Financial Development and Income Inequality in Rural China

by Zhicheng Liang
Zhicheng Liang

The Chinese economy has experienced impressive growth over the last two decades. However, this rapid growth has been accompanied by remarkable increases in inequality. According to the World Bank (1997), China’s Gini coefficient rose from 0.288 in 1981 to 0.388 in 1995. While many scholars have provided important insights into the evolving pattern of inequality in China, little research has been conducted to address the role of financial development in the dynamic changes in Chinese income distribution. This article attempts to fill this gap by exploring the relationship between finance and inequality in China.

Theories on Finance and Inequality

There are two main theoretical viewpoints on the finance–inequality linkage. Greenwood and Jovanovic posit an inverted U-shaped relationship; that is, financial development could widen income inequality during the early period, then tend to lessen it as average income rises and more households gain access to financial intermediaries and services. By contrast, other theoretical models suggest a negative and linear relationship, showing that development of the financial market and financial intermediation helps reduce income inequality.

Only a few previous empirical studies have tested these alternative theories. These studies generally find that: better-functioning financial markets are strongly associated with lower income inequality; inequality is lower in countries with better-developed financial sectors; and inequality decreases as economies develop their financial intermediaries. These empirical results support the linear hypothesis suggestion rather than an inverted U-shaped pattern.

Financial Development in Rural China

Traditionally China had a mono-banking system with the People’s Bank of China (PBC) acting as the only formal financial institution in the country. However, the traditional financial system failed to provide sufficient financial support to meet the needs arising from expanded production in such economic sectors as agriculture, industry, construction, transport, and commerce. The abandoning of the mono-banking system in the late 1970s marked the beginning of China’s financial reforms. Four state-owned specialized banks, authorized with specialized functions concerning different scopes of economic activities, were separated from the traditional system, and the PBC was then reorganized as the Central Bank of China.

Among the four state-owned specialized banks, the Agricultural Bank of China (ABC) plays the most important role in serving the rural sector and acts as the key institution in China’s rural financial system. Another important financial institution are the rural credit cooperatives (RCCs), located at the county and township level, subject to monitoring by branches of the ABC.

Since the beginning of the 1990s, the government began to accelerate the process of commercializing the state-owned banks. To facilitate the transformation of the ABC into competitive, autonomous, and self-accountable commercial banks, the Agricultural Development Bank of China (ADBC), a policy-lending bank responsible for financing loans on the purchase and sale of agricultural products, was established in 1994. The promulgation of the 1995 Commercial Bank Law ensured independent operations for the commercial banks, which considerably strengthened the commercializing reforms of the state-owned specialized banks. The process of commercialization was further advanced by the separation of the RCCs from the branches of the ABC in 1996, becoming subject to direct supervision and monitoring by the PBC. Meanwhile, rural cooperative foundations (RCFs)—which were created at the beginning of the 1980s and organized by local governments as informal financial institutions to fill the credit vacuum of formal finance in the rural sector—also experienced rapid development during this period. Therefore, a multi-institutional financial system was formed in rural China, including the formal financial institutions and various types of informal financial organizations.

Recently, significant changes have occurred in the ABC market orientation and operational strategy. In order to improve efficiency and profitability, the ABC began to reduce its rural financial business. Along with expansion of the ABC’s credit business into non-agricultural sectors, the role of the ABC in promoting rural development has weakened significantly. Other state-owned commercial banks also gradually withdrew from rural areas. Moreover, the Chinese government and the PBC have recently implemented a series of policy measures to control the development of informal finance in rural China. As a result, the RCFs were either abolished or merged into the RCCs in 1999.

Consequently the RCCs have become the dominant financial institution serving China’s rural sector. The ratio of RCC agriculture loans in total agricultural credits increased rapidly from 26 per cent in 1979 to 54 per cent in 1997, and then to 77 per cent in 2001. For loans to township and village enterprises (TVEs), the RCCs’ proportion also expanded from 32.1 per cent in 1979 to 69.5 per cent in 1997, and to 77.3 per cent in 2001. These results indicate that the monopoly of the RCCs in rural finance has been gradually strengthened over the last several years.

Due to the important role of the RCCs in the rural financial system, the Chinese government and the PBC have launched a series of reforms to transform the RCCs into viable financial institutions that operate independently, bear risks on their own, and take responsibility for their own profits and losses. In the long run, however, to strengthen rural financial systems and promote economic growth in rural areas, fundamental financial reforms in the structure of ownership and corporate governance are required.

Income Inequality in Rural China

Two decades of market-oriented transition have altered the patterns of income distribution in rural China significantly. The Figure presents the official Gini coefficient for rural China. During the early stage of rural reforms (1978–84), the Household Responsibility System (HRS) successfully released farmers’ potential and significantly raised production efficiency. Along with improvements in agricultural productivity, increased agricultural prices also contributed to rural income growth over this period. As a result of egalitarian land distribution, the gains of rural reforms were widely shared among rural households; thus, the rural Gini coefficient increased only slightly from 0.212 in 1978 to 0.244 in 1984.

Rural income inequality in China, 1978–2002 (Gini coefficient)
Rural income inequality in China, 1978–2002 (Gini coefficient)

However, rural China has witnessed significant changes in household income structure since 1985, due mainly to stagnant agricultural production, unbalanced growth of TVEs, and the rapid development of off-farm opportunities. In the second half of the 1980s, China’s rural Gini coefficient rose from 0.227 in 1985 to 0.319 in 1989. This mainly resulted from the changed nature of income gains and the growing differential in rural non-farm opportunities among regions.

During the early 1990s, China’s rural Gini coefficient increased from 0.310 in 1990 to 0.341 in 1995, and then fell to 0.323 in 1996. Since 1997, however, China has once again recorded significant increases in rural inequality, with the rural Gini coefficient rising from 0.329 in 1997 to 0.365 in 2002. Unequal access to off-farm employment, as well as falling agricultural income due to a sharp decline in agricultural product prices in the late 1990s were important factors that contributed to the deterioration in rural income distribution.

The Relationship between Financial Development and Income Inequality

How did the financial development described above impact on rural inequality in China? I used panel data over the period 1991–2000, and applied the generalized method of moment (GMM) technique to empirically investigate the impacts of rural financial development on the distribution of income in rural China. The full results are described in Chapter 3 of Wan (2008) (see further reading). I find that rural financial development, which I measure as the ratio of total rural loans to rural GDP, significantly contributes to the reduction of rural inequality in China. My findings strongly support the linear relationship—rather than the Greenwood and Jovanovic inverted U-shaped relationship—between finance and inequality. Thus, to lower China’s rural inequality, the Chinese government should make greater efforts to strengthen rural financial systems, paying particular attention to development of viable credit markets in poor areas of rural China.

WIDER Angle newsletter, December 2008

ISSN 1238-9544

Development Finance
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