How is Financial Market Liberalization Influencing Income Inequality?

Is the Matthew-effect supported by Financial Market Liberalization?

Diploma Thesis, 2012

77 Pages, Grade: 1,0


Table of Contents

1. Introduction
1.a. What are Liberalized Financial Markets?
1.b. Hypotheses and Structure of the Paper

2. Literature Review and Hypotheses
2.a. Reasons for Financial Market Liberalization and Integration
2.b. Capital Account Liberalization and Economic Growth
2.c. Capital Account Liberalization and Economic Stability
2.d. Capital Account Liberalization and Poverty / Income Inequality

3. Quantitative Research
3.1 Model Design
3.2 Data
3.2.a. Response Variable: Income Inequality
3.2.b. Explanatory Variable: Capital Account Openness
3.2.c. Explanatory Variable: Institutional Quality
3.2.d. Explanatory Variable: Economic Development
3.2.e. Logarithms, Polynomials, Lags, Binaries and Interaction Variables
3.3 Regressions and Causality
3.3.a. Interpretation of Basic Regressions
3.3.b. Crises, CAL and Income Inequality
3.3.c. Endogeneity and Instruments
3.3.d. Endogeneity Calculations
3.4 Quantitative Answers for Hypotheses
3.4.a. Open Capital Accounts generally Increase Inequality
3.4.b. Capital Account Liberalization leads to an especially high increase in income inequality if the institutional quality is low
3.5. Sensitivity Analysis
3.5.a. Adjustment for Outliers
3.5.b. Alternative Proxies

4. Discussion of the Results

5. Conclusion
5.a. Summary of Results
5.b. Limitations and Further Research
5.c. Implications

6. References

7. Appendix


Observing an increasing financial liberalization and income inequality during the last decades, this study investigates how the opening of financial markets is influencing income inequality. Operationalizing the research question, it focuses on capital account liberalization (CAL). The paper begins with an extensive literature review which recognizes the importance of a countries institutional quality and derives the following two hypotheses: “CAL generally increases income inequality” and “CAL leads to an especially high increase in income inequality if the institutional quality is low”. These hypotheses are empirically tested based on a panel data set covering 159 countries from 1996 – 2009. The results suggest that CAL is in six out of seven world regions positively, and institutional quality in all world regions negatively related to income inequality. However, CAL was not found to lead to an especially high increase in income inequality if the institutional quality is low. An important implication for policy makers it that increasing institutional quality might not be sufficient to limit the inequality effects of CAL. It should therefore be accompanied by other policies focusing among others on a stabilization of capital flows and social assistance to the poor.

1. Introduction

In the last decades the economies and financial systems of many countries liberalized and integrated with each other in order to benefit economically. However, at the same time income inequality and the gap between the extreme poor and the rich increased1. The European Union is one of the regions with the most remarkable development regarding financial liberalization and integration. Some countries have been transformed within the last 25 years from centrally planned economies with controlled financial markets to market economies with open financial markets, integrated within the European Monetary Union. On the one hand this financial liberalization and integration is argued to be an important reason for economic growth2. However, on the other hand it is strongly related to the Euro currency crises which is currently the main challenge facing the EU and is discussed daily on the news. The lower- and middle-classes in particular are protesting against immense financial supports for banks and investors on the one side and wage reductions, unemployment and social benefit cuts on the other3. Can these inequalities be explained by the increasing liberalization of financial markets? Are they logical consequences of international financial liberalization and integration? This paper approaches these questions on a meta-level by answering the research question:

How is Financial Market Liberalization Influencing Income Inequality?

Before elaborating on this research question and explaining the investigated hypotheses it is explained what exactly is meant by financial market liberalization.

1.a. What are Liberalized Financial Markets?

Financial market liberalization consists of the reduction of regulations of financial institutions, financial transactions and equity markets. In order to understand the effects of financial market liberalization, the terms financial market and financial liberalization as well as open and integrated financial markets are elaborated upon in this section.

Madura (2011) defines a financial market as a “market in which financial assets (securities) such as stocks and bonds4 can be purchased or sold. … Financial markets facilitate the flow of funds and thereby allow financing and investing by households, firms, and government agencies” (p.3). It is thus the main task of financial markets to improve the allocation of funds by providing a framework allowing financing by the trading of financial securities.

According to Cobham (2002) financial liberalization is “the removal of perceived barriers to the freedom of financial markets – in particular, to the ability of deposit institutions to set their own interest rates and choose their own lending policy and recipients” (p.165). In addition, Kaminsky and Schmukler (2003) emphasize that financial liberalization is a multidimensional term. It consists out of the deregulation of the domestic financial sector, the foreign sector capital account and the equity market. The following paragraphs will shortly outline the links between these different parts before distinguishing between liberalized, open and integrated financial markets.

The domestic financial sector provides households, organizations and government agencies with capital, by granting credits or buying bonds. Whether it is additionally possible to acquire money from foreign investors or to invest in foreign companies depends on the degree of the country’s foreign sector capital account liberalization (CAL). The domestic financial sector and the foreign sector capital accounts are therefore closely related. Cobham (2002) explains that CAL “involves the removal of controls on domestic residents’ international financial transactions and on investments in the home country by foreigners” (p. 165).

Besides acquiring capital in the domestic and foreign financial sector, companies have furthermore the option of selling their shares on the equity market. Because of the complexity of both equity markets and capital accounts, research often investigates them separately. The incorporation of the effects of equity markets, as well as the before mentioned domestic financial markets, is beyond the scope of this paper which focuses, especially in the empirical part, on the liberalization of capital accounts5. However, results of studies investigating general effects of financial liberalization often apply to CAL. These studies are therefore included in the literature review.

It is finally important to point out that this paper uses the terms liberalized and open financial markets as synonyms. However, it distinguishes them from the closely related term of integrated financial markets. While liberalized and open financial markets relate to the above explained markets with limited restrictions, speaking of integrated markets emphasizes furthermore a close link and interdependence with other financial markets. Despite varying definitions and emphasis of scholars, these terms are often used as synonyms which implicitly assumes perfect information, complete markets and powerless national policies6. Since these assumptions are idealistic, this study continues to differentiate between open or liberalized financial markets and integrated financial markets which includes their liberalization.

1.b. Hypotheses and Structure of the Paper

This study investigates the research question by answering two hypotheses which are shortly explained before the structure of this paper is outlined. Since this paper focuses on CAL it is possible that the rich, those who have money to invest, benefit more from it than the poor, who need a higher proportion of their income for their daily needs. It can therefore be reasoned that:

Capital account liberalization generally increases income inequality (Hypothesis one).

It is often reasoned that strong institutional and legal systems can reduce undesirable effects of financial liberalization7. Referring back to the Euro crisis, many experts believe that not “less Europe” (less integration), but “more Europe” is needed8. They are calling for more control and new and stronger institutions such as a common Euro Area financial supervision and resolution agency. It is therefore believed that weak and/or missing institutions are one reason for the crisis and resulting increasing income inequalities. These arguments build on the supposition that the effect of financial liberalization on inequality depends on the quality of institutions. It is therefore hypothesised that:

Capital account liberalization leads to an especially high increase in income inequality if the institutional quality is low (Hypothesis two).

While the first hypothesis has been investigated by a limited amount of previous research9, no study approaching the second hypothesis could be identified. This study is therefore an important addition to existing literature.

This paper consists of two main parts. The first part concentrates on a literature review and derives the hypotheses (Chapter one and two) while the second part tests these hypotheses empirically (Chapter three to five). The literature review begins by explaining why countries liberalize and integrate their financial markets. This first subsection is general and does not yet focus exclusively on CAL. Following this, connected studies of three related research fields are considered. First, literature about the relation between liberalized capital accounts and economic growth as well as its link to income inequality are reviewed. In a second step it is seen whether CAL increases economic volatility and explained why the poor tend so suffer more under economically unstable situations than the rich. Finally, the limited amount of research investigating a direct link between the liberalization of capital accounts and poverty as well as income inequality is reviewed. Understanding these studies helps to grasp the research question in more depth and leads to the development of the two hypotheses.

In the second part of the paper an empirical model investigates these hypotheses in depth by considering, among others, a country’s economic and institutional development as well as different geographical regions. Finally the results and policy implications are discussed and the paper is concluded.

2. Literature Review and Hypotheses

Much research has been done on the effects of liberalized financial markets. Most of it focuses on the relation between open financial markets and growth. However, there are also studies about the effects on economic stability and about its effects on poverty and inequality. Literature about the effect of general globalization on inequality is usually concentrating on trade and/or is not differentiating between trade and financial liberalization. Therefore, most of these studies contain only limited value for this research and are only included if they distinguish between the liberalization of trade and financial restrictions10.

The following sections derive the hypotheses by first explaining why financial markets liberalize and then investigating the relations between CAL and economic growth, economic stability and poverty/inequality.

2.a. Reasons for Financial Market Liberalization and Integration

Open and integrated financial markets are supposed to support economic growth which is the main reason for their liberalization. Growth can be achieved through different channels (Figure 1), including the channel “promotion of specialization” (Prasad, Rogoff, Wei and Kose, 2007). Standard economic theory suggests that economies consisting of specialized entities exchanging goods and services are generally more productive than those less specialized (Frank and Bernanke, 2004). These specializations will lead to an increasing amount of products and services offered on the market and thus initiate economic growth. If the economy is growing and producing a bigger aggregate supply, every participant in the economy could (in absolute terms) receive an increasing part. This includes theoretically the poor who will eventually benefit from a trickle down effect. A recent study (Prasad et al., 2007) showed that economic growth and poverty reduction are not only closely related but growth is also the most reliable source of reduced poverty. This resulting poverty reduction might either be absolute, or relative. In the latter case, lower poverty levels would also decrease income inequality.

The promotion of specialization is achieved by intermediating between borrowers (those who need money e.g. to invest and further specialize) and lenders/investors (those who earned money and do not have a competitive way of investing). Internationally integrated financial markets on the one hand lead to a bigger market for financial institutions and therefore to economies of scale and increased efficiency. On the other hand it leads to higher competition among financial institutions which again supports increasing efficiency. Besides these specializations and efficiency gains, integrated financial markets might also support economic growth through other channels (Figure 1), including cross country risk sharing (higher risk allocation). Reduced risks increase the willingness to invest and therefore results in a more efficient allocation of resources across countries (Devereux and Sutherland, 2010). These improved investment opportunities increase domestic savings which again decrease the costs of capital. Investments are also likely to lead to a transfer of technology (e.g. by foreign direct investments (FDI)). Foreign investments and specialization could furthermore serve as an inducement for the development of the financial sector and better policies which in return might lead to an even greater enhancement of capital inflow (Figure 1).

According to these theoretical foundations - which do obviously not consider disturbances due to market imperfections, legal and regulatory aspects, mismanagement or corruption -- international financial integration should offer economic growth and positive welfare gains11 (Devereux and Sutherland, 2010). For these reasons, the International Monetary Fund (IMF) agreed in 1997 that the “Fund’s Articles should be amended to make the promotion of capital account liberalization a specific purpose of the Fund and to give the Fund appropriate jurisdiction over capital movements” (Polak, 1998, p.55). This decision sparked up the academic discussion about the chances and risks of CAL which will be reviewed in the next paragraphs.

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Figure 1: Channels of financial integration leading to economic growth (Prasad et al, 2007).

2.b. Capital Account Liberalization and Economic Growth

Based on the described theory, the opening of financial markets can be beneficial and lead to economic growth, which some would argue will lead to a reduction in poverty and eventually inequality. This link between economic growth and income inequality will be analyzed before looking for empirical evidence of the theory.

One of the most famous scientific publications about economic growth and inequality was written by Simon Kuznets (1966) who observed the economic history of countries and realized that the economic growth of a country is typically first accompanied by increasing inequality. However, after a certain threshold he observed a decrease in inequality. The so called Kuznets curve (Figure 2) reflects these observations. Empirical tests of the Kuznets curve led to contradictory results12. Despite diverse discussions among scholars, the curve was adopted to other fields such as trade openness (e.g. Dobson and Ramlogan, 2009) and environmental harm (e.g. Mills and Waite, 2009).

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Figure 2: Kuznets curve.

Assuming that integrated financial markets lead to growth and thus increase GDP, the Kuznets curve predicts that inequality increases as GDP per capita increases until a threshold of inequality is reached. After that inequality is expected to decrease.

The theoretical previously discussed argumentation that open financial markets lead to economic growth is challenged for its unrealistic assumptions about a close to perfect international financial market with globally consistent rules and limited information and enforcement failures13. The question of whether the opening of financial markets leads to growth, not in theory but in reality, was investigated by several scholars during the last decades. The IMF decision on its new focus in 1997 sparked up the discussion and led to increasing empirical research. The Harvard Professor Dani Rodrik published in 1998 a study posting the question: “Who needs capital account convertibility?” His results were negative. He could not find evidence for a positive causal relationship between capital account integration and growth. Rodrik (1998) highlights two major risks of increasing financial market integration: First, an increase in liquidity for borrowers magnifies “the effects of turnarounds in market sentiments” (p.10). Second, systematic risk increases through contagion from other markets while the benefits of removing capital controls still need to be proven. Due to these rising risks, it is often stated that the likelihood of crises increases14 (e.g. Bonfiglioli, 2008). Cobham (2002) agrees with Rodrik and states that “the growth benefits of CAL which proponents would typically claim to offset the costs of crises – have simply not been shown to exist at all” (p.21).

Edwards (2001) however finds that CAL is likely to lead to economic growth if a certain threshold of economic development is achieved. Rancière, Tornell and Westermann (2006) react to the fear that financial liberalization might be undesirable because of the crises associated with it by stating that “this is … the wrong lesson to draw. Our empirical analysis shows that financial liberalization leads to faster average long-run growth, even though it also leads to occasional crises. … Although crises are costly and have severe recessionary effects, they are rare events. Therefore, over the long run, the pro-growth effects of greater financial deepening and more investment by far outweigh the detrimental growth effects of financial fragility and a greater incidence of crises” (p.13). Noticing that this paper was written in 2006, just before the current world economic crises, it is questionable whether this statement is still valid today and it is regrettable that follow up research has so far not been conducted.

One reason for this wide variety of arguments and empirical evidence of the link between financial liberalization and growth is that economic growth and capital account liberalization are simultaneously determined. “With growth come higher incomes, and with higher incomes come the stronger institutions and policies needed to manage capital flows and heighten the likelihood that the benefits of an open capital account exceed the costs. However those stronger policies and institutions which influence the decision to open the capital account also affect growth directly” (Eichengreen, Gullapallia and Panizza, 2009, p.44). Considering these effects, researchers adopted their methodologies. Since individual industry or firm level growth does not necessarily lead to higher overall government income15 it is not linked to stronger institutions. By concentrating on evaluating the growth of these individual industries or firms, rather than overall economic growth, studies therefore eliminated the problem of simultaneous causality (ibid). Levchenko, Rancière and Thoenig (2008) provide empirical evidence for the theory that financial liberalization leads to higher levels of growth and volatility across industries. They explain that an increased entry of firms combined with higher capital accumulation and increasing total employment leads to growth. However, they also emphasise that the growth effects appear temporary rather than permanent. Also Vlachos and Waldenstrom (2005) report similar results. They observe growth effects under the pre-requirement that the domestic financial market and the stock market have reached a certain level of development. In line with this, Prasad, Rogoff, Wei and Kose (2003) state that countries are more likely to benefit from financial liberalization if they have a high level of transparency, a high quality governance system and good financial-sector regulations. In addition, Eichengreen et al. (2009) observe that these growth effects were eliminated during crises situations. Meaning that the growth of financially-dependent sectors during decades of crises, is found to be similar in financially more open and less open economies. They conclude that countries which have succeeded in avoiding crises have benefited from open capital accounts, while countries experiencing crises situations have neither benefited nor suffered on average. Realizing that these findings were mainly driven by developed countries, they identified a limitation to countries with a good institutional infrastructure (strong creditor rights, rule of law, well developed financial systems and good accounting standards).

Eichengreen et al. (2009) observe thus that benefits of open capital accounts can only be expected if countries reached a threshold in terms institutional and economic development. These threshold effects are a second reason for the contradicting results of other studies. Arestis and Carner (2004) argue that even when financial liberalization brings economic expansion, if macroeconomic stability is not maintained and supporting institutions and policies are not established, financial institutions will take excessive risks and the expansion will often be accompanied by crises and increasing inequality. However, they also emphasise the empirical evidence that income poverty (in absolute terms) falls as the economy develops and countries become richer. These effects will be investigated in the next chapters.

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Table 1: Studies about CAL and economic growth (compiled by author, 2012).

In short, theory suggests that open financial markets and economic growth seem to be positively related in countries with a certain economic development, development of the financial markets and a good institutional infrastructure (Eichengreen et al., 2009; Vlachos and Waldenstom, 2005). Furthermore growth is likely to reduce poverty (Arestis and Carner, 2004). However whether the poor or the rich are more affected by economic growth depends on country specific characteristics meaning that a general conclusion about increasing or decreasing income inequality can not be drawn.

2.c. Capital Account Liberalization and Economic Stability

In order to value economic growth the link between CAL and economic stability needs to be understood. The following section first discusses whether the rich or the poor have more disadvantages during economically unstable situations and afterwards reviews literature about link between CAL on economic volatility.

It can be generally said that economically unstable situations lead to fluctuating individual incomes which can be more easily compensated by the rich than by the poor (Cobham, 2002). Prasad et al. (2007) emphasise that government spending, especially in developing countries, tends to be pro-cyclical which magnifies the destructive impact of economic volatility on poverty. Economic unstable periods are therefore often not only accompanied by salary changes or (temporarily) job losses but furthermore by changes in government spending. Since the poor often strongly depend on government transfers and public services (education and healthcare) they are directly affected by these changes (Cobham, 2002; Laursen and Sandeep, 2005 ).

In addition the poor are strongly affected by economically unstable situations because they need a high percentage of their income for daily needs. A decrease in income directly reduces the satisfaction of their fundamental human needs. According to utility theory, people prefer stable over volatile consumption and thus smooth it by managing their income (Gruber, 2011)16. Ways of doing this include saving resources or insuring themselves on the insurance market against situations of less income (e.g. crises). This precaution is obviously not possible for the poor who need all their income for daily life. For the poor consumption volatility therefore increases together with income volatility (Laursen and Sandeep, 2005). Another way to smooth consumption is by smoothing income and quickly adapting to the changing demand on the labour market. In economically unstable situations, the labour market adjusts to the changing economic conditions and also the workforce needs to be flexible. However, the poor often lack education and professional experience “which limits their ability to move across sectors in order to adjust” (Prasad et al., 2007, p.3). Laursen and Sandeep (2005) confirm these results also empirically and call for more government intervention to protect the poor.

In short, it is seen that an unstable economic situation has more negative effects on the poor than on the rich. Since the poor are less able to smoothen their income, income inequality tends to increases during recessions and crises (Laursen and Sandeep, 2005); which leads to the question whether open financial markets have an increasing or decreasing effect on economic fluctuation.

Devereux and Sutherland (2010) explain that “financial diversification leads to interdependence of financial portfolios across countries. These portfolio linkages have risk-sharing benefits on the one hand, but they may also expose countries to ‘financial contagion’ through interdependent balance sheets, when balance sheets have implications for access to financial markets” (p.428). The economic situation can either be stabilized or destabilized by liberalized financial markets which will be further explained in the next paragraphs.

One theory is that stabilization might take place because of risk diversification. By investing in different economies, domestic banks and other investors become less dependent on their home market and reduce the negative effects of a local recession and/or crisis (Bonfiglioli, 2008). Related to this Hwang (2011) shows that financial openness can reduce negative macroeconomic impacts of domestic financial distress. He argues that in an “open international capital market, the capital outflow caused by the domestic financial shock does not lead to drastic exchange rate variation. This helps dampen the adverse effects of the financial distress on the economy” (p.212).

Glick, Guo and Hutchison (2005) empirically analyze the effect of CAL on currency crises only. They find that “when two countries have the same likelihood of maintaining a liberalized capital account (based on historical evidence and a very similar set of identical economic and political characteristics at a point in time)—and one country imposes controls and the other does not-- the country without controls has a lower likelihood of experiencing a currency crisis” (p.20).

On the contrary, Devereux and Sutherland (2010) as well as Eatwell and Taylor (1998) among others17 pointed out that financial liberalization and open capital accounts may cause general financial and economic instability and thus support crises situations. Their argument for open markets causing instability is closely related to the risk diversification argument of increasing stability. They argue, as mentioned before, that the financial diversification and the integration of different financial markets lead to an increasing interdependence of financial portfolios and financial markets. As an example Devereux and Sutherland mention the current financial crisis. The collapse of several US American financial institutions and the immense capital outflow affected financial institutions in a lot of other countries very quickly and caused the global financial crisis.

Risk diversification leads furthermore to a higher willingness to invest in risky projects which is accompanied by fluctuating short term investments and missing long term commitments towards individual companies (Stiglitz, 2000). This kind of investment behaviour leads companies into excessive risk taking which is likely to benefit the rich in case of a success, but strongly harms the poor (e.g. destruction of workplaces) in case of a failure. Eatwell and Tayler (1998) analyzed the economic development of the previous decades arguing that “liberalization has undoubtedly resulted in financial markets becoming more volatile, whether measured by short term swings in exchange rates and interest rates, or the longer swings” (p.7). They argue in line with Devereux and Sutherland (2010) that the integration of financial markets leads to mutual contagion in case of financial distress. Nine years before the start of the current global economic crisis, Eatwell and Tayler (1998) identified the risk of a western markets crash and suggested adopting the system to avoid such misfortunes before they could happen. Their paper concludes with the observation that a complete liberalization is not desirable: “Historical experience has confirmed the necessity of regulation and of the lender of last resort in domestic markets” (p.20). In line with this, Stiglitz (2000) states that liberalization requires strong and stable financial institutions, which means that strong regulatory frameworks are a prerequisite for open financial markets. However, to develop a regulatory framework and strong institutions capable of enforcing the framework takes a lot of time. Stiglitz explains that hurriedly liberalizing financial and capital markets without first initiating effective regulatory frameworks was a core problem leading to the Asian financial crises. In line with this is a recently published paper by 17 leading European economists, analyzing the current Euro crisis and demanding among other stronger central regulation and a common Euro Area level financial supervision and resolution agency (Artus et al., 2012).

Prasad et al. (2007) on the contrary put less emphasis on institutional and regulatory stability. They state that it “may be valuable for developing countries to experiment with different paces and strategies in pursuing financial integration. Empirical evidence does suggest that improving governance, in addition to sound macroeconomic frameworks and the development of domestic financial markets, should be an important element of such strategies. This conclusion does not necessarily imply that a country must develop a full set of sound institutions matching the best practices in the world before embarking on financial integration.” (p.45)

In sum, financial distress in any interlinked economies can either be offset by each other, or if it is too destructive, can negatively affect each other and lead to an international crisis (Devereux and Sutherland, 2010). It seems therefore that -- given a decent institutional framework which effectively enforces regulations -- integrated financial markets are less vulnerable for domestic but still more vulnerable for international crises. Incorporating this, it can be concluded that these effects might partly cancel each other out. In fact, an empirical analysis (Bonfigloili, 2008) of 70 countries from 1975 to 1999 showed that the overall likelihood of financial crises rises slightly under financial integration, which will at least partially offset the growth benefits identified above.

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Table 2: Studies about CAL and economic volatility (compiled by author, 2012).

Based on the insights that CAL and economic volatility seem to be generally positively related and realizing that the poor suffer more under economic volatility than the rich (Devereux and Sutherland, 2010; Laursen and Sandeep, 2005), the first hypothesis is derived, stating that capital account liberalization generally increases income inequality.

The last two sections furthermore emphasised the importance of a high institutional quality in order to not only foster economic growth, but also reduce economic volatility (Stiglitz, 2000). Liberalized financial markets in countries with a low quality institutional and thus regulatory infrastructure support the excessive risk taking of investors (Arestis and Carner, 2004). This is likely to increase the incomes of a small amount of people while especially the poor tend to suffer and income inequality increases. The second hypothesis can therefore be derived, stating that c apital account liberalization leads to an especially high increase in income inequality given that the institutional quality is low.

2.d. Capital Account Liberalization and Poverty / Income Inequality

It was extensively explained in the previous sections that CAL tends to foster growth which is an important source of poverty reduction. However, CAL also tends to increases economic volatility which is likely to worsen the income situation of the poor. In light of these observations, the effect of open capital accounts on income poverty will be investigated before turning to its effect on income inequality.

Income Poverty

Similar to the effect of CAL on growth, the effect of CAL on income poverty can be argued to be either positive or negative. Regrettably, most research about the effect of open financial markets on the poor concentrates on the effects of financial liberalization on growth and/or economic volatility and argues how this might affect the poor. In a paper titled “Financial Liberalization and Poverty: Channels of Influence” Arestis and Caner (2004) analyze different channels through which financial liberalization influences poverty. The first and second channels are in line with our previous two sections about financial markets and their relation to growth and economic volatility/crises. The third channel they mention is about the access to credit and financial services, which is a major factor influencing poverty.

To enable poor people to access financial services is the main idea behind the recent enthusiasm about microcredits. The World Bank stated that “Microfinance can be the biggest instrument in the fight against poverty” (The World Bank, 2005, p.1) and the United Nations announced the year 2005 as the “International Year of Microcredit” (UN, 2005). This resulted from the belief that the access to credits and financial services will lead to a reduction in poverty. Beck, Demirgüc-Kunt and Levine (2007) support this view by showing empirically that increasing access to credit markets can reduce income inequality. The question therefore arises whether the opening of financial markets really leads to an increasing access of the poor population to the credit market or whether it is the rich who benefit the most, those who already have enough money to invest and enough securities to borrow money.

Arestis and Carner (2004) believe that open financial markets increase the availability of financial services for the poor at least in the long run. They argue that “while the distributional effects of financial deepening are adverse at the early stages of financial globalization, they may become positive after a turning point. So, even if capital account liberalization leads to higher growth, it is an open question whether liberalization will lead to better living conditions for the poor” (p.13).

Easterly (2007) and Cobham (2002) state however that financial flows do not have a significant impact on poverty. Cobham continues that the theoretical benefits of short term flows and FDI have not been established for developing countries. He argues that “stronger supervisory and regulatory institutions – essentially anti-crisis measures – (as required by the Bretton Woods Institutions) will be insufficient to ensure that capital account and domestic financial liberalisation are beneficial to the poor. The massive costs to the poor of crisis periods – the combination of reduced levels of social expenditure, reduced levels of transfers, increased unemployment and reduced real wages – are most apparent” (p.1).

Arestis and Caner (2008) came to the same appraisal as Easterly and Cobham, stating that capital account liberalization does not alleviate poverty. However, in their empirical analysis on the effect of liberalized capital markets on poverty in developing countries they found that the proxy of the initial level of economic activity and a better quality of institutions are significant variables with a potential impact on poverty. These findings underline the previously mentioned importance of a countries institutional quality and economic development. Also the results of Jaumotte’s, Lall’s and Papageorgiu’s (2009) empirical analysis are in line with these findings, arguing that a high quality institutional infrastructure is needed in order for the poor and the rich to benefit equally which is often not the case in developing countries.

In short it can be said that the number of studies on capital account liberalization and poverty are very limited. The reviewed studies revealed opposing views about the question of how far high quality institutions ensure beneficial effects of financial liberalization towards the poor (e.g. Jaumotte, Lall and Papageorgiu, 2009; Stiglitz, 2000) . However, they all agree on the fact that capital account liberalization does not significantly reduce poverty.

Income Inequality

Investigating the effect of open financial markets on income inequality, Lee and Jayadev (2005), Calderon and Chong (2001) and Quinn (1997) conducted empirical analyses and found that de jure capital account openness is positively related to income inequality. Jaumotte et al. (2009) as well as Reuveny and Li (2003) considered de jure capital account liberalization and identified that FDIs are associated with higher values of Gini-coefficients. However, their studies do not support that foreign financial capital inflows generally have a significant effect on income inequality. Realizing that FDIs require a certain degree of capital account liberalization, these studies are not contradictory with those measuring de jure capital account openness. Based on these studies it can be argued, that there is evidence that CAL increases inequality. However this effect is likely to be caused by FDIs rather than general foreign capital inflow.

The case of China (Wu, 2005) gives an example of an immense increase in income inequality caused by FDIs. The opening of the Chinese market, and to a certain degree its financial market in the 1980s and 1990s, led to a massive inflow of foreign direct investments and the economy was given a significant boost. At the same time the Gini-coefficient increased from 0.31 in 1985 to 0.42 in 200118 (Wu, 2005). Wu explains that in the past the private sector and collectively owned enterprises had to fulfil enormous financial obligations (e.g. social security contributions) and were therefore paying wages below those in the state sector. Since China wanted to attract FDIs, these obligations have not been applied to foreign ownership and joint ventures. This led to increasing wages in the foreign industries and therefore to an erosion of the highly productive workforce from local enterprises and the state sector. An increasing difference of average productivity followed which again led to higher income inequalities. It goes without saying that high quality institutions and fair business policies could have reduced these income inequalities.

Interestingly, all of the reviewed studies in the last paragraphs predict that CAL is positively related to income inequality which further supports hypothesis one. Additionally, many studies emphasize the importance of a good institutional quality as important in order to ensure a certain living standard of the poor and reduce income inequalities which further supports the second hypothesis. Lee and Jayadev (2005) in their study about CAL and inequality even use a proxy to control for institutional quality. However, they do not investigate whether CAL leads to an especially high increase in income inequality if the institutional quality is low (hypothesis two).

Finally it should be emphasised, that income inequality and absolute poverty are not necessarily positively related meaning that an increase in income inequality can be combined with decreasing absolute poverty19.

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Table 3: Studies about CAL and Poverty/Inequality (compiled by author, 2012).

Summing up, it can be said that while (neoliberal) theory suggests a strong link between open financial markets and poverty reduction, only few studies tested this link empirically. The reviewed studies suggest that open capital accounts and poverty reduction are not positively related (e.g. Arestis and Carner, 2008). In addition, liberalized financial markets were found to be positively related to income inequality (e.g. Lee and Jayadev, 2005). Which supports the first hypothesis; stating that open financial markets generally increase inequality. However, none of the reviewed studies tested the second hypothesis, stating that CAL leads to an especially high increase in income inequality if the institutional quality is low. The next chapter of this study will therefore evaluate empirical data to test both hypotheses.


1 Global perspective: Wade (2004) and Sala-i-Martin (2002); referring to countries which liberalized their financial markets (therefore without India and China). European perspective: Increasing financial inequality is reflected by increasing Gini-coefficient. In the period 2006-2010 the Gini-coefficient of the financially integrated Euro-Area (Kaopen of 2.45) increased from 29.1 to 30.2 (EU-SILC, 2012). Data for the years of 2011 and 2012 are not yet published (05.08.2012).

2 Giannetti, Guiso, Jappelli, Padula and Pagano (2002)

3 These protests include demonstrations, strikes, vandalism and street battles in Greece, Spain and Portugal (Borman, 2012; Burridge, 2012; Feltes, 2012; Hewitt, 2012).

4 Bonds are legal promises to repay a debt, including the original principle amount, and periodical interest payments (Frank and Bernanke, 2004).

5 Possible effects of these limitations are mentioned in the section “5.b. Limitations and Further Research”.

6 For details see Lee and Jayadev (2005).

7 Arestis and Carner (2004)

8 Artus et al. (2012)

9 Jaumotte, Lall and Papageorgiu (2009); Lee and Jaydev (2005) and Calderon and Chong (2001)

10 For more information see: “Is Globalization Reducing Poverty and Inequality?” (Wade, 2004), “The disturbing ‘rise’ of world income inequality” (Sala-i-Martin, 2002) and “Empirics for growth and distribution: Stratification, polarization, and convergence clubs” (Quah, 1997).

11 Devereux and Sutherland (2010) use the term “welfare” in this case in accordance with the first welfare theorem. Increasing welfare levels are therefore always Pareto improving.

12 Williamson (1999) and Ahluwalia, Carter, and Chenery (1979) found supporting evidence; however, Deininger and Squire’s (1998) research did not support the Kuznets curve.

13 See e.g. Bernanke, Gertler and Gilchrist; 1999 as well as Kiyotaki and Moore (1997) about moral hazard problems in investment finance.

14 The next section will investigate whether open financial markets really lead to more volatility and thus crises.

15 While the growth of one industry or firm is positive, it is likely that it is negative for some other industry or firm. Firm and industry growth is therefore not necessarily positively linked to the overall government income.

16 Consumption smoothing means that they transfer their income from periods with high consumption and low marginal utility to periods with low consumption and high marginal utility (Gruber, 2011).

17 See also Rodrik (1998) and Stiglitz (2000)

18 The 1985 and the 2001 levels are comparable to the current Gini-coefficients in Switzerland and Russia respectively.

19 This would be the case if the wealth of the whole society increased, but at different paces; meaning that the wealth of the rich increases stronger than that of the poor.

Excerpt out of 77 pages


How is Financial Market Liberalization Influencing Income Inequality?
Is the Matthew-effect supported by Financial Market Liberalization?
Maastricht Graduate School of Governance
Catalog Number
ISBN (Book)
Inequality, Liberalization, Financial Markets, Matthew-effect
Quote paper
Daniel Jägers (Author), 2012, How is Financial Market Liberalization Influencing Income Inequality?, Munich, GRIN Verlag,


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