Curse or blessing? The effect of inequality on financial development

An important feature of the process of transformation in developing economies is the depth and outreach of their capital and credit markets, i.e. financial development. As this is often considered crucial to support growth and poverty reduction, it is important to understand what structural factors drive it. The literature so far has assessed the role of historical, political, cultural, and institutional determinants, but has not yet adequately investigated the role of inequality. This paper addresses this lacuna by empirically investigating its effects. Exploiting instrumental variable estimations for a sample of up to 166 economies during 1960-2019, cross-section and panel results find that inequality has a negative effect on credit market development, which works both via the top and bottom parts of the distribution. They also find that, when accounting for its effects on economic development, inequality supports capital market development. The results are robust to a variety of checks, including violation of the exclusion restriction, a rich set of controls, alternative samples, and alternative income inequality data and financial development measures.