Bankable Frontier Weblog

A recent Economist article about the US government’s new international aid channel, the Millennium Challenge Corporation, highlights some of the difficulties of adopting an alternative approach to aid, and yet also the need to do so.

The MCC’s mission is to promote economic growth as a means of addressing poverty. It does this by providing targeted grants to low income countries which meet certain basic threshold standards. So far, only four have qualified, and two have been signed up to receive MCC money. In terms of a recently signed compact with the Indian Ocean island of Madagascar, the MCC is to provide $110m over four years, primarily to improve the land titling system, which is antiquated and backlogged; and to deepen and broaden the banking system.

Compact: Madagascar wants titling systems

As The Economist comments on this grant: “The New York Times has dismissed these efforts as “worthy” but besides the point in a country where many villages lack running water, clinics or schools. Many Malagasy disagree. ‘These are our main bottlenecks,’ says Emma Ralijohn, who coordinated Madagascar’s application to the MCC. ‘Other donors never tried to solve these problems,’ she adds.

In these times when so much focus is being placed on ‘making poverty history’, and so much new money is becoming available to the poorest countries, there is a risk that the ‘worthy’ will crowd out the some of the fundamental. Improved health, education and basic infrastructure are clearly important in alleviating poverty. However, sound institutional underpinnings, such as land titling systems and improved financial systems, are necessary for long run sustainable growth.

Recent research from the World Bank takes this argument a key step forward. Previously, much empirical research had found strong correlations between financial sector development and growth; some had gone further to find evidence of causality: financial sector development causes growth (for a good summary of this research, see the DFID Financial Sector Briefing Note). Now, Thorsten Beck, Asli Demirguc-Kunt and Ross Levine have published a World Bank Working Paper entitled Finance, Inequality and Poverty: Cross Country Evidence.

The cross country evidence in question is data from 52 developed and developing countries over 40 years (1960-1999). They find a robust causal relationship between the ratio of private credit to GDP (a proxy for financial depth) and the average annual increase in the income of the poorest quintile of the population. In other words, financial sector development causes faster growth in incomes of the poorest in society. But they deduce a still stronger result: countries with higher levels of financial development experience faster absolute poverty alleviation. As the authors state: “By showing that finance helps to both to boost economic growth and to reduce income inequality, the pro-poor characteristic of financial development has been established.“

Although there is not yet sufficient extensive micro-level impact data on the effect of microfinance (for one summary, see this CGAP piece), this macro finding should be sufficient to earn financial sector development a seat at the new development strategy table, alongside the health, education and infrastructure initiatives. After all, as the people of Madagascar have indicated to the MCC, the slow, complex even boring work of improving credit systems along with its sister, land titling systems, is vital to building a foundation for sustainable growth.