Financial openness and inequality

Summary

Focus

Recent increases in inequality have prompted a lot of interest in what causes it. Existing research has identified international financial openness as one of the main potential drivers of income inequality. Nevertheless, the evidence has not been conclusive so far. This is largely due to the use of very different measures and methods across studies. Most papers have focused on legal restrictions on capital flows as a measure of openness ("de jure measures"). The few that have examined measures based on actual external financial positions ("de facto measures") have used only a subset of the key metrics.

Contribution

We conduct a comprehensive empirical examination of the link between inequality and external financial openness for a sample of 48 countries between 1991 and 2013. In contrast to most existing studies, we focus on de facto rather than de jure measures of financial openness. Furthermore, we examine not only a key aggregate openness measure – gross external liabilities – but also its main components: foreign direct investment (FDI), portfolio equity, portfolio debt and other investment.

Findings

We show that the relationship between financial openness and inequality varies considerably over time and across the main components of total external liabilities. In emerging market economies (EMEs), an increase in external liabilities is associated with an initial rise and a subsequent fall in inequality. This suggests that the inequality-increasing channels tend to be active immediately, while the channels working in the opposite direction tend to operate with a lag. While the overall pattern for FDI and portfolio debt is similar, there are notable quantitative differences. Meanwhile, an increase in "other investment" liabilities is associated with a lagged fall in inequality. In advanced economies, the link between financial openness and inequality is much weaker than in EMEs.

Abstract

We conduct a comprehensive empirical investigation of the link between inequality and financial openness. We document that the relationship varies considerably not only over time, but also across the main components of total external liabilities, which have been largely overlooked by the existing literature. In emerging market economies (EMEs), an increase in a country's external liabilities is associated with an initial rise and a subsequent fall in inequality. This appears to be driven by the fact that the channels through which financial openness increases inequality tend to be active immediately, while the inequality-decreasing channels tend to operate with a lag. The link between financial openness and inequality tends to be substantially weaker in advanced economies than in EMEs.

JEL classification: F30, F40, O11.

Keywords: financial openness, gini-based inequality measures, foreign direct investments, external liabilities.