Contemporary Issues in Development Finance - Essay Example

Contemporary Issues in Development Finance Introduction Development finance indicates the system that attempts to improve the quality, quantity and effectiveness of financial intermediary services. Even after globalization and massive liberalization of most of the economies, the world economy still suffers from economic uncertainty and economic imbalances that compels the expert to question on the sustainability of the world economy as a whole (Beck, Demirgüç-Kunt and Honohan, 2009). Moreover, whereas financial unrest and financial deregulations are creating huge divergence among the major economies in the world, the emerging economies are also suffering from fragile public finances, low Foreign Direct Investment (FDI), huge unemployment and high inequality. Many countries such as Mexico, Greece, Spain and Portugal etc. suffers from high inequality and poverty due to utilization of only one engine of growth. Financial development aims to recover such countries from poor economic condition through ensuring equitable capital allocation, monitoring investments and corporate governance, mobilization of savings pool and managing risk. However, some of the economists are of the opinion that the policies taken by development finance leads to widen the gap of inequality further (Clark, 2006). In this paper, the relationship between inequality and financial development will be critically analysed in the light of theories and empirical evidences. For the purpose of analysis, the case of Mexico will be incorporate in order to examine the level of inequality and poverty exists in that particular economy and how the measures of financial development is helping the economy to progress from its current economic situation. Discussion Development Finance and Its Importance Development finance holds huge importance mainly for promoting economic growth through capital accumulation, mobilization of savings for technological inclusion and poverty eradication. The system also aims to encourage the flow of foreign capital. In fact, a meta analysis done on the basis of 67 empirical studies have shown strong correlation between the metrics of development finance and economic growth. Analysing the cases of courtiers with sound tend of economic development, it has been identified that development finance has worked as a driver of economic growth in those countries. The system also strives for better risk management that helps the vulnerable group of the society to obtain opportunities for enhancing their productivity and expands the investment avenue so that the group can generate higher income. Development finance facilitates the growth of small and medium-sized enterprises through providing access to finance in order to create job opportunities at the grass root level. The vulnerable section of the economy also gets an easy access of capital from those SMEs. In this way, development finance attempts to reduce economic inequality and poverty. Moreover, the system tends to institute a regulatory framework in the financial sector of the economy and monitor the financial policies over a stipulated time period in order to strengthen the foundation of economic sustainability and accelerate economic growth (DFID, 2004). However, in spite of application of all such measures of traditional development finance, many strong economies have encountered economic turmoil that have led the world economy to opt for advanced methods of development finance. Alternative sources of development finance such as global taxation and special drawing rights sufficiently aid the world economy to recover from economic inequalities. As a positive consequence of globalization, many companies have started operating in multiple regions of the world, their activities are failing under varied tax structures, practiced in different countries. Global tax tends to collect taxes from organizations or individuals according to the tax law of the countries in which they are operating their business. Tobin tax is another source of contemporary development finance in which tax is imposed on the short term securities transaction done in foreign exchange market in order to control the scope of speculations and subsequent possibilities of financial crisis associated with such speculations. Apart from these two, environmental tax is also applied on the activities that create negative impact on the environment such as emission of carbon-di-oxide and aviation transportation. The main purpose behind imposing all these taxes is to drive global business in a sustainable, ethical and environment-friendly way and more importantly, to generate additional resources for development finances. Special Drawing Rights (SDR) is also an instrument of international finance created by International Monetary Fund (IMF). It contains weighted average of various convertible currencies for the purpose of providing emergency funds to the countries running in deficits (Hamilton and Webster, 2015). It also facilitates monetary support to the development programs of the underdeveloped and developing countries as well as countries that are suffering from high economic inequalities. Economic Inequality Economic inequality indicates the degree to which the economic resources and attributes are distributed among the population of the country. Economists have suggested three parameters to reckon the level of inequality prevailing in an economy. The measures are wealth, income and level of consumption. Role of development finance in eradicating inequality can be attributed as the effort taken for changing the pattern of income distribution which will lead to institute a better consumption and improved allocation of wealth within the nation. Though development finance appears to be beneficial in removing poverty and inequality, the theory provides three contrasting hypothesis regarding the impact of development finance on inequality (Galor and Zeira, 1993). The first hypothesis says that the development finance decreases inequality as it tends to restrict the access of credit market to the poor segment of the economy, reduces the scope for investment in social sectors such as health and education. The second hypothesis indicates that development finance increases inequality through enhancing financial services of those already accessing them. Finally, the third hypothesis signifies an inverted U shaped relationship between the two variables according to which during the initial days of financial development, the level of inequality tends to increase at an increasing rate. However, when the economy starts realising the benefits of development finance, the level of inequality tends to decline. Such shape also depends on the stage of development in which the economy in concern is standing presently (Levine, 2008). Hence, if positive relation between development finance and economic inequality is considered as null hypothesis, the alternative hypothesis can be framed as H1: The relationship between development finance and economic inequality is negative. H2: The relationship between development finance and inequality is inverted U shaped. Whereas, the null hypothesis, H0: The relationship between development finance and economic inequality is positive. In the next segment, empirical analysis will be done on the basis of examining the economic indicators of Mexico. Empirical Analysis Several empirical analyses have been done in order to establish the relationship between development finance and economic inequality. In this paper, the relationship will be analysed by evaluating the economic indicators of Mexico as well as through examining the factors that determine the degree of inequality for this particular country. According to the reports from International Monetary Fund (IMF), Mexican economy is considered to be the 15th largest economy in the world in terms of Nominal GDP (Gross Domestic Product). Though the economy was highly affected during the period of great recession in2008-2009, it has been able to maintain a slow but position growth rate over the period of time. However, in spite of achieving macro- economic stability, reduced inflation and low interest rates, the problem of poverty and inequality remains prominent in this economy (World Bank, 2012). Though per capita income has increased, persistent gap between rural and urban population in accessing modern infrastructure, technologies and other amenities have further worsened the situation. The aggregate poverty rate of the country as on 2014 is 44.2% among which 17% lives below poverty line and 21% lie in moderate poverty condition. The level of absolute poverty significantly rose between 2006 and 2010, reflecting the reason behind three times higher mortality rate as compared to the standard average rate set by OECD (Organization for Economic Co-operation and Development). Income inequality in this country is so high that it has been observed that only 10% of the Mexico population constitutes for 25% of the country’s aggregate GDP. Taking a smaller sample size, 4% Mexican are noticed to contribute 12.5% of the total GRP of the country. In fact, OECD has identified the country to be the second highest economy in terms of economic inequality, only after Chile. If the income group can be segregated into bottom 10% and upper 10%, the first segment has only 1.36% access to the country’s resources, whereas, the next segment enjoys 36% of the critical resources and economic benefits (Hamilton and Webster, 2015). Observing such economic disparity in spite of having a positive economic growth, when OECD and IMF attempted to detect the reason behind this, it was found that it was noticed that management of public finance is very poor in the country. The allocated budget for poverty elimination and social development is only one third of the average specified by OECD in both absolute and relative numbers (World Bank, 2012). This indicates poor application of development finance in Mexican economy. Whether it can be blamed as the sole reason behind existing inequalities in Mexico, it can be examined from the following empirical analysis. Chart 1: The Relationship between GDP and Growth of Per Capita Income The chart indicated the relationship between real GDP of Mexican economy over the past 20 years and the growth in the per capita income. Considering the fact that, GDP indicates aggregate income of the nation; the above graph is clearly indicating huge disparity between the aggregate income of the economy and per capita income. Hence, the chart proves that the GDP of Mexican economy is constituted with the contribution of few. Per capita income of the major population is much lower than the aggregate income of the economy. In fact, sometimes the per capita GDP growth has become negative, even when the aggregate GDP has shown a positive figure. Hence, existence of income inequality in Mexican economy is evident (Hui and Siong, 2012). Chart 2: The Relationship between GDP and Poverty Headcount Ratio Considering the poverty headcount ratio in Mexico over last 20 years and comparing the data with the GDP of the economy for the same time period, an asymmetric tend between the two can be noticed. During the initial time frame, the poverty head count ratio was much higher than the GDP of the economy. Before 2008, as GDP increased, the poverty ratio tended to decrease indicating a trifling sign of lowering inequality. However, during the global financial crisis, when the economy was thrashed, rise in poverty headcount ratio was much higher than the decline in gross income of the nation. Therefore, aftershock of the financial crisis hit the pre-existed poverty level as prevailing economic divergence and financial structural imbalances could not provide enough support to safeguard the poverty ratio of the economy (Hui and Siong, 2012). Chart 3: The Relationship between GDP and Capital Formation As the existence of inequality in the Mexican economy has been proved, now it will be analysed whether influence of development finance has increased or decreased the economic inequality in Mexico. From the above graph, it can easily be plotted that before the financial crisis in 2008-2009, the financial capital formation has been slowly but steadily increased. Though in 2009, it has decreased by a trivial percentage, throughout the years, the capital formation has provided cushion to the economic growth as the GDP of the country has increased at an exponential rate compared to the growth of capital formation. Therefore, a constituent of development finance has definitely supported the economy to generate more income. As income is considered as one of the three parameters for measuring economic inequality, observing such relationship it can be inferred that development finance definitely contributes towards minimizing economic inequality (Hui and Siong, 2012). Chart 4: The Relationship between Capital Formation and Consumption Expenditure Consumption expenditure is considered to be another parameter for evaluating the existence of inequality in an economy. Therefore, in order to define relationship between economic inequality and development finance, consumption expenditure of Mexican economy has been examined to understand the effect of capital formation on it. Plotting these two variables for 20 years of time period, as the capital formation slowly accelerated, the aggregate consumption expenditure of the population of the economy has shown marked increase, even with a higher magnitude. Therefore, capital formation has facilitated consumption expenditure which in turn lessens the scope for economic inequality (Clark, 2006). As discussed earlier, existence of the level of economic inequality is measured by three distinct parameters such as income, consumption and wealth. Analysing the effect of traditional development finance on two of these three parameters, it can be stated that the constituent of development finance has sufficiently contributed towards improving the parameters that indicates income inequality. Therefore, in the economy of Mexico, the relationship between development finance and economic inequality is negative. As the contribution from development finance increases, income and consumption level of this particular economy better off, reducing the level of economic inequality in long term perspective (Hui and Siong, 2012). Critical Analysis As a bulk of empirical researches have been conducted to analyse significance of financial development on the pattern of income distributions, many economists have come up with various theories and literatures as outcomes of such researches. Regarding economic inequality, Clark (2006) has specified that before analysing the effect of financial development on economic inefficiency it is better to identify the best indicator that can provide clarity on the existing level of inequality in a country. For this purpose, he suggested that Gini co-efficient can be used to check the income distribution and economic inequality. Galor and Zeira (1993) have shown that inequality and income distribution can be best measured by combining the Gini Coefficient with Lorenz Curve. Along with the slope of Lorenz curve, a Gini Coefficient of 0 indicates that perfect equality prevails in the economy whereas 100 signify existence of maximum inequality within the economy. In 2008, the Gini coefficient of Mexico was found to be 48.28 which indicated that approximately 50% population of the economy suffers from high level of inequality due to lack of access to the critical economic resources and other facilities. Now, the relationship between financial development and economic inequality will be critically analysed. Figure 1: Gini Coefficient of Mexico till 2012 (Source: World Bank, 2012) Beck, Demirgüc-Kunt and Levine (2007) are of the opinion that there is a direct relationship between financial development and economic inequality. As the applications of development finance such as capital formation, FDI accumulation, investments on technology and infrastructure as well as creating provisions for financial inclusion, especially in rural sectors etc. are incorporated into an economy, all the economic entities are facilitated with a better access to the economic resources and capital. As development finance concentrates on improving various social aspects as well, the health, education, poverty eradication, access to foods and fresh water etc. are also substantially monitored and controlled, reducing further scope for economic inequalities. Therefore, according to these three economists, development finance contributes positively towards reducing the degree of economic inequalities. Regarding the contribution of financial development in establishing economic well-being, Clark (2006) had shown that as imperfection prevails in the market due to presence of transaction cost, uneven number of lenders and borrowers and incomplete information, financial intermediaries tries to take advantages of such market imperfections through asset transformation. Asset transformation is the process through which financial intermediaries attempt to secure the interest of both borrowers and lenders through channelizing the long term capital and at the same time maintain liquidity issues in the economy. In this way, all population segments of the economy including the vulnerable segment get an access to long term capital utilizing which they can generate a higher income and thus economic inequality is reduced. However, according to Beck, Demirgüç-Kunt and Honohan (2009), financial development cannot resolve the issues related to transaction cost which in turn delays the scope for minimizing economic inequality. To be more specific, because of the presence of transaction cost, it becomes difficult for the potential lender to locate appropriate borrower. Moreover, due to imposition of enforcement cost that makes it difficult for the borrower to meet the condition inflicted by the lender, the poor section of the society gets affected the most because of their inability to fulfil the strict borrowing terms enforced by the lenders. Strict governance of the public finance department of the economy often results in retention of the loan if the financial auditors find it difficult for the borrower to repay the loan in the long term. Hence according to them, though development finance tries to utilize market imperfection for promoting capital requirement of the economy and thus reducing the economic inequality, presence of transaction cost and strict policy regulations restricts the fragile population segment to get an access to the financial facilities which in turn enhances the economic inequality to a great extent. Gu and Huang (2014) are of the opinion that as information asymmetry prevails in any real economy, the scope for adverse selection and moral hazard highly increases. Adverse selection arises when the potential lenders tends to provide loans to the borrowers who are ineligible for the loan. Such selection of borrower creates amounting bad debts or raising nonperforming assets. Sometimes it may also happen that potential borrowers tend to opt for loans without analysing its adverse future consequences. Such adverse selection of loans may appear to be beneficial in short term, however in long term, the economy can be penalised through exposition of credit risk that may lead to create financial crisis in the economy. The financial crisis in 2008 that had affected the whole world was originated mainly due to the problem of information asymmetry and adverse selection of loans by the borrowers. Hui and Siong (2012) identified another reason that had ignited financial crisis in 2008 which is known as moral hazard. Moral hazard also takes shape due to information asymmetry under imperfect market condition when the risk associated with the borrower’s activities yields undesirable outcome for the lenders. For instance, it may happen that the lenders become lenient in providing loan to the borrowers without analysing their potency to repayment. In such circumstances, if the borrowers act indifferently in repayment of the loans, it will create potential loss for the borrowers and the borrower may go out of business. According to Kim and Lin (2011), this is exactly the scenario created by development finance. Financial development facilitates the vulnerable society of an economy to obtain access to loans from banking sector or more importantly from the SMEs. In fact, with an objective to reduce economic inequality and promote economic growth, the policies of financial development are often loosen so that more and more needy people can be facilitated with short or long term loans according to their requirement. However, in most of the cases, the segment fails to replay such loans on time. As a consequence, imposition of higher interests further converts such loans into bad debt. As the amount of bad debt continues to increase, the financial system experiences considerable difficulties in running its other functions and subsequently stands on the verge of collapsing. Therefore, in the view of some of the researchers, though financial development aims to reduce inequality and accordingly creates provisions that help the vulnerable to establish some source of income and reduce poverty in the short run, in long run such defective financial policy formulations create hindrance in the path of economic growth of the economy and consequently drag the economy to experience financial crisis (Levine, 2008). Conclusion Examining the constituents of development finance and its implication on economic inequality one thing is prominent that it is difficult to establish a universally accepted liner relationship between the two variables. In spite of rapid progression of globalization and enhancement in the scope for trade and development, economic inequality is inevitable in many economies in the world. However, the reason behind such inequalities can be attributed differently. Though the measures of development finance are incorporated in the countries suffering from economic inequality, as the reason behind such inequality differs, the influence of development finance on such different economies reacts differently. For instance, observing the case of Mexican economy it is clear that financial inclusion has contributed positively towards reducing economic inequality in the country. In contrast, adopting similar measures in the economy of the United States such as providing cheap mortgage loans has created problems of adverse selection and moral hazard which had eventually pushed the economy to experience financial crisis. Moreover, while analysing the Mexican economy the parameter of economic inequality was compared only on the basis of a single parameter of development finance such as capital accumulation. However, effect of development finance on economic inequality depends on aggregate outcome of all the parameters of development finance such as inflow of foreign capital, microfinance interest rate etc. Hence, arriving at a conclusion relying only on one variable will also not be a feasible option. Therefore, examining the multi-dynamic relationship between development finance and economic inequality it can be inferred that development finance can increase or decrease economic inequality and even it can decrease inequality at a decreasing rate, depending on the economic scenario in which it has been applied. Reference List Beck, T., Demirgüç-Kunt, A. and Honohan, P., 2009. Access to Financial Services: Measurement, Impact and Policies. World Bank Research Observer, 24(1), pp.119-145. Beck, T., Demirgüc-Kunt, A. and Levine, R. 2007. Finance, inequality and the poor. Journal of Economic Growth, 12(1), pp.27–49. Clark, G.R.G., 2006. Finance and Income Inequality: What Do the Data Tell Us? Southern Economic Journal, 72(3), pp. 124-132. DFID, 2004. The Importance of Financial Sector Development for Growth and Poverty Reduction, Policy Division Working Paper. Washington D.C: International Monetary Fund. Galor, O. and Zeira, H., 1993. Income Distribution and Macroeconomics. The Review of Economic Studies, 60(1), pp. 35-52. Gu, X. and Huang, B., 2014. Does Inequality Lead to a Financial Crisis? Revisited. Review of Development Economics, 18(2), pp. 502–516. Hamilton, L. and Webster, P., 2015. The International Business Environment. Oxford: Oxford University Press. Hui, B. T. and Siong, H. L., 2012. Nonlinear dynamics of the finance-inequality nexus in developing countries. The Journal of Economic Inequality, 10(4), pp. 551-563. Kim, S. C. and Lin, D. H., 2011. Nonlinearity in the financial development–income inequality nexus. Journal of Comparative Economics, 39(2), pp. 310–325. Levine, R., 2008. Finance and The Poor. The Manchester School, 76(1), pp. 1-13. World Bank, 2012. Global Financial Development Report 2013: Rethinking the role of the state in finance. Washington D.C: World Bank Publishing. Read More