Financial development to formalize economies

Informal economic activity is spreading all over the world. On average, this activity accounts for about a third of output, and informal employment makes up nearly a third of total employment (Fig. 1). It undermines revenue collection, hampers productivity, hampers investment, and traps some of the most vulnerable workers in low-paying, unproductive jobs. For policy makers in countries where informality is widespread, this is a formidable challenge.

Figure 1. Informal character around the world

Sources: Elgin et al. (2021).

Note: The bars are simple averages. “Emerging markets and developing countries” means emerging intermediate and developing economies. Informal output is derived from estimates based on the dynamic general equilibrium (DGE) model as a percentage of official GDP. Self-employment, a common proxy for informal employment, is a percent of total employment. Global averages between 1990-2018 are in orange.

Underdeveloped financial systems have often been identified as a possible cause of informality but the direction of causation has been difficult to determine. Financial development can affect the benefits and costs of informal economic activity undertaken by firms and households. Firms in the informal sector are usually characterized by small scale ratios, low capital-labour ratio, lack of investment, low productivity, low propensity to apply new technologies, and unskilled managers. By influencing the investment strategies of firms, financial development encourages the transition of informal firms into the formal sector, and ultimately encourages capital accumulation and productivity improvement.

Plenty of empirical evidence shows that financial development is associated with reduced informality. Several empirical studies have come to a strong and important conclusion, for different groups of countries, time periods, definitions of financial development and unregulated trait, control of many factors: greater financial development correlates with less informal trait (Figure 2).

Figure 2. Financial development and informality

Figure 2. Financial development and informality 1Sources: Ohnsorge and Yu (2022).

Note: The bars show simple averages for emerging market and developing countries over the period 2010–2018. “High informality” (“low informality”) are emerging market and developing economies (EMDEs) with overall equilibrium informal output measures Dynamic above average (below average). Bank Branches measures the number of commercial bank branches per 100,000 adults. Automated Teller Machines measure 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 Ownership” is the percentage of survey respondents (aged 15 or over) who reported having an account (by themselves or with another person) at a bank or other financial institution, or who personally reported their use of a mobile money service in another 12 years months. *** Indicates that group differences are not zero at the 10 percent significance level.

From correlations to causation

But is it financial development that reduces informal activity, or vice versa? The literature is divided on this question.

Several theoretical studies have identified different channels that may lead to a negative relationship between financial development and informality, with a causal relationship that may go either way. These studies primarily compare the costs of informal operation, such as accessing costly external financing, with benefits, such as avoiding regulatory and tax compliance burdens.

The main idea behind most of the studies advocating a causal link from financial development to informality is that in the presence of information asymmetry, firms and informal workers face a higher cost of credit because they are more opaque to external creditors. The high cost of financing, in turn, reduces the attractiveness of the activity of the formal sector. With the development of financial markets, the cost of credit decreases, and the activity of the formal sector becomes more attractive. However, there are also arguments to support the idea that causation extends from informality to low financial development. Specifically, more widespread informality leads to lower total investment and this in turn accompanies shallow capital markets.

This approach shows that increased financial development actually reduces the activity of the informal sector. This causal link is stronger in countries with greater openness of trade and openness of capital accounts.

In our new study, we use an effective covariate approach to show that the trend of causation extends from greater financial development to less informal sector activity. Specifically, this approach exploits one aspect of financial development that is likely to be more appropriate for the vast majority of informal workers and firms: banking relationships. Banking relationships require close interactions between the bank and the borrower and usually also require the presence of branches of the bank where these relationships can be established and nurtured. Inspired by a large body of literature documenting the link between domestic and foreign banking sector development, we use the power of branch networks in geographically close countries as a tool for financial development.

This approach shows that increased financial development actually reduces the activity of the informal sector. This causal link is stronger in countries with greater openness of trade and openness of capital accounts (Fig. 3). The results are robust to the use of proxy indicators of informality and financial development.

Figure 3. The impact of banking sector development on informality

Figure 3. The impact of banking sector development on informalitySources: Capasso, Ohnsorge, and Yu (2022)

Note: The bars show the estimated coefficients of commercial bank branches (used as a proxy for banking sector development) on regression versus DGE-based informal output as a share of official GDP. “High (low) trade openness” are countries in which the flow of trade (ie imports plus exports) as a share of GDP is above (lower) than the average. The number of commercial bank branches per 100,000 adults and is determined by the average number of bank branches in the region (excluding the country under consideration; discounted by distance). Data between 2004 and 2018. *** Indicates that transactions are significant at a 10 percent significance level.

Politics Promise

For policy makers, this is a promising outcome. Our results suggest that efforts to promote financial development, usually undertaken for reasons unrelated to informality, may also be an effective tool for reducing informality.

A wide range of policy tools have been identified to promote financial development and financial inclusion. These policies were often aimed at increasing domestic savings and investment, reducing poverty, and reducing financial vulnerabilities. It has included, among other things, measures to strengthen credit records; Expansion of mobile payment and banking systems; digitization of transactions and records; Increasing competition among financial service providers while strengthening regulation and oversight. Our results show that such policies can also increase the attractiveness of formal operation, in part by removing information asymmetries and reducing financing costs. Hence, financial development can be an effective part of a broader policy agenda to reduce informality.

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