Financial Sector Development, Income Inequality and Human Welfare in Sub Saharan Africa

This thesis contains the findings of an examination of the joint and endogenous evolution of financial development, income inequality and human welfare using data for a sample of 29 Sub-Sahara African countries from 1990 to 2010. Specifically, the study purposed to investigate whether the relationship between human welfare measured by the aggregate Human
Development Index and financial sector measured by broad money (M2) is influenced by the level of income inequality in SSA. Unlike previous studies, this study uses the Vector Error Correction Model (VECM) methodology to correct for biases arising from the presence of unit roots, serial correlation and endogeneity.
The results suggest that financial sector development measured by its size or broad money as a percentage of GDP (M2/GDP) yields a disproportionately higher and significant robust effect on living standards in SSA when national incomes are highly unequally distributed (GINI > 0.45) both in the long and short run. This finding is strongly causal and irrespective of whether a multidimensional measure of welfare such as the human development index (HDI) or a one-dimensional measure such as the infant mortality rate is employed. Also, the finding that high income inequality is not a fatality in SSA could be taken as evidence in support of the Kuznets (1955) hypothesis.
In addition, the results suggest that the disproportionate impact of financial sector deepening (credit to the private sector) on human welfare in the highly unequal countries only occurs in the long run. Contrary to Beck et al. (2007), the liquidity, savings and transactions functions offered by a more developed financial sector in terms of broad money (M2) provides a higher economic wellbeing for the residents of our highly unequal SSA sub-sample than credit issued to private individuals and businesses. Again, this study found that the disproportionate impact of financial sector development in the highly unequal countries is related to an average ratio to GDP of broad money (M2) of 25 percent and credit to the private sector of 18 percent calculated independently of the VECM model. The implication is that these average ratios could be important thresholds for which the impact of financial development on human welfare becomes vital. This is consistent with theories that suggest that there is increasing returns to scale as the financial sector develops from a lower level.
Consequently, and because of the finding that there is strong causality between M2 and human welfare in the highly unequal SSA countries in our sample, any policy designs to combat poverty and enhance living standards in such countries must have a strong financial sector development component. Then too, the findings suggest that low income SSA countries must
enact adequate policies to increase the size and depth of their financial sectors to reach at least, a
long term average ratio to GDP of 25 percent for M2 and 18 percent for credit to the private sector.