via the dynamic panel GMM approach. This is one of the pioneer works that empirically test for the nonlinear relationship.

Objectives of the Study (cont) To obtain new empirical evidences by employing the newly assembled income-equality measure (Galbraith and Kum, 2005) and robust technique. To examine whether income-inequality responds differently to financial factors at different levels of development. Is there a threshold value that reverse the relationship at a certain level of development?

IV. Theoretical Framework Three Influential Hypotheses on finance inequality nexus Two linear hypotheses Inequality-widening hypothesis Inequality-narrowing hypothesis derived from the conceptual framework of Banerjee and Newman (1993), and Galor and Zeira (1993). One nonlinear hypothesis Inverted U-shaped hypothesis derived from the pioneering theoretical model of Greenwood and Jovanovic (1990).

Inequality-widening hypothesis The rich are able to offer collateral, and they are the people who have a high possibility to repay the loans. The poor, who do not have the above criteria, might, therefore, find it difficult to get loans even when financial markets are well developed. Therefore, financial deepening worsens income inequality.

Inequality-narrowing hypothesis When financial sector grows, the poor, who were previously excluded from getting loans, might gain access to it. In this aspect, finance may be an equalizer for people with talents, ambition, and persistence. Therefore, financial deepening improves income equality.

Inverted U-shaped hypothesis A hump or inverted U-shaped relationship between income inequality and financial factors predicts a nonlinear relationship At the early stages of development, only the rich can afford to access and profit from financial markets Financial market development intensifies income inequality. At higher levels of financial and economic development, financial development helps an increasing proportion of society.

V. Models and Methodology Dynamic Panel Data Models Linear Non-linear Methodology and Data

Dynamic Panel Data Model Linear dynamic panel data model: G is an indicator of income inequality FD is financial deepening Y is income INS is institutional quality INF is inflation rate. lagged of G - dynamic adjustment If 1 > 0 and is significant then financial deepening will widen inequality. if 1 < 0 and is significant then financial deepening will narrow the dispersion in income.

Nonlinear Dynamic Panel Data Model A square term of FD is included. The inverted U-shape hypothesis predicts 1 > 0 and 2 < 0.

Nonlinear Dynamic Panel Data Model Git Threshold level Is there a threshold level for this dynamic relationship? 1 > 0 & 2 < 0 FEit Git 1 < 0 & 2 > 0 FEit Threshold levle

Econometric Method & Data Dynamic Panel GMM estimator Arellano & Bond (1991) Data Sources Gini Coefficient is collected from Galbraith and Kum (2005) – The University of Texas Inequality Project (UTIP) Financial factors are collected from World Development Indicators (WDI) Institution quality data (corruption, rule of law, Bureaucratic quality and government repudiation on contracts) are collected from the International Country Risk Guide (ICRG)

VI. Result (i) Linear Model Private sector credit exerts a significant negative effect on income inequality. This result supports the inequality-narrowing hypothesis.

Results (cont) (ii)Non-linear Model All the other financial factors appear to be unimportant to income distribution of the countries, except the private sector credit. This rejects the inverted-U hypothesis, and suggests a U-shape finance-inequality relationship.

VII. Empirical Findings The financial deepening proxy by private sector credit exerts a significant negative effect on income inequality. This result supports the inequality-narrowing hypothesis Income inequality is found to be relatively lower in countries where the private sector credit is relatively greater as a share of GDP.

Empirical Findings (cont) Neither market capitalization, nor total value traded in stock markets, significantly influence income inequality. The banking sector seems to be a more influential sector than the stock market in closing the gap of income inequality in developing countries.

Empirical Findings (cont) Besides the financial deepening indictor, Real GDP per capita (-), Corruption (+) inflation (+) are also significant factors to income inequality.

Empirical Findings (cont) The coefficients on the private sector credit and its squared term (Model 2(a)) are negative and positive respectively rejects the inverted-U hypothesis suggests a U-shape finance-inequality relationship. This is a new empirical finding on finance- inequality nexus in developing countries.

Empirical Findings (cont) This is a different finding from the theoretically established inverted U-shape relationship. It implies that even at the early stages of development, not only the rich, but also the poor in the countries can afford to access and profit from financial market.

Empirical Findings (cont) Financial deepening narrows the income inequality gap even at the early stages of development. This improvement will only be sustained until a threshold value. Further financial deepening above the threshold will lead to a deterioration of income inequality reflecting the inefficiency of the market above the threshold.

I. Low-threshold Countries

II. Medium-threshold Countries

III. High-threshold Countries

Thank you