Finance: Research, Policy and Anecdotes

Finance and poverty reduction in India

After many years, Meghana, Mohammad and I finally managed to find a home for our paper Finance, Law and Poverty: Evidence from India, now forthcoming in the Journal of Corporate Finance.  The paper relates to a longer-standing debate on the role of financial development and – even more important for the policy debate – the relative importance of expanding access to financial services versus increasing the efficiency of the financial system.  These are two important though not necessarily correlated dimensions of financial sector deepening.  We use state-level variation in India over the period 1983 to 2005 in rural and urban poverty rates, branch penetration and Credit to SDP to explore these questions. While we do not have perfect gauges for the outreach and the deepening of the financial system, we use branch penetration as a proxy for outreach effort of the banking system (before the arrival of digital and mobile finance) and Credit to SDP as proxy for financial deepening. Our findings suggest that over the period 1983 to 2005 it is Credit to SDP rather than branch penetration that is associated with lower rural but not urban poverty. Branch penetration, on the other hand, does not enter significantly, though it enters significantly and negatively in a regression of rural poverty, when extending the sample period to 1965 to 2003, consistent with the seminal paper by Burgess and Pande.  As interesting as establishing this result (in line with the findings in the paper by Asli, Ross and me) is to explore the channels.  We cannot find any evidence that financial sector deepening reduced poverty by increasing schooling, but find some evidence for more entrepreneurship in the rural areas.  Where we find the most robust evidence is in interstate migration into urban areas and the tertiary sector going hand in hand with financial sector deepening in the target states.  This is in line with most of the additional credit going into the tertiary rather than the primary and secondary sectors. In summary, the story of financial sector deepening contribution to the long-term reduction in rural poverty in India is one of indirect effects going through labour markets rather than through increasing financial sector outreach. This, again, is consistent with some of my earlier work, with Ross and Alex, on the U.S., but also with evidence on Thailand, by Xavi Gine and Robert Townsend.