How financial inclusion reduces poverty, income inequality

Published on Tuesday, 03 April 2018

Published by Cyn-Young Park on Tuesday, 03 April 2018

Structural impediments in developing countries often constrain inclusive growth.
Structural impediments in developing countries often constrain inclusive growth.

An estimated 2 billion adults have no access to formal financial services worldwide. More than half of them live in Asia. Access to finance is a major constraint to doing business, especially at small- and medium-sized enterprises (SMEs).

Studies show access to finance is positively correlated with economic growth and employment, although the causal relationship between them is harder to establish.

It is widely believed that financial inclusion aids inclusive growth, economic development, and financial deepening. More specifically, it expands poor people’s access to financial services, increasing their economic opportunities and improving their lives.

Recognizing the positive impact of financial inclusion on growth and poverty reduction, G20 leaders issued in 2009 their first pronouncement on financial inclusion, and the following year endorsed 9 high-level principles for Innovative Financial Inclusion.

So, does financial inclusion lower poverty or income inequality? While the question seems to ask something obvious, there is no simple answer.

This is largely because definitions of financial inclusion seem to vary. As no single conceptual definition of financial inclusion exists, there is no standard measure of the concept that is universally accepted. A second reason is that many factors can affect financial inclusion, poverty and income inequality and do so simultaneously rather than through causal connections.

  How does access to finance support inclusive growth?

From a policy point of view, we need a solid measure to assess financial inclusion and to establish which factors contribute to cross-country variations. Such a measure would help us understand how financial inclusion helps to achieve inclusive growth.

The World Bank recently made available the Global Financial Inclusion (Global Findex) database to measure and track the progress of financial inclusion. Using a new index of financial inclusion for 151 economies with indicators based on the Global Findex database, we tried to answer those questions in a new working paper.

The degree of financial inclusion seems to vary widely across countries. While high-income countries tend to show greater financial inclusion, there are many exceptions. We further investigated how the most commonly cited factors (economic growth, financial sector development, and technological advances) that contribute to financial inclusion can influence changes in financial inclusion.

For all countries in the sample, our results suggest that—perhaps counterintuitively—none of these factors have any bearing on the level of financial inclusion.

Interestingly, however, if we limit the sample to high- and upper-middle-income economies, higher output growth and financial sector development seems positively related to higher financial inclusion.

These results do not hold for middle-low and low-income economies, indicating that high- and upper-middle-income economies offer a positive backdrop for economic growth and financial sector development that can enhance financial inclusion. Also, high-income economies have better quality institutions, which can support financial inclusion.

  Access to finance curbs income inequality when it empowers poor

Another important question is whether financial inclusion impacts poverty and income inequality, and if so how. We find robust evidence that economies with high financial inclusion have significantly lower poverty rates.

However, the validity of the results seems to depend on which income group the country belongs to. Splitting the sample by country income groups, we find financial inclusion appears to have a significant impact on poverty rates in high- and upper-middle-income economies, but not in middle-low and low-income economies.

The results suggest that financial inclusion only helps to lower poverty and income inequality when overall economic conditions empower people to use access to finance for productive purposes such as expanding a business or investing in children’s education. Such a relationship is much more reliable in high-income economies where better policy, legal, and regulatory conditions provide an enabling environment for a range of development outcomes.

Structural impediments in developing countries often constrain inclusive growth. These include those relating to education, health, and infrastructure, where more proactive public policy interventions are needed.

Given that a large share of developing Asia’s poorest work in the agricultural and SME sectors, removing impediments to and increasing productivity in these sectors is essential. This means paying greater attention to generating economic opportunities in rural areas and for SMEs.

Public policy interventions can help build the necessary legal and institutional framework and create a level-playing field that gives inclusive businesses the finance they need to start up and grow.