Addis Ababa, 13 July 2015 (WIC) – Governments, businesses, and ordinary folks alike are increasingly convinced of the importance of financial inclusion. But how financial inclusion could impact on macroeconomic growth and inequality often remains ambiguous and even confusing.
Clarity on how financial inclusion is linked to economic growth and income distribution is important not only in making the case that financial inclusion is desirable, but also more critically for formulating effective public policies for maximizing social welfare.
A recent IMF and NBER Working Paper [1], 2 makes a timely and welcomed contribution in filling this gap, and it does so with commendable analytic rigor. Firms—particularly small and medium-sized enterprises (SMEs)—in many developing countries continue to face barriers that impede access to finance.
Limited credit, high collateral requirements, and high interest rates also hamper SME growth. What this means is that individuals must rely on limited savings to start an SME.
Once established, these fledgling enterprises tend to depend on self-financing to meet investment needs. This, in turn, limits the overall size and productivity of the firm.
To capture this, the IMF/NBER Working Paper (“the study”) groups impediments or blockages to financial inclusion into three dimensions: (i) Access to Credit: high participation costs leading to lack of access to credit because of high transaction costs and annual fees, and/or onerous documentation requirements; (ii) Depth of Credit: borrowing constraints that are imposed on small business operators who may have access to the formal financial sector but have to face higher collateral requirements when borrowing; and (iii) Intermediation of Credit: high intermediation costs resulting from information asymmetry between banks and borrowers where smaller and less capitalized borrowers are charged higher interest rates and fees
The study shows that elimination of these blockages to financial inclusion has significant and unambiguous direct impacts on GDP growth and productivity through smarter allocation of resources and more efficient financial contracting; resulting in stronger entrepreneurial activities and new business start-ups that increase aggregate output.
The impacts on inequality, on the other hand, could be either positive or negative depending on specific local conditions. When more funds are made available to more talented but financially-constrained entrepreneurs relative to less talented entrepreneurs as a result of financial inclusion, inequality may rise in the short term.
On the other hand, lowering participation costs would improve income distribution and reduce inequality as enterprises previously excluded from the financial system are able to obtain credit and workers receive higher wages.
Overall, the study suggests that there is the possibility that income inequality may get worse (more talented entrepreneurs benefit from financial inclusion ahead of others) before it gets better (less talented entrepreneurs start to catch up benefiting from new demand generated by more talented entrepreneurs).3
The consequences of increased financial inclusion could have sharp distributional consequences. The study indicates that lowering participation costs benefits the poor, but wealthy enterprises can lose somewhat as a result of higher interest rates and wages.
By contrast, policies that relaxing borrowing constraints benefit productive firms. Yet such policies also can impose losses on less productive firms as well as those with low credit demand.
The study covers six developing countries in its analysis: three low income countries – Uganda, Kenya and Mozambique, and three emerging economies – Malaysia, Philippines, and Egypt.
An important finding of the study is that specific country level conditions affect the magnitude of impacts of the elimination of different blockages to financial inclusion. So a deep understanding of the country level conditions is necessary to maximize the impacts of financial inclusion in policy formulation.
Using data from the World Bank’s Enterprise Surveys and World Development Indicators, the study quantifies the impacts of financial inclusion on GDP growth, total factor productivity, and income inequality in these six countries.
In all instances, the impacts on GDP growth and productivity are unambiguously positive and very significant in some instances; while the impacts on income inequality, as mentioned above, vary from case to case. The overall result demonstrates that there is a powerful linkage between financial inclusion and macroeconomic performance.
The table below highlights the study’s findings on financial inclusion’s impacts on GDP. For each of the six countries, the increase in GDP is estimated as a result of a 1% increase in credit to investment ratio that is made possible due to a reduction of one of the three blockages to financial inclusion.
When reduction of participation costs leads to a 1% increase in credit to investment ratio, Kenya’s GDP shows the biggest gains among the six countries at 0.63%.
When borrowing constraints are relaxed sufficiently to lead to a 1% increase in credit to investment ratio, Mozambique and Malaysia, at 0.51%, show the biggest GDP gains. When reduction in intermediation costs raises the credit to investment ratio by 1%, Kenya shows the biggest GDP gain at 1.17%.