Financial Liberalization, Inequality and Inclusion in Low-Income Countries

Abstract

This paper examines the distributional impact of capital account reforms and the linkage among liberalization, inequality and inclusion in low-income countries. Using a panel data for 29 low-income countries from 1970 to 2010, we find that capital account liberalization reforms are associated with statistically significant and persistent increase in income inequality in both short and medium term. We also highlight that the level of financial development has an important role in determining the response of inequality to liberalization: impact of capital account liberalization on inequality is larger in countries with lower level of credit market development and financial inclusion.

Disclaimer: This Working Paper should not be reported as representing the views of the IMF. The authors acknowledge the support from U.K.’s Department for International Development (DFID) under the project Macroeconomic Research in Low-Income Countries. The views expressed here are those of the authors and do not necessarily represent those of the IMF, IMF policy, or DFID.

Appendix: Data Appendix

This appendix provides details on other variables used in this paper.

1.1 Current Account Openness Index

De jure index of current account openness is taken from Quinn and Toyoda (2008) dataset which is based on IMF’s AREAER and is mostly available from 1980 to 2009 for 125 countries. The index measures a country’s degree of compliance under IMF’s Article VIII to free government restrictions in regard to international trade of goods and services. The higher the index, the more open the current account is.

Using the same method outlined in the paper to identify capital account liberalization, we assume current account liberalization reform occurs when, for a low-income country at a given time, the annual change in current account openness index exceeds by two standard deviations the average annual change of all observations covering 125 countries. As a result, with our low-income country sample, we are able to identify 10 current account liberalization episodes in 1980s, 21 in 1990s and 3 in 2000s.

1.2 Regulation Reform

The regulation index is from Fraser Institute’s EFW (Economic Freedom of the World) database developed by Gwartney et al. (2016). It assesses the regulatory restraints of credit market, labor market and business regulations together for about 160 countries from 1970 to 2014, with lower number indicating more restrictions in these areas.

We identify an episode of regulatory reform if, for a given country at a given time, the annual change in the composite regulation index exceeds by two standard deviations the average annual change of all observations included in the EFW dataset. Following this methods, we find 8 regulatory reforms in 1980s, 21 in 1990s and 17 in 2000s for our low-income country sample.

1.3 Macroeconomic Variables

Macroeconomic variables: Gross domestic Product (GDP), GDP Growth Rate, Log GDP per Capita, Industry Value Added over GDP, Agriculture Value Added over GDP, Government Expenditure, Imports, Exports and Dependency Ratio are from World Bank’s World Development Indicators (WDI), with annual data covering from 1970 to 2010. We calculated Trade Openness as the sum of exports and imports over GDP.

1.4 Redistributive Policies

To measure the redistributive policies of a government, we used the difference between market Gini indices, which measures the pre-tax and pre-transfer income inequality and net Gini indices, which measures inequality in post-tax and post-transfer income, as a proxy. Both measures of Gini indices are taken from Standardized World Income Inequality Database (SWIID) from 1970 to 2010.

1.5 Credit Market Freedom Indicator

Credit market freedom indictor (ownership of banks), based on the percentage of bank deposits held in privately owned banks, is from Fraser Institute’s EFW as well, which measures conditions in the domestic credit market. The indicator is consisted of numeric variables between 0 and 10, covering around 160 countries from 1970 to 2014. When private held deposits ranges from 95 to 100% of total deposits, countries were given a score of 10 that indicates high financial depth and high level of credit market openness. When the private deposits were 10% or less of the total deposits, countries were assigned a rating of 0 to indicate low financial depth and low level of credit market openness.

1.6 Financial Inclusion

The financial inclusion indictor was taken from The Global Financial Inclusion database (Global Findex) developed by Demirguc-Kunt et al. (2015) at World Bank, covering around 140 economies. The inclusion indicator is defined as ratio of adults who borrowed from a formal financial institution in the past years to the number of total adults.