Academic journal article Economic Inquiry

Informal Sector and Economic Development: The Credit Supply Channel

Academic journal article Economic Inquiry

Informal Sector and Economic Development: The Credit Supply Channel

Article excerpt


A popular idea in policy circles holds that granting potential entrepreneurs access to formal credit markets by improving public institutions and specific regulations is an important condition for economic development. In particular, reforms allowing economic agents to formalize, and therefore gain better access to formal credit markets, should naturally lead them to invest more and increase their productivity; ultimately, the benefits of higher overall growth would ensue. Such reforms typically include strengthening property rights on land and housing and reducing burdensome registration procedures. (1)

This article examines, in a general equilibrium framework, the chain of causality behind that line of thinking. It does so by modeling individual agents' decisions to become formal in relation to their access to a credit market plagued by moral hazard and examining the effect of these decisions on the size of the formal sector and the level of output. The main insight is that while better property rights and less burdensome regulations under certain conditions may facilitate agents' access to formal loans, such reforms interact with the characteristics of the credit market and its environment in ways that crucially shape the ultimate magnitude of the effect on formality and output.

In a nutshell, the modeling strategy relies on an overlapping-generations model where economic agents, when young, undertake productive projects, deciding whether to work in the formal or informal sector. These decisions depend on the trade-off between the costs of entry and the benefits of accessing the formal credit market, which itself is a function of the quality of enforcement and property rights that allow for efficient loan recovery by lenders. Entrepreneurs save part of their profits for future consumption and these savings constitute the next period's supply of credit in the economy.

In this context, the equilibrium interest rate that results from the interaction between the supply of lendable funds and the demand for credit is a key variable in determining the equilibrium level of formality. Indeed, lower entry costs and better contract enforcement unambiguously imply a larger formal sector, a higher demand for credit, and higher output as long as an infinitely elastic supply of funds is available at the prevailing interest rate (e.g., an open economy with no barriers to international capital flows and a competitive banking sector). However, absent these conditions, an increase in demand resulting from a higher rate of formality increases the interest rate, which weakens the links among reform, formality, and output.

Finally, we present empirical evidence related to the implications of our model. We find that countries with lower entry costs or a higher quality of enforcement tend to have larger credit markets and smaller informal sectors and that this relationship is stronger when the banking sector is more competitive and the economy is more open to international capital flows. Using industry-level measures of financial dependence and controlling for country fixed effects, we show that the results on credit supply also hold in a cross- and within-industry setting.

A. Related Literature

The argument above is composed of two parts. First is the link between better regulations and access to credit at the individual level, which results in increased incentives to enter formality, and second is the link between these individual decisions and output or growth.

It is relatively well understood how light registration procedures and strong property rights interact to provide the necessary conditions to access the credit market. As de Soto (1990) showed in the case of Peru, and further documented by Djankov et al. (2002) for 85 countries, firms first face significant entry costs in the form of registration and license fees to be able to operate formally. …

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