New research suggests that better financial development can directly boost nourishment
Although most countries experienced healthy per capita growth rates in the 20th century, extreme poverty and undernourishment are still widespread. In 2001, GDP per capita was, on average, about $21 a day, but more than half the world's population lived on less than $2 a day and more than 1 billion lived on less than $1 a day. And in the late 1990s, on average, about 20 percent of the world's population was undernourished—ranging from a high of 70.5 percent in Eritrea to virtually zero in most developed countries. For the international community, both measures of development, or the lack thereof, are critical. They form the number one Millennium Development Goal for 2015: reducing income poverty by half and reducing hunger by half from their 1990 levels. One could even argue that reducing undernourishment should take priority, given that being undernourished—when an individual cannot obtain enough food to meet dietary energy requirements continuously—defines a person's chances of living.
For a long time, economists have known that higher growth and lower inequality reduce poverty and hunger. They have also known that a better financial sector helps growth and reduces inequality. And in recent years, studies have tied these together, showing that financial development reduces poverty. But does financial development also reduce hunger and, if so, how? Is it just because more developed countries tend to have better-developed financial systems and less undernourishment simultaneously? Or is it because financial sector development promotes economic growth, which reduces income poverty, allowing more people to eat better? Or is it because there are specific channels through which better financial services directly ameliorate undernourishment? The answers to these questions matter to the extent that they can help guide policy interventions aimed at greater financial sector development. We recently undertook a study (Claessens and Feijen, 2006) to explore these questions. Our findings suggest that increased agricultural productivity and investments in agricultural equipment hold the key.
It is well understood why financial development helps alleviate poverty. If poor people have access to financial services, they can obtain funds to invest in productivity-enhancing assets, say, a small weaving machine. They can borrow to buy a shop or find capital to start a small firm. By accumulating financial assets and availing themselves of insurance, households can reduce the impact of such unfortunate events as drought, disease, or death, which are part of daily life in many developing countries. If households have better access to financing, a calamity need not force them to sell productive assets such as a cow or a tractor, keeping a bad situation from worsening dramatically. Instead, they can save for their old age.
How much does financial development reduce poverty? Recent research suggests that the impact is significant and of a causal nature. One study finds that a 10 percentage point increase in private credit as a percentage of GDP (private credit), a common proxy for financial development, reduces poverty ratios by 2.5–3.0 percentage points (Honohan, 2003). Another study shows that financial development actually accelerates poverty reduction (Beck, Demirgüç-Kunt, and Levine, 2005). For example, if between 1985 and 2000 Peru had improved its private credit from 13 percent to 54 percent, the level prevailing in Chile, 2 percent of Peruvians would have been living in poverty in 2000, rather than the actual 15 percent.
Given the strong relationship between income poverty and hunger, and given that financial development reduces income poverty, financial development can be expected to reduce hunger largely by reducing poverty. There is ample country evidence that income poverty is the main cause of undernourishment. For example, in Indonesia during 1984–87, rising income standards reduced malnutrition, and the fraction of people living on fewer than 1,400 calories a day fell by 26 percent.
What might be the specific channels through which financial development affects hunger? In terms of indirect effects, financial sector development reduces income poverty, which would allow people to better satisfy their dietary needs. Financial sector development also would make it easier for households to smooth consumption, reducing the effects of adverse income shocks on undernourishment. In terms of direct effects, one would expect financial development to facilitate higher value added per agricultural worker. With better access to credit, farmers can acquire inputs and equipment—such as fertilizer, tractors, other farming equipment, and livestock—that make them more productive and enhance overall agricultural productivity. That, in turn, causes increased food output, improved household incomes, and lower food prices—reducing undernourishment.
Our study, which covered more than 50 countries between 1980 and 2003 (using data from World Bank, 2005), tried to find evidence of these channels. We analyzed three relationships: between financial development and overall agricultural productivity; between agricultural productivity and nourishment; and, most important, between financial sector development and investment in agricultural equipment. As part of a second round of testing, we related financial sector development to other productivity measures, such as crop and livestock production and cereal yields; checked whether cereal yield, a specific productivity measure, related positively to undernourishment; and explored whether financial sector development relates to the use of two productivity-enhancing inputs—fertilizer and tractor use (see Chart 1).
Following other studies of the relationship between financial sector development and poverty, we proxied financial development by private credit, which is the value of credit extended by financial intermediaries to the private sector as a percentage of GDP. And we used several country-level control variables that are likely to affect these relationships. Specifically, we controlled for the initial level of undernourishment, government expenditures as a percentage of GDP, economic development, initial income poverty, inflation, the fraction of the population in rural areas, the fraction of the population employed in the agricultural sector, and openness of the country (the value of trade, exports plus imports, as a fraction of GDP). In some cases, we also took into account production and trade in food.
On the hunger front
Our results show that a 1 percent increase in private credit to GDP would reduce the prevalence of undernourishment by between 0.22 percent and 2.45 percent. By comparison, a 1 percent increase in GDP per capita would reduce the prevalence of undernourishment by about 0.85 percent. The impact of financial sector development on undernourishment is substantial—at a minimum, about one-fourth that of general development—implying that there is a lot to gain from financial sector development, especially because of its great potential to increase. The ratio of private credit to GDP in low-income countries, for example, is about 16 percent, well below the 88 percent level in high-income countries.
Not only does this indirect link between financial development and undernourishment remain statistically strong after we take into account other factors that are known to affect poverty and hunger; all analyses work even when they take into account the possibility that the relationship between hunger and financial development actually goes the other way: financial development occurs because better-nourished people are economically more active and have a higher demand for financial services. Although there undoubtedly is some reverse causality, the development of the financial sector is far more important to reducing hunger than is a decline in undernourishment to stimulating demand for financial services. Even when we take the redundant step of including poverty and GDP per capita, the effects of financial sector development on undernourishment remain significant at the 10 percent level.
How about any direct links? First, we found evidence to support the causal link between private credit and agricultural productivity. Our analysis implies that a 1 percent increase in private credit to GDP boosts value added per agricultural worker by 1.0–1.7 percent. We also found specific evidence of increases in crop yields, especially of cereals, and livestock production because of greater financial sector development. In both cases, the positive relationship continued after we controlled for the effect of several other factors that could drive the links.
Second, we found a causal relationship between value added per agricultural worker and undernourishment. For example, a 1 percent increase in value added per agricultural worker reduces the prevalence of undernourishment by 0.4–1.0 percent. We also found evidence that, as farmers become more productive, the increased food supply and lower prices benefit society as a whole, including people who are unable to obtain financial services themselves but can afford a better diet because food prices are lower.
Third, we found evidence to support the important causal link between the financial sector and investment in agricultural equipment. Our results imply that private credit is significantly associated with fertilizer use and the use of tractors per worker, even after we controlled for the initial level of fertilizer use, the use of tractors, GDP per capita, and poverty (see Chart 2). We also found evidence that it is not just financial sector development itself that matters in reducing undernourishment, but also the ease of access to financial services. For example, the more banking branches there were per 1,000 square kilometers in 2003–04, the lower the level of undernourishment. This relationship held, even when we took into account trade activity, government size, inflation, and the fraction of people living in rural areas. We also found that reach matters for the various productivity measures.
Fostering financial development
Because financial sector development can play a significant role in reducing not only income poverty but also undernourishment, it can contribute substantially to attaining the number one Millennium Development Goal (Claessens and Feijen, 2007). Many policies could foster financial sector development, including ensuring a stable macroeconomic environment, enhancing financial sector regulation and supervision, creating a proper information institutional infrastructure, and enforcing property rights.
However, there is still much that is not known about how best to enhance access to financial services for the poor and undernourished. The formal financial system has had only a minimal relationship with extremely poor people in many developing countries. And microfinance institutions have a small presence in most countries. Still, mainstream commercial banks have begun to serve the lower market segment in some developing countries and other success stories are emerging, including the development of sustainable microfinance institutions, such as Grameen Bank in Bangladesh, whose founder Muhmmad Yunus won the Nobel Peace Prize last year. Technology also appears to hold promise. If early experiences with mobile phone banking, smart cards, and extending credit on the basis of simple scoring models are prophetic, then these developments could facilitate the delivery of financial services to many more people at low cost.