Financial development and income inequality in Africa

Income inequality's negative impact on development has spurred research into its eradication. It's both a social and economic issue, potentially leading to conflicts as seen in some African nations. The rise in global, and particularly African, income inequality threatens the UN's Sustainable Development Goals (SDGs), specifically SDG-10 (reduced inequalities). Financial development is proposed as a solution, as it involves efficient capital allocation. A well-developed financial system can alleviate constraints hindering capital redistribution, enabling the poor to access funds for productive activities, thus reducing income inequality. However, this theory often contradicts reality; many economies with strong financial development also experience increased income inequality, exemplified by South Africa. Existing literature focuses primarily on the depth of financial development, a narrow approach. Previous studies have yielded conflicting results, with some finding financial development widens income inequality in both advanced and emerging economies, while others find it reduces inequality in some income groups. This highlights the need for a more holistic evaluation of financial development’s impact on income inequality in Africa, considering its multifaceted dimensions.

The literature presents conflicting views on the relationship between financial development and income inequality. The "finance-income inequality-narrowing hypothesis" posits that financial development reduces inequality by easing access to finance. Conversely, the "finance-income inequality-widening hypothesis" suggests that financial development benefits the already wealthy, exacerbating inequality. The "financial Kuznets hypothesis" proposes a nonlinear relationship, with inequality initially increasing and later decreasing as financial development progresses. A U-shaped relationship has also been suggested, where inequality initially falls but then rises with further development. The impact of finance on income distribution depends on the level of financial development in the economy, but many studies focus solely on the depth dimension. Some studies focusing on specific economies or regions have found varying effects of financial development on inequality, based on the methodology used and the specific measure of financial development. In particular, prior studies on Africa have reported mixed findings and often focused on single indicators of financial development, making a comprehensive analysis necessary.

This study employs the financial imperfection theory, which posits that market imperfections hinder access to finance, leading to persistent income inequality. Easing these constraints through financial development should reduce inequality, but focusing solely on the size of the financial system is insufficient. The study evaluates the impact of financial development dimensions (access, depth, efficiency, and stability) on income inequality in Africa. The main model, based on the financial imperfection theory by Galor and Zeira (1993), uses the natural logarithm of the Gini coefficient as the dependent variable and includes lagged Gini coefficient to capture persistence in income inequality. The independent variables are financial development dimensions (access, depth, efficiency, and stability). Control variables include education, age dependency ratio, trade openness, and mobile subscriptions. The study uses data from 48 African countries from 1996 to 2018, sourced from the World Bank, Global Financial Development Database, and Global Consumption and Income Project. The study utilizes both Pooled Ordinary Least Squares (OLS) and System Generalized Method of Moments (SGMM) estimations. Pooled OLS serves as a baseline, but its limitations in addressing endogeneity and heterogeneity are acknowledged. SGMM is employed to address these limitations, particularly the endogeneity arising from the lagged dependent variable. The study employs four separate regressions analyzing the impact of each financial development dimension individually on income inequality.

The pooled OLS regression shows that financial access (measured by bank branches per 100,000 adults) significantly reduces income inequality. Financial efficiency (measured by the bank cost-to-income ratio) has a positive and significant effect, suggesting that inefficiency increases inequality. Financial stability (measured by the bank Z-score) significantly reduces inequality. However, financial depth (measured by credit to the private sector as a percentage of GDP) has a positive and significant effect, suggesting it exacerbates inequality. The System GMM estimates generally support these findings, although the effects of some control variables differ between the two methodologies. The SGMM analysis confirms that financial access significantly reduces inequality, while financial efficiency and depth have opposite effects compared to access and stability, mirroring the OLS findings. The control variables show varying relationships with income inequality, depending on which dimension of financial development is considered. Specifically, education and trade openness have varying effects across the different dimensions of financial development, suggesting a complex interaction between these factors.

The study's findings highlight the importance of considering the multifaceted nature of financial development when analyzing its impact on income inequality in Africa. While access, efficiency, and stability reduce inequality, depth exacerbates it. This suggests that simply increasing the size of the financial sector is not sufficient to reduce inequality; rather, a focus on broadening access to financial services, improving efficiency, and ensuring stability is critical. The differing effects of the various dimensions of financial development suggest the need for targeted policies to address each dimension. For instance, policies promoting financial inclusion and reducing transaction costs are necessary to improve access to financial services among the poor. Efforts to improve the efficiency of financial institutions and to regulate and strengthen financial systems to improve stability are also needed. The findings also suggest the need for a more nuanced understanding of the relationship between education and income inequality in Africa, taking into account the existence of inequality in access to quality education, as well as other contributing factors.

This study's main contribution lies in its holistic assessment of the impact of financial development on income inequality in Africa, considering four key dimensions. It demonstrates that financial development's impact is not uniform, with some dimensions reducing and others exacerbating inequality. Policies should focus on improving financial access, efficiency, and stability, while addressing the challenges associated with financial depth. Further research could explore the interaction between financial development and other factors, such as institutional quality, governance, and technological advancements, to gain a more comprehensive understanding of the determinants of income inequality in Africa. Qualitative studies exploring the lived experiences of different groups within the context of financial development would also be valuable.

The study relies on aggregate-level data, which may mask variations at the individual or household level. The choice of control variables may not fully capture all factors influencing income inequality. The study focuses solely on African countries, limiting the generalizability of its findings to other regions. Further research employing more granular data and considering other contextual factors would offer more comprehensive insights.