Does financial market growth improve income distribution? A comparison of developed and emerging market economies of the global sample

• DOI: http://doi.org/10.1002/ijfe.1683
• Published date: 01 January 2019
• Author: Sudharshan Reddy Paramati,Thanh Pham Thien Nguyen
• Date: 01 January 2019

RESEARCH ARTICLE

Does financial market growth improve income distribution?

A comparison of developed and emerging market

economies of the global sample

Sudharshan Reddy Paramati

1

| Thanh Pham Thien Nguyen

2

1

School of Business, University of

Dundee, Dundee, UK

2

Business Department, James Cook

University, Singapore

Correspondence

Corresponding: Sudharshan Reddy

Paramati, School of Business, University

of Dundee, Dundee DD1 4HN, UK.

Email: s.paramati@dundee.ac.uk

JEL Classification: C23; D63; O16; O57

Abstract

The objective of this research is to investigate the effects of stock market

indicators, banking, and foreign direct investment inflows on income

inequalities in developed and emerging market economies around the world.

For this reason, the study utilizes annual data that range from 1981 to 2014

on the selected indicators. Given the nature of our variables, we employ panel

autoregressive distributed lag models to explore the long‐run estimates of

income inequalities. The long‐run estimates indicate that the stock market

indicators have significant positive and negative impact on income inequalities

in developed and emerging market economies, respectively. Further, our find-

ings show that the banking credit adversely affects income inequalities both in

developed and emerging economies. Our results also establish significant

short‐run causalities among stock market indicators and income inequalities.

Given these findings, we argue that the stock markets are playing an important

role in reducing income inequalities in emerging economies whereas they con-

tribute for higher inequalities in developed economies.

KEYWORDS

banking credit, developed‐emerging market economies, FDI inflows, income inequalities, panel

ARDL, stock market indicators

1|INTRODUCTION

Income inequality across most countries has been rising

over the past two decades (Christopoulos & McAdam,

2017; Liberati, 2015). The increase in income inequality

could dampen global economic growth and accelerate

unemployment rate (Dabla‐Norris, Kochhar,

Suphaphiphat, Ricka, & Tsounta, 2015); therefore, fight-

ing against income inequality has been at the central of

the development policies in both developed and develop-

ing countries. To fight for an improvement of income

distribution, understanding the determinants of income

inequality is fundamental to form policy measures. Trade

and financial globalization (Gozgor & Ranjan, 2017;

Jaumotte, Lall, & Papageorgiou, 2013) and technological

change (Jaumotte et al., 2013) have been found to be

responsible for the rise of income inequality. It is mainly

because the modern technology substitutes for many jobs

and tasks that traditionally performed by unskilled

workers and globalization has also enabled vast salaries

and profits to be shared among a narrow set of employees

and shareholders of market winners. However, they

cannot be used as tools for reducing income equality, as

they are essential for economic and social development

and life quality improvement (Coulibaly, Erbao, &

Metuge Mekongcho, 2018; Miah & Omar, 2012; Samimi

& Jenatabadi, 2014). Meanwhile, financial development

can be a flexible tool to fight for even income distribution,

Received: 30 March 2018 Revised: 15 August 2018 Accepted: 10 September 2018

DOI: 10.1002/ijfe.1683

Int J Fin Econ. 2019;24:629–646. © 2018 John Wiley & Sons, Ltd.wileyonlinelibrary.com/journal/ijfe 629

because access to financial services is critical for individ-

uals' productivity and welfare (Claessens & Perotti,

2007). This makes it interesting to study the impact of

financial development on income inequality.

Financial development has been historically captured

by domestic credit provided by banking sector (i.e., bank-

ing development), although there is a consensus of the

role of banking development as an engine of economic

growth (Barajas, Chami, & Yousefi, 2013; Boukhatem,

2016; Ehrlich & Seidel, 2015; Gozgor, 2015; Hassan,

Sanchez, & Yu, 2011; Odhiambo, 2009), and empirical

studies document mixed findings of the effect of banking

development on income inequality. This mixed impact

could be due to whether the rich or the poor can benefit

more from banking credit allocation (Beck, Demirgüç‐

Kunt, & Levine, 2007a; Hamori & Hashiguchi, 2012).

Moreover, financial system has two main components:

stock market and the banking system. Going public

allows firms to access more financial capital that can fuel

investment and innovation (Wies & Moorman, 2015) and

then influence the unemployment and the distribution of

income. A number of studies have explored the nexus

between financial development and income inequality,

but financial development in these studies is mostly cap-

tured by the banking development, whereas stock market

development is usually ignored, though the growth of

stock markets have been very impressive during the last

few decades. In addition, in wealthy nations, stock mar-

kets are large, stable, and liquid (Choong, Baharumshah,

Yusop, & Habibullah, 2010; Singh, 2008) and concen-

trated by some industrialized companies that tend to pro-

duce technology‐intensive products and hence rely more

on skilled workers. Therefore, the stock market develop-

ment in developed countries may widen the income gap

between the rich and the poor. On the other hand, the

stock markets in developing countries, although have

low liquidity and market capitalization (Singh, 2008),

are a place for listed firms to raise financial capital to

diversify or expand their business. Nevertheless, a major-

ity of these listed firms lack access to technology and rely

on low‐cost unskilled workers to produce labour‐inten-

sive products, and hence, the stock market development

in developing countries may narrow the income gap

between the rich and the poor. Given this background

and knowledge gap in the existing literature, this study

aims to investigate and compare the effect of financial

development, including stock market and banking devel-

opment, on income inequality in developed and emerging

economies. This study also examines the role of foreign

direct investment (FDI) inflows on income inequality as

FDI inflows tend to mitigate unemployment problem of

both types of labour: skilled and unskilled (Balcerzak &

Zurek, 2011; Chang, 2007; Chaudhuri & Banerjee, 2010).

This study measures stock market development by

three stock market indicators: market capitalization,

turnover ratio, and total value traded, and banking devel-

opment is measured through the domestic credit to the

private sector (DCPS) by the banks. The study considers

20 developed and 18 emerging economies and uses

annual data from 1981 to 2014. Our study employs two

robust panel econometric techniques such as the

autoregressive distributed lag (ARDL) model and hetero-

geneous panel noncausality test to see the role of stock

markets and banking credit on income inequalities in

these two groups of economies. The panel ARDL method

provides results on long‐run income inequality elastici-

ties, whereas noncausality test helps in identifying the

direction of causality among the variables in the short

run. Given the significance of these models, the findings

derived from these techniques will be more robust and

reliable.

Our long‐run empirical findings, based on panel

ARDL method, establish that the growth in stock market

indicators significantly increase income inequality,

whereas banking credit reduces. On the other hand, the

growths in stock markets and banking credit play an

important role to decrease income inequality in develop-

ing economies. The results of short‐run causalities indi-

cate that the stock market indicator Granger causes

income inequalities in developed economies, whereas

we find feedback relationship between stock market indi-

cators and income inequalities in emerging economies.

Given that our study makes significant contributions to

the policy and to the body of knowledge. More specifi-

cally, the study adds a considerable value to the policy

in terms of understanding the role that stock markets

play on income inequalities across the developed and

emerging market economies. Therefore, these findings

will be critical for the policymakers to formulate appro-

priate policy measures to reduce the income inequality.

For instance, emerging economies might continue to

develop their stock markets and banking sector, whereas

developed economies might specifically focus on the

expansion of banking industry. Further, the study utilizes

the most updated data, 1981 to 2014, a period with signif-

icant reforms implemented across the financial markets

of developed and emerging economies, which were aimed

for easy capital mobilization, and improving capital allo-

cation to the poor and small firms. Finally, this study

employs robust panel econometric techniques such as

the panel ARDL and heterogeneous noncausality test to

achieve the study objectives. Given all of these, this study

adds significant value to the existing empirical literature.

The rest of this study is organized as follows. Section 2

presents a review of the literature on the effects of finan-

cial market development, including stock market

630 PARAMATI AND NGUYEN