This article was downloaded by: [University of Otago]

On: 05 October 2014, At: 03:25

Publisher: Routledge
Informa Ltd Registered in England and Wales Registered Number: 1072954 Registered
office: Mortimer House, 37-41 Mortimer Street, London W1T 3JH, UK

Journal of the Asia Pacific Economy

Publication details, including instructions for authors and
subscription information:
http://www.tandfonline.com/loi/rjap20

Long-run relationship between income

inequality and financial development in
China
a b
Abdul Jalil & Mete Feridun
a
School of Economics , Quaid-i-Azam University , Islamabad,
45320, Pakistan
b
Department of Banking and Finance, Faculty of Business and
Economics , Eastern Mediterranean University , Gazi Magosa,
Mersin, 10, Turkey
Published online: 03 May 2011.

To cite this article: Abdul Jalil & Mete Feridun (2011) Long-run relationship between income
inequality and financial development in China, Journal of the Asia Pacific Economy, 16:2, 202-214

To link to this article: http://dx.doi.org/10.1080/13547860.2011.564745

PLEASE SCROLL DOWN FOR ARTICLE

Taylor & Francis makes every effort to ensure the accuracy of all the information (the
“Content”) contained in the publications on our platform. However, Taylor & Francis,
our agents, and our licensors make no representations or warranties whatsoever as to
the accuracy, completeness, or suitability for any purpose of the Content. Any opinions
and views expressed in this publication are the opinions and views of the authors,
and are not the views of or endorsed by Taylor & Francis. The accuracy of the Content
should not be relied upon and should be independently verified with primary sources
of information. Taylor and Francis shall not be liable for any losses, actions, claims,
proceedings, demands, costs, expenses, damages, and other liabilities whatsoever
or howsoever caused arising directly or indirectly in connection with, in relation to or
arising out of the use of the Content.

This article may be used for research, teaching, and private study purposes. Any
substantial or systematic reproduction, redistribution, reselling, loan, sub-licensing,
systematic supply, or distribution in any form to anyone is expressly forbidden. Terms &
Conditions of access and use can be found at http://www.tandfonline.com/page/terms-
and-conditions
 Journal of the Asia Pacific Economy
Vol. 16, No. 2, May 2011, 202–214

Long-run relationship between income inequality and financial

development in China
Abdul Jalila∗ and Mete Feridunb
a
School of Economics, Quaid-i-Azam University, Islamabad, 45320, Pakistan;
b
Department of Banking and Finance, Faculty of Business and Economics,
Eastern Mediterranean University, Gazi Magosa, Mersin 10, Turkey
Downloaded by [University of Otago] at 03:25 05 October 2014

This article aims at investigating the long-run relationship between financial develop-
ment and income inequality in China using Autoregressive Distributed Lag (ARDL)
model from 1978 to 2006. The results suggest that there exists a strong relationship
between the Gini coefficient and financial development, and that financial development
leads to a reduction in the income inequality.
Keywords: income inequality; financial development; China
JEL classifications: G28, O16, O53

1. Introduction
China’s successful transition from a centrally planned economy to a market-oriented econ-
omy during the last 25 years is one of the most important events in modern economic
history. China adopted a gradual and evolutionary approach to the transition since the re-
form started at the end of 1978 in contrast to any ‘shock therapy’ or ‘big bang approach’.
The objective of the economic reforms was to establish a socialist market-oriented economy
based primarily on public ownership, and the financial sector reform was an integral part
of this move. This strategy has proved to be phenomenally successful with a tremendous
rate of economic growth and a high level of financial development.
Nonetheless, this rapid growth in economic activities and financial sector development
has been accompanied by the increase in income inequality as well. The Gini coefficient,
a conventional measure of income inequality, went up from 0.21 in 1978 to 0.46 in 2006.
Compared to other transitional economies, the income in China is distributed quite un-
equally among residents. The Gini coefficient rose sharply from 0.16 to 0.34 from 1978 to
2006 in urban China. The rise in income inequality in urban China can be attributed to the
declining role of subsidies and entitlements, the increase in wage inequality and the layoffs
during restructuring (Giles et al. 2005, Knight and Xue 2006). Furthermore, as Okushima
and Unchimura (2005) explain, the introduction of foreign capital and technology through
economic liberalization initially concentrated on special economic zones in coastal regions,
resulting in economic growth in these regions while other regions were not so fortunate.
However, the rise in income inequality in rural China can be divided into three phases.
First, from 1978 to 1984, when rural income rose significantly due to the adoption of

∗
Corresponding author. Email: [email protected]

ISSN: 1354-7860 print / 1469-9648 online

C 2011 Taylor & Francis
DOI: 10.1080/13547860.2011.564745
http://www.informaworld.com
 Journal of the Asia Pacific Economy 203

Household Responsibility System (HRS) in the agricultural sector. The HRS successfully
recognized the potential of farmers and became a significant source of increased efficiency
and productivity. The rise in productivity, along with the increase in agriculture prices,
contributed to a rural income growth over this period. These gains of rural reforms were
widely shared among rural households; thus, the rate of rise of the rural Gini coefficient
dropped significantly and increased only slightly from 0.212 to 0.244 during this period
(Liang 2006b). Second, from 1985 to 1989, when the Gini coefficient increased from
0.227 to 0.319 due to stagnant agriculture productions, unbalanced growth of township and
village enterprises (TVEs) and the development of off-farm opportunities. Third, in the
1990s, mainly because of decrease in off-farm unemployment and a sharp decline in the
agriculture prices.
As evident from Table 1, the overall Gini coefficient, along with the financial develop-
ment and economic growth, has risen significantly throughout the last decade.
This is because the reform process in the last 30 years has led to a greater wage inequality
Downloaded by [University of Otago] at 03:25 05 October 2014

through the bonuses and efficiency wages. Also, food, education, healthcare and housing
subsidies, which are known as the best source of income equality, were gradually decreased
in the early 1990s. The restructuring of the state-owned enterprises (SOEs), in the second
half of the 1990s also led to significant layoffs, unemployment and at least short-term
inequality of access to jobs. Another source of income inequality is the development of a
dynamic private industrial and service sector with higher wages.
There exist a growing number of studies, which investigate the sources of economic
growth, income inequality and the dynamics of the finance-growth nexus for the Chinese
economy.1 However, to date, there exists a narrow literature that focuses on the relationship
between financial development and income inequality.2 But these studies document the im-
pact of financial development on the urban and rural inequality based on the provincial level
panel data and do not investigate the long-run relationships between financial development
and income inequality. Therefore, the present paper aims at filling this gap in the litera-
ture through investigating the long-run relationship between financial development and per
capita income inequality using Autoregressive Distributed Lag (ARDL) model from 1978
to 2006. Another novelty of the present paper is that it uses an index to measure the overall
financial sector developments, which has been built using the principal component analysis
(PCA).
The rest of this paper is organized as follows. The next section presents a brief review of
literature. Section 3 and Section 4 introduces the variables and methodology, respectively.
Section 5 provides the empirical results. Section 6 draws conclusions and presents some
important policy implications that emerge from the analysis.

2. Literature review
The relationship between financial development and income inequality has recently at-
tracted attention, and the literature, to date, consists of contradictory conclusions. The
existing literature can be broadly categorized into two main schools of thought: first, in-
verted U-hypothesis (Greenwood and Jovanovic 1990), and second, the linear hypothesis
(Banerjee and Newman 1993, Galor and Zeira 1993). The former school suggests an in-
verted U-shaped relationship between finance and inequality. According to this theory, in
the early stage of financial developments, the economies are accompanied by a low level of
income inequality. In the second stage, the economies experience a more rapid economic
growth and financial development along with the widening income inequality. In the third
and maturity stage, an extensive well-functioning financial system accompanies a high
 Downloaded by [University of Otago] at 03:25 05 October 2014

204

Table 1. Recent trends in income inequality and the financial sector in China.

1990 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Gini 0.33 0.39 0.37 0.37 0.38 0.39 0.41 0.42 0.43 0.45 0.44 0.44
Per capita GDP growth rate (%) 0.42 9.01 7.73 7.76 6.02 5.91 8.06 6.01 6.07 7.71 8.58 10.20
Ratio of liquid liabilities to GDP 0.62 0.74 0.81 0.91 0.98 1.07 1.11 1.16 1.24 1.32 1.37 1.38
Ratio of M2 to GDP 0.83 1.04 1.21 1.22 1.33 1.46 1.51 1.63 1.76 1.89 1.86 1.64
Credit to private sector/GDP 0.00 0.02 0.02 0.03 0.04 0.04 0.07 0.09 0.10 0.13 0.15 0.12
A. Jalil and M. Feridun

Source: Data come from NBS (2007).

 Journal of the Asia Pacific Economy 205

level of income and the declining degree of income inequality. On the other hand, the latter
school of thought presents some other theoretical models that suggest a negative and linear
relationship between financial development and income inequality.
The majority of empirical work to date has reported evidence that an increase in
financial development curtails the income inequality. For example, Li et al. (1998) employ
a data-set for 40 countries to investigate the relationship between financial depth and
income inequality and report evidence that a well-functioning financial system improves the
income distribution. In a similar study, Clarke et al. (2006) report evidence that inequality
is lower in countries with better-developed financial sectors. More recently, Beck et al.
(2007) found that higher levels of financial developments are associated with a lower
growth rate of Gini coefficients. Apart from these multi-country studies, a few studies
have focused on single-country experiences. For example, Chen et al. (2006) argue that the
rural-urban income disparity in China may be explained by the development of financial
intermediaries. Furthermore, Liang (2006a) finds a linear and negative relationship between
Downloaded by [University of Otago] at 03:25 05 October 2014

income inequality and finance for urban China and rules out the possibility of inverted U-
shaped relationship. In a similar study, Liang (2006b) reports similar conclusions for rural
China. However, these studies fail to investigate the long-run relationship between finance
and income inequality. The present study tries to fill this gap in the literature.

3. Construction of variables and data

Following the recent empirical work such as Liang (2006a), Liang (2006b), and Ravallion
and Chen (2007), the present study takes the natural logarithm of Gini coefficient as a
proxy (denoted by GINI). The rationale behind using the Gini coefficient is that it is a
full-information measure, looking at all parts of the distribution and facilitates the direct
comparison of two populations regardless of their sizes. Therefore, it is probably the most
well known and broadly used measure of inequality used in economic literature.
In order to proxy financial development, several variables have been employed as
suggested by the existing literature. For example, Rousseau and Wachtel (1998), Rioja and
Valev (2004), and Levine et al. (2000) use ratio of liquid liabilities to GDP (denoted by LLY )
to measure the overall size of the financial intermediary sector as it includes the central
bank, deposit money banks and other financial institutions. Demetriades and Hussein (1996)
and King and Levine (1993) use the ratio of credit to the private sector to GDP (denoted
by PRIVO) to avoid the problem of ignoring the allocation of capital. The present study
also uses the ratio of commercial bank assets to the sum of commercial bank and central
bank assets (denoted by BTOT), as suggested by King and Levine (1993), to employ the
advantage of financial intermediaries in channeling savings to investment, monitoring firms
influencing corporate governance and undertaking risk management relative to the central
bank (Huang 2005). The present study does not consider the stock market because the
net flows through stock exchanges are relatively small in most of the developing countries
(Rojas-Suarez and Weisbord, 1996), and therefore, stock markets at best play a minor role;
more often, they resemble gambling casinos and may actually slow down the growth in
developing countries (Singh 1997). Furthermore, there exist no reliable data for the Chinese
stock markets before 1992.
The high correlation coefficients among the financial indicators suggest that there is
some redundancy in the information provided by the three variables (see Table 2).
If we drop any of the variables, then there is a possibility of loss of valuable information.
However, if we consider all the variables simultaneously in the model, then there is a high
possibility of multicollinearity, over-parameterization and a chance of loss of degree of
 206 A. Jalil and M. Feridun

Table 2. The correlation matrix.

PRIVO LLY BTOT

PRIVO 1.000
LLY 0.956 1.000
BTOT 0.65 0.726 1.000

freedom (Ang and McKibbin 2007). This is even more severe in the present work, in which
the sample of data is limited to 29 observations. To overcome this problem, we calculate
the principal components of the selected financial development variables following Creane
et al. (2003). Table 3 presents the results of the PCA.
As can be seen from the reported eigenvalues, the first principal component explains
about 87% of the standardized variance. Therefore, the first principal component is an
Downloaded by [University of Otago] at 03:25 05 October 2014

accurate measure of financial development, as it explains the variations of the depen-

dent variable better than any other linear combination of explanatory variables. Therefore,
only the information related to the first principal component is presented. The factor
scores suggest that the individual contributions of PRIVO, LLY and BTOT to the stan-
dardized variance of the first principal component are 36%, 37% and 32%, respectively.
We use these as the basis of weighting to construct a financial depth index, denoted as
IFD.
Apart from the measure of financial development and Gini coefficient, this paper uses
other variables to control other factors associated with either income inequality or finan-
cial development. In this regard, following Beck et al. (2007) and Ang (2010), the growth
rate of per capita GDP (GRO), inflation rate (INF) and trade ratio (TR) are used. Barro
(2000), Beck et al. (2007) and Ang (2010) document that the increase in growth rate of
per capita helps in alleviating the income inequality. Therefore, the relationship between
the GRO and Gini coefficient should be negative. The INF is the growth rate of con-
sumer price index and the literature remains inconclusive about the effect of INF on the
income inequality. Cutler and Katz (1991), Clarke et al. (2006) and Ang (2010) point
out that the inflation improves the income inequality. The real wages may decrease due
to the higher inflation rate that, in turn, may lead to higher employment and thus im-
provement in the income inequality. Easterly and Fischer (2001) and Beck et al. (2007)
think in sharp contrast of the earlier mentioned studies. They believe that inflation has
an adverse effect on the income inequality, while Bulir (2001) argues that the inflation
rate improves the income inequality in the low-inflation economies and vice versa. TR

Table 3. Principal component analysis.

Principal component Eigenvalues % of variance Cumulative%

1 2.621 0.865 0.865

2 0.352 0.123 0.988
3 0.027 0.012 1.00
Variable Factor loadings Communalities Factor scores

PRIVO 0.58016 0.88004 0.3626

LLY 0.59584 0.92806 0.3724
BTOT 0.51842 0.70266 0.3234
 Journal of the Asia Pacific Economy 207

is the total value of exports and imports as a share of nominal GDP. Barro (2000) and
Ang (2010) point out that trade ratio should enter positively in the income inequality
regressions.
The data are on an annual basis and span a period from 1978 to 2007, and are taken
from China Statistical Yearbook (various issues), Almanac of China’s Finance and Banking
(various issues) and China’s National Bureau of Statistics.

4. Methodology and estimation strategy

The present study follows Ang (2010) to test the hypothesis that income inequality depends
on financial development along with other variables such as growth rate of per capita
GDP, inflation rate and trade openness. Accordingly, the following econometric regression
equation is used:
Downloaded by [University of Otago] at 03:25 05 October 2014

GINIt = α0 + α1 FDt + α2 GROt + α3 INFt + α4 TRt + ut , (1)

where GINI is the measure of income inequality, FD is the indicator of financial devel-
opment, GRO is the growth rate of per capita GDP, INF is the inflation rate and TR is
a measure of trade openness. Four different variables, PRIVO, LLY , BTOT and IFD, are
employed for financial development.
In order to test the existence of the long-run equilibrium relationship among the vari-
ables, ARDL, as suggested by Pesaran and Pesaran (1997), Pesaran and Smith (1998),
Pesaran and Shin (1999), and Pesaran et al. (2001), is used. The ARDL has a number of
advantages to other techniques of cointegration. For example, it can be used irrespective
of whether the underlying variables are I(0), I(1) or fractionally cointegrated (Pesaran
and Pesaran 1997). Second, the model takes sufficient number of lags to capture the data
generating process in a dynamic framework of general-to-specific modeling framework
(Laurenceson and Chai 2003). Third, the error correction model (ECM) can be derived
from ARDL through a simple linear transformation (Banerjee et al. 1993). The ECM
integrates short-run adjustments with the long-run equilibrium without losing long-run
information. Fourth, small sample properties of ARDL approach are far superior to other
cointegration techniques (Pesaran and Shin 1999). Fifth, endogeneity is less of a problem
in ARDL technique because it is free of residual correlation. Lastly, Pesaran and Shin
(1999) also demonstrated that the simultaneous estimation of the long-run and short-run
components and appropriate lags in the ARDL framework remove the problems that are
associated with serial correlation and endogeneity problems.
The ARDL framework of Equation (1) is specified as follows:

p


p


p


p
GINIi = β0 + δi GINIt−i + φi FDt−i + i GROt−i + γi INFt−i
i=1 i=1 i=1 i=1

p
+ θi TRt−i + λ1 GINIt−1 + λ2 FDt−1 + λ3 GROt−1
i=1

+ λ4 INFt−1 + λ5 TRt−1 + Ut , (2)

where β0 is the drift component and Ut white noise. The terms with summation signs
represent the error correction dynamics. The second part of the equation with λi corresponds
to a long-run relationship. The first step in the ARDL bounds testing approach is to estimate
 208 A. Jalil and M. Feridun

Equation (2) by ordinary least square (OLS) method. The F-test is conducted to test the
existence of long-run relationships among the variables. The null hypothesis is H0 : λi = 0
or all coefficients are equal to zero, which suggests that there exists no long-run relationship.
On the other hand, the alternative hypothesis is H 1 : at least one of the coefficients is not
equal to zero.
The calculated F-statistics value is compared with two sets of critical values given by
Pesaran et al. (2001). One set assumes that all the variables are I(0) and the other assumes
they are I(1). If the calculated F-state exceeds the upper critical value, then the null
hypothesis with no cointegration will be rejected irrespective of whether the variable is I(0)
or I(1). If it is below the lower value, then the null hypothesis with no cointegration cannot
be rejected. If it falls inside the critical value band, the test is inconclusive. In order to choose
the optimal lag length for each variable, the ARDL method estimates (p + 1)k number of
regressions, where p is the maximum number of lags and k is the number of variables in
the equation. The model can be selected on the basis of Schawrtz-Bayesian Criteria (SBC)
Downloaded by [University of Otago] at 03:25 05 October 2014

and Akaike’s Information Criteria (AIC). The SBC is known as the parsimonious model, as
it selects the smallest possible lag length, while AIC is known for selecting the maximum
relevant lag length.
In the second step, the long-run relationship is investigated using the selected ARDL
model through AIC or SBC. When a long-run relationship exists among the variables, then
there is an error correction representation. Therefore, the following error correction model
is estimated in the third step:


p


p


p
GINIi = β0 + δi GINIt−i + φi FDt−i + i GROt−i
i=1 i=1 i=1

p


p
+ γi INFt−i + θi TRt−i + ηECMt−1 + Ut . (3)
i=1 i=1

The error correction model result indicates the speed of adjustment back to the long-run
equilibrium after a short-run shock.
5. Empirical results
As mentioned earlier, the ARDL techniques can be applied regardless of whether the
underlying variables are I(0), I(1) or fractionally integrated. However, the unit root tests in
the ARDL procedure are still necessary in order to ensure that none of the variables are
I(2) or beyond. For this purpose, the conventional Augmented Dicky Fuller (ADF) test is
used. Table 4 shows that none of the variables are beyond I(1).
After establishing that none of the selected series is I(2) or beyond, the existence of
the long-run relationship is tested. To carry out the bound tests, Equation (2) is estimated
through the OLS procedure to compute the F-statistics for the joint significance of lagged
levels of variables. It is evident from Table 2 that the computed F-values are much higher
than the above critical bounds values provided by Pesaran et al. (2001). So, there is strong
evidence of a long-run relationship among the underlying variables.
Next, Equation (2) is estimated following the ARDL cointegration methodology for the
long-run estimates. The total number of regression estimated is (2 + 1)5 = 243. This stage
utilizes the R 2 Criterion, Hannan Quinn Criterion, AIC Criterion and the SBC Criterion
to find the coefficient of the level variables. All models are estimated thoroughly for these
four criterion for the different financial development indicators. The long-run and short-run
results of all the models are almost identical. Therefore, we presented only the result of the
model that is selected on the basis of the SBC out here and also because the SBC is known
 Journal of the Asia Pacific Economy 209

Table 4. Unit root tests.

ADF k ADF k

GINI −0.6189 0 GINI −4.4554∗∗∗ 3

IFD −0.1177 0 IFD −3.7758∗∗ 0
PRIVO −1.6447 0 PRIVO −4.4554∗∗∗ 3
LLY −0.7441 0 LLY −4.7054∗∗∗ 1
BTOT −0.7384 1 BTOT −3.7733∗∗∗ 0
GRPRIVO −0.8992 1 GRPRIVO −3.6695∗∗ 2
GRIFD −1.2546 0 GRIFD −4.2546∗∗∗ 1
SQPRIVO −0.9255 1 SQPRIVO −3.9998∗∗∗ 3
SQIFD −1.4526 2 BTOT −3.2564∗∗ 2
GRO −0.6419 2 GRO −5.4117∗∗∗ 5
INF −2.1544 1 INF −4.8226∗∗∗ 1
TR −1.5485 0 TR −4.7236∗∗∗ 0
Downloaded by [University of Otago] at 03:25 05 October 2014

∗∗ = 5% significant; ∗∗∗ = 1% significant.

to yield a parsimonious model. Hence, selecting the smallest possible lag length minimizes
the loss of degree of freedom.
The long-run results are presented in Table 5. The coefficients for PRIVO, LLY, BTOT
and IFD are negative and statistically significant, which imply that the increase in financial
development will reduce the level of income inequality in China. For instance, the coefficient
of PRIVO is −0.08455, which implies that a 1% increase in PRIVO has a significantly
favorable effect on the income inequality. The coefficients of LLY , BTOT and IFD also
support the same conclusion. These results are consistent with the findings of Honohan
(2004), Clarke et al. (2006) and Beck et al. (2007). The reason for using the alternative
measure of financial development is to check the sensitivity of the result, as Aziz and
Duenwald (2002) state that the empirical results are sensitive to the measure of financial
development and may change their pattern when the variable changes. Our results show
that IFD is not changing its behavior and this shows the robustness of IFD.
The present study also tests the effects of growth of financial development. For this
purpose, the growth rates of PRIVO and IFD are considered and are labeled as GRPRIVO
and GRIFD, respectively. These variables are included in Equation (2).3 The results show
that the growth of financial development and income inequality is in a negative relationship
in the long run. Next, the non-linearity hypothesis of Greenwood and Jovanovic (1990)
is tested. For this purpose, the squares of PRIVO and IFD are taken and are denoted as
SQPRIVO and SQIFD, respectively. The results suggest no evidence of an inverted U-shaped
relationship. This finding is consistent with those of Beck et al. (2007) and Ang (2010).
In addition, to test the finance-inequality nexus, we control our models for the growth
rate of real per capita GDP, trade openness and inflation rate. The negative sign of GRO
shows that the increase in income has an equalizing effect. This finding is in line with
the general literature on the growth-inequality nexus. We also find a significant positive
coefficient for trade openness, which implies that an increase in the international trade
will lead to an increase in the income inequality. This is consistent with the findings of
Barro (2000). The coefficients for the inflation rate are significantly negative for all the
four models, which implies that a higher inflation rate leads to a reduction in the income
inequality. Our results are consistent with the findings of Cutler and Katz (1991), Clarke
et al. (2006) and Ang (2010); however, they stand in sharp contrast to those of Easterly
and Fischer (2001) and Beck et al. (2007). Theoretically, inflation has an adverse effect
on the real agricultural wages and the income inequality. However, Ang (2010) argues that
 Downloaded by [University of Otago] at 03:25 05 October 2014

Table 5. The effects of financial development on income inequality.

210

Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Model 7 Model 8

Cointegeration tests
F-states 5.969 4.880 5.265 6.325 7.235 6.214 6.214 5.889
ARDL estimate
Intercept 2.569∗∗ 3.255∗∗∗ 1.255∗∗∗ 2.699∗∗∗ 1.326∗∗ 2.356∗∗∗ 1.984∗∗∗ 2.451∗
(1.986) (6.875) (2.459) (3.313) (1.744) (4.251) (2.965) (2.007)
GRO −0.033∗∗∗ −0.040∗∗∗ −0.248∗∗ −0.028∗ −0.148∗∗∗ −0.025∗∗∗ −0.365∗∗∗ −0.027∗∗∗
(−2.651) (−3.435) (−2.256) (−1.819) (−2.568) (−9.355) (−4.526) (−3.153)
TR 1.119∗∗∗ 1.064∗∗∗ 0.248∗∗∗ 1.205∗∗∗ 1.754∗∗∗ 0.987∗∗∗ 0.655∗∗∗ 1.123∗∗∗
(36.649) (38.179) (9.687) (25.102) (17.222) (14.556) (22.555) (13.754)
INF −0.014∗∗ −0.006 −0.041∗ −0.044∗∗∗ −0.660∗∗∗ −1.254∗∗∗ −0.366 −0.081∗∗∗
(−2.305) (−1.008) (−1.706) (−4.079) (−3.225) (−2.338) (−1.547) (−4.101)
PRIVO −0.845∗∗∗ NA NA NA NA NA 0.322 NA
(−6.998) NA NA NA NA NA (1.554) NA
LLY NA −0.338∗∗∗ NA NA NA NA NA NA
NA (−3.355) NA NA NA NA NA NA
BTOT NA NA −0.137∗∗∗ NA NA NA NA NA
NA NA (−2.780) NA NA NA NA NA
IFD NA NA NA −0.247∗∗∗ NA NA NA 0.115
NA NA NA (−6.881) NA NA NA (1.921)
GRPRIVO NA NA NA NA −0.632∗∗ NA NA NA
NA NA NA NA (−2.230) NA NA NA
A. Jalil and M. Feridun

GRIFD NA NA NA NA NA −0.014∗∗ NA NA
NA NA NA NA NA (−2.001) NA NA
SQPRIVO NA NA NA NA NA NA 1.254 NA
NA NA NA NA NA NA (0.987) NA
SQIFD NA NA NA NA NA NA NA 0.274
NA NA NA NA NA NA NA (1.541)
Error correction coefficient
ECMt-1 −0.3063∗∗∗ −0.2782∗∗∗ −0.0994∗∗∗ −0.2092∗∗∗ −0.199∗∗∗ −0.456∗∗∗ −0.115∗∗∗ −0.271∗∗∗
(−3.5259) (−4.3302) (−2.4127) (−3.9868) (−6.355) (−2.874) (−7.221) (−3.184)
Diagnostic test
DW 1.826 1.762 1.648 1.877 1.967 1.598 1.754 1.877
R2 0.610 0.762 0.688 0.573 0.790 0.545 0.715 0.814

Note: The calculated F-statistics of the bounds test are compared against the critical values reported in Pesaran et al. (2001). The calculated t-statistics are presented in parenthesis;
∗ = 1% significant; ∗∗ = 5% significant; ∗∗∗ = 1% significant.
 Journal of the Asia Pacific Economy 211

unemployment may decline due to lower real wages and thus benefit the poor. Moreover,
Bulir (2001) documents that the Gini coefficient improves with a higher level of inflation
rate for low-inflation countries.
The statistical signs of short-run coefficients of all the models are similar to the coeffi-
cients of the long-run model, but the magnitudes may differ. Moreover, in most cases, the
magnitudes are smaller than the magnitudes of the long-run coefficients, which imply that
the variables have a stronger impact in the long run. The coefficient ECMt-1 is correct in
sign and significant for all eight cases and varies from 0.09 to 0.456. This implies a speedy
adjustment process. Nearly 30% of the disequilibria, in the case of PRIVO where ECMt-1 is
−0.3060, in the GINI of the previous year’s shock adjust back to the long-run equilibrium
in the current year. R2 also indicates that the fitness of the estimated models is quite good.
The last stage of the ARDL estimation is to check the stability of the estimated models.
Pesaran and Pesaran (1997) suggest using the Brown et al. (1975) stability test. This
technique is also known as the cumulative sum (CUSUM) and cumulative sum of squares
Downloaded by [University of Otago] at 03:25 05 October 2014

(CUSUMSQ). The CUSUM and CUSUMSQ statistics are updated recursively and plotted
against the breaks points. If the plots of CUSUM and CUSUMSQ statistics stay with in the
critical bounds of 5% level of significance, the null hypothesis of all the coefficients in the
model are stable and cannot be rejected. The plots of CUSUM and CUSUMSQ statistics
are well within the critical bounds, implying that all the coefficients in the ECM model are
stable (Figures 1 and 2).

15
10
5
0
−5
−10
−15
1979 1984 1989 1994 1999 2004
The straight lines represent critical bounds at 5% significance level

Figure 1. Plot of cumulative sum of recursive residuals. Note: The straight lines represent critical
bounds at 5% significance level.

1.5

1.0

0.5

0.0

−0.5
1979 1984 1989 1994 1999 2004
The straight lines represent critical bounds at 5% significance level

Figure 2. Plot of cumulative sum of squares of recursive residuals. Note: The straight lines represent
critical bounds at 5% significance level.
 212 A. Jalil and M. Feridun

6. Conclusion
The present paper has investigated the relationship between financial development and
income inequality in the case of China. The results of the ARDL bounds tests suggest that
there exists a strong relationship between the Gini coefficient and financial development.
This suggests that financial development leads to a reduction in the income inequality in
China and that the non-linearity hypothesis of finance and inequality does not hold. This
is an interesting finding as the financial sector in China is generally accepted as ineffi-
cient in the presence of targeted allocation of resources to the inefficient SOEs and higher
non-performing loans (NPLs) as compared to the other transitional countries. The results
of the present paper suggest some interesting policy implications. As the results of this
paper have shown, financial development leads to a reduction in the income inequality in
China. Therefore, the Chinese policy-makers are advised to take the necessary actions to
ascertain financial development. China has been phenomenally successful in transitioning
Downloaded by [University of Otago] at 03:25 05 October 2014

from a centrally planned economy into a more market-oriented – a trillion dollar econ-
omy. In the last few decades, the culmination of policy loans, soft budget constraints for
SOEs and the decentralization of the local state-owned commercial banks in China have
resulted in a considerable stock of non-performing loans estimated at 2 trillion RMB,
which constitutes roughly 20% of the total national income. In this respect, the problem
of non-performing loans constitutes one of the most significant challenges confronting
China at present. In fact, the Chinese policy-makers have begun to tackle this problem. The
results obtained in this article suggest that the policy-makers should continue following
this path. If China carries on with the unproductive loan expansion, then the income in-
equality may increase further. Hence, it is vital that further institutional reforms are brought
into effect for more efficient allocation of resources. The results also emphasize the im-
portance of the continuation of the reforms in the banking and financial services and the
anticipated move toward some privatization in both the state-owned enterprises and banks
in China.

Notes
1. See for example Rozelle (1994); Lardy (1998); Tsui (1998); Kanbur and Zhang (1999); Shan
et al. (2001); Gustafsson and Li (2002); Chen (2006); Liang and Teng (2006); and Ma and Jalil
(2008).
2. See for example Liang (2006a) and Liang (2006b).
3. We do not present the results of LLY and BTOT for this exercise since they are also showing the
same behavior.

References
Ang, J.B., 2010. Finance and inequality: the case of India. Southern economic journal, 76 (3),
738–761.
Ang, J.B. and McKibbin, W.J., 2007. Financial liberalization, financial sector development and growth:
evidence from Malaysia. Journal of development economics, 84, 215–233.
Aziz, J. and Duenwald, C., 2002. Growth-financial intermediation nexus in China. IMF Working
Paper 02/194. Washington, DC: IMF.
Banerjee, A., et al., 1993. Co-integration, error-correction, and the econometric analysis of non-
stationary data. Oxford: Oxford University Press.
Banerjee, A.V. and Newman, A.F., 1993. Occupational choice and the process of development. Journal
of political economy, 101, 274–298.
Barro, R.J., 2000. Inequality and growth in a panel of countries. Journal of economic growth, 5, 5–
32.
 Journal of the Asia Pacific Economy 213

Beck, T., Demirgüç-Kunt, A., and Levine, R., 2007. Finance, inequality and the poor. Journal of
economic growth, 12, 27–49.
Brown, R.L., Durbin, J., and Evans, J.M., 1975. Techniques for testing the constancy of regression
relations over time. Journal of the royal statistical society, 37, 149–163.
Bulir, A., 2001. Income inequality: does inflation matter? IMF staff papers, 48, 139–159.
Chen, H., 2006. Development of financial intermediation and economic growth: the Chinese experi-
ence. China economic review, 17 (4), 347–362.
Chen, Y.P., Liu, M., and Zhang, Q., 2006. Development of financial intermediation and the dynamics
of rural-urban inequality: China, 1978–1998. Research Paper No. 2006/65. Helsinki: UNU-
WIDER.
Clarke, G., Xu, L.C., and Zou, H.F., 2006. Finance and income inequality: what do the data tell us?
Southern economic journal, 72, 578–596.
Creane, S., et al., 2003. Financial development and economic growth in the Middle East and North
Africa finance and development. A quarterly magazine of the IMF, 4 No.1.
Cutler, D.M. and Katz, L., 1991. Macroeconomic performance and the disadvantaged. Brookings
papers on economic activity, 2, 1–61.
Downloaded by [University of Otago] at 03:25 05 October 2014

Demetriades, P.O. and Hussein, K.A., 1996. Does financial development cause economic growth?
Time series evidence from 16 countries. Journal of development economics, 51, 387–411.
Easterly, W. and Fischer, S., 2001. Inflation and the poor. Journal of money, credit and banking, 33,
160–178.
Galor, O. and Zeira, J., 1993. Income distribution and macroeconomics. Review of economic studies,
60, 35–52.
Giles, J., Park, A., and J. Zhang., 2005. What is China’s true unemployment rate? China economic
review, 16, 149–170.
Greenwood, J. and Jovanovic, B., 1990. Financial development, growth, and the distribution of income.
Journal of political economy, 98, 1076–1107.
Gustafsson, B. and Li, S., 2002. Income inequality within and across counties in rural China 1988
and 1995. Journal of development economics, 69 (1), 179–204.
Honohan, P., 2004. Financial development, growth, and poverty: how close are the links?,” Policy
Research Working Paper Series 3203. Washington, DC: The World Bank.
Huang, Y., 2005. Will political liberalization bring about financial development? Bristol Economics
Discussion Paper No. 05/578.
Kanbur, R. and Zhang, X., 1999. Which regional inequality? The evolution of rural-urban and
inland/coastal inequality in China from 1983 to 1995. Journal of comparative economics, 27,
686–701.
King, R.G. and Levine, R., 1993. Finance and growth: Schumpeter might be right. Quarterly journal
of economics, 108, 717–737.
Knight, J. and Xue, J., 2006. How high is urban unemployment in China? Journal of Chinese economic
and business studies, 4, 91–107.
Lardy, R.N., 1998. China’s unfinished economic revolution. Washington, DC: The Brookings Insti-
tutions.
Laurenceson, J. and Chai, C.H.J., 2003. Financial reform and economic development in China.
Cheltenham: Edward Elgar.
Levine, R., Loayza, N., and Beck, T., 2000. Financial intermediation and growth: causality and causes.
Journal of monetary economics, 46, 31–77.
Li, H., Squire, L., and Zou, H., 1998. Explaining international and intertemporal variations in income
inequality. The economic journal, 108 (446), 26–43.
Liang, Q. and Teng, J.-Z., 2006. Financial development and economic growth: evidence from China.
China economic review, 17 (4), 395–411.
Liang, Z., 2006a. Financial development and income distribution: a system GMM panel analysis with
application to urban China. Journal of economic development, 31 (2), 1–21.
Liang, Z., 2006b. Financial development and income inequality in rural China 1991–2000. Research
Paper No. 2006/96. Helsinki: UNU-WIDER.
Ma, Y. and Jalil, A., 2008. Financial development, economic growth and adaptive efficiency: a
comparison between China and Pakistan. China and world economy, 16 (6), 97–111.
Okushima, S. and Uchimura, H., 2005. Economic reforms and income inequality in urban China.
IDE Discussion Papers 25. Chiba: Institute of Developing Economies, Japan External Trade
Organization (IDE-JETRO).
 214 A. Jalil and M. Feridun

Pesaran, M.H. and Pesaran, B., 1997. Working with Microfit 4.0: Interactive Econometric Analysis.
Oxford: Oxford University Press.
Pesaran, M.H. and Shin, Y., 1999. An autoregressive distributed lag modelling approach to cointegra-
tion analysis. In: S. Strom, ed. Econometrics and economic theory in 20th century. Cambridge:
Cambridge University Press, Chapter 11. 371–413.
Pesaran, M.H., Shin, Y., and Smith, R.J., 2001. Bounds testing approaches to the analysis of level
relationships. Journal of applied econometrics, 16, 289–326.
Pesaran, M.H. and Smith, R.P., 1998. Structural analysis of cointegrating VARs. Journal of economic
survey, 12, 471–505.
Ravallion, M. and Chen, S., 2007. China’s (uneven) progress against poverty. Journal of development
economics, 82 (1), 1–42.
Rioja, F. and Valev, N., 2004. Does one size fit all? A reexamination of the finance and growth
relationship. Journal of development economics, 74, 429–447.
Rojas-Suarez, L. and Weisbrod, S.R., 1996. Building stability in Latin American financial markets.
Washington, DC: Inter American Development Bank, Office of the Chief Economist. Working
Paper No. 320.
Downloaded by [University of Otago] at 03:25 05 October 2014

Rousseau, P.L. and Wachtel, P., 1998. Financial intermediation and economic performance: historical
evidence from five industrial countries. Journal of money, credit and banking, 30, 657–678.
Rozelle, S., 1994. Rural industrialization and increasing inequality: emerging patterns in China’s
reforming economy. Journal of comparative economics, 19 (3), 362–391.
Shan, Z.J., Morris, A.G., and Sun, F., 2001. Financial development and economic growth: an egg-
and-chicken problem. Review of international economics, 9 (3), 443–454.
Singh, A., 1997. Financial liberalization, stock markets and economic development. Economic jour-
nal, 107, 771–782.
Tsui, K.Y., 1998. Trends and inequality of rural welfare in China: evidence from rural households in
Guangdong and Sichuan. Journal of comparative economics, 26, 78.