Informal economic activity is widespread around the world. On average, such activities account for about one-third of output and informal employment accounts for nearly one-third of total employment (Figure 1). It undermines revenue collection, stifles productivity, stifles investment, and traps some of the most vulnerable workers in low-wage, unproductive employment. This is a daunting task for policy makers in countries where informality is prevalent.
Figure 1. Informality around the world
Source: Elgin et al. (2021).
Note: Bars are simple averages. “EMDEs” represent emerging market and developing countries. Informal production is substituted by estimates (as a percentage of official GDP) based on dynamic general equilibrium (DGE) models. Self-employed, a common proxy for informal employment, is a percentage of total employment. The global average from 1990 to 2018 is in orange.
An underdeveloped financial system has often been identified as a potential source of informality, but it has been difficult to pinpoint the direction of causality. may affect the benefits and costs of economic activity in Informal sector firms are typically characterized by small size, low capital-to-labor ratios, underinvestment, low productivity, low propensity to adopt new technologies, and low managerial skills. there is. By influencing corporate investment strategies, financial developments facilitate the migration of informal firms into the formal sector, ultimately facilitating capital accumulation and productivity gains.
A large body of empirical evidence shows that financial development correlates with a decline in informality. A number of empirical studies have found robust and significant results for different country sets, periods, definitions of financial development and informality, controlling for many factors.Figure 2).
Figure 2. Financial development and informality
Source: Ohnsorge and Yu (2022).
Note: Bar chart shows simple average of EMDE for the period 2010-2018. ‘High informality’ (‘low informality’) refers to emerging market economies with informal measures of output based on dynamic general equilibrium (DGE) above the median (below the median) and It is a developing country (EMDE). “Number of bank branches” is the number of commercial bank branches per 100,000 adults. “ATM” measures the number of automated teller machines (ATMs) per 100,000 adults. ‘Private credit’ measures domestic credit to the private sector as a percentage of GDP. ‘Account holding rate’ refers to survey respondents (ages 15 and older) who reported having an account (either themselves or with someone else) with a bank or other financial institution, or who had mobile is the percentage who reported using his money service personally12. Moon. *** indicates non-zero group differences at the 10% significance level.
From correlation to causation
But is it financial development that reduces informality, or vice versa? The literature is divided on this question.
Several theoretical studies have identified a variety of channels that can create a negative relationship between financial development and informality, with causation likely going either way. there is. These studies essentially compare the costs of operating informally, such as more costly access to external funding, against the benefits, such as avoiding the burden of regulatory and tax compliance.
The main concept behind most of the studies that assert a causal link from financial development to informality is that, in the presence of information asymmetries, informal firms and workers are more vulnerable to external creditors. Because it is more opaque, it faces higher credit costs. High funding costs make formal sector activity less attractive. As financial markets develop, credit costs will fall and formal sector activity will become more attractive. Yet there are also arguments that support the idea that causality extends from informality to declining financial development. Become.
This approach shows that greater financial development actually reduces informal sector activity. This causal relationship is stronger for countries with higher trade openness and capital account openness.
Our new study employs an instrumental variable approach to show that the direction of causality is from greater financial development to declining informal sector activity. Specifically, this approach taps into her one aspect of financial development that seems most relevant to the majority of informal workers and businesses: relationship banking. Relationship banking requires close interaction between banks and borrowers, and usually requires the existence of bank branches that can establish and nurture these relationships. Inspired by the large body of literature documenting the relevance of national and international banking sector development, we harness the strength of our branch networks in geographically adjacent countries as a means of financial development.
This approach shows that greater financial development actually reduces informal sector activity. This causal relationship is stronger for countries with higher trade openness and capital account openness (Figure 3). The findings are robust to informality and the use of proxy indicators of financial development.
Figure 3. The informal impact of banking sector development
Source: Capasso, Ohnsorge, and Yu (2022)
Note: Bar charts show the estimated coefficients of commercial bank branches (used as a proxy for banking sector development) when regressed on DGE-based informal output as a share of official GDP. A “high (low) trade openness” is a country with above (below) the median trade flow (i.e., imports and exports) as a percentage of GDP. The number of commercial bank branches is per 100,000 adults, adjusted by the average number of bank branches within the region (excluding countries covered, discounted by distance). Data are from 2004 to 2018. *** indicates that the coefficient is significant at the 10% significance level.
policy pledge
For policymakers, this is a promising finding. Our results suggest that efforts to strengthen financial development, usually for reasons unrelated to informality, may also be effective tools to reduce informality.
A wide range of policy tools have been identified to promote financial development and financial inclusion. Such policies are often aimed at increasing domestic savings and investment, reducing poverty and reducing financial vulnerability. They include, among other things, measures to strengthen credit registration. Expansion of mobile payment and banking systems. Digitization of transactions and records. Increase competition among financial service providers while increasing regulation and supervision. Our results show that such policies can also make them more attractive to operate formally by removing information asymmetries and reducing funding costs. , can be an effective part of a broader policy agenda to reduce informality.
