Informal economic activity is widespread around the world. On average, this activity represents about a third of production, and informal employment represents nearly a third of total employment (Graph 1). It undermines revenue collection, stifles productivity, hampers investment and locks some of the most vulnerable workers into low-paying and unproductive jobs. For policy makers in countries where informality is widespread, this is a formidable challenge.

Figure 1. Informality around the world

Source: Elgin et al. (2021).

Note: Bars are simple averages. “EMDE” stands for Emerging Economies and Developing Economies. Informal production is represented by estimates based on a dynamic general equilibrium (DGE) model as a percentage of official GDP. Self-employment, a common indicator of informal employment, is expressed as a percentage of total employment. The global averages between 1990 and 2018 are in orange.

Underdeveloped financial systems have often been identified as a potential cause of informality, but the direction of causality has been difficult to pinpoint. Financial development can affect the benefits and costs of informal economic activity undertaken by firms and households. Informal sector enterprises are generally characterized by small size, low capital/labour ratios, lack of investment, low productivity, low propensity to implement new technologies and unskilled managers. By influencing firms’ investment strategies, financial development promotes the transition of informal firms to the formal sector and ultimately encourages capital accumulation and productivity improvements.

Much empirical evidence shows that financial development is correlated with a reduction in informality. Many empirical studies have found a robust and significant result, for different sets of countries, time periods and definitions of financial development and informality, and taking into account many factors: greater financial development is associated with less ‘informality (Figure 2).

Figure 2. Financial development and informality

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

Note: Bars show simple averages for EMDE over the period 2010-18. “High informality” (“Low informality”) are emerging market and developing economies (EMDEs) with above-median (below-median) measures of informal production based on dynamic general equilibrium (DGE). “Bank branches” measures the number of commercial bank branches per 100,000 adults. ATMs measure the number of automatic 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+) who report having an account (alone or with someone else) at a bank or other financial institution, or say they have personally used a mobile money service in the past 12 years. month. *** indicates that the differences between the groups are not zero at the 10% significance level.

From correlations to causation

But is it financial development that reduces informality or vice versa? The literature is divided on this issue.

Several theoretical studies have identified the different channels that can give rise to a negative relationship between financial development and informality, with a causality that can work in both directions. These studies essentially compare the costs of informal operations, such as more costly access to external finance, with the benefits, such as avoiding regulatory and tax burdens.

The main notion underlying most studies arguing for a causal link between financial development and informality is that in the presence of information asymmetries, informal firms and workers face a cost of credit higher because they are more opaque to external creditors. A high cost of financing, in turn, reduces the attractiveness of formal sector activity. As financial markets develop, the cost of credit falls and formal sector activity becomes more attractive. And yet, there are also arguments to support the idea that causality runs from informality to lower financial development. Specifically, more widespread informality reduces overall investment, which, in turn, is accompanied by shallower capital markets.

This approach shows that greater financial development actually reduces informal sector activity. This causal link is stronger in countries where trade openness and the capital account are more open.

In our new study, we use an instrumental variable approach to show that the direction of causality runs from higher financial development to lower informal sector activity. Specifically, the approach taps into an aspect of financial development that is likely to be most relevant to the vast majority of informal workers and enterprises: relationship banking. Banking relationships require close interactions between the bank and the borrower and usually also require the presence of bank branches where these relationships can be established and maintained. Inspired by an abundant literature that documents the link between the development of the domestic and foreign banking sector, we use the strength of branch networks in geographically close countries as an instrument of financial development.

This approach shows that greater financial development actually reduces informal sector activity. This causal link is stronger in countries where trade openness and capital account openness are greater (Chart 3). The results are robust to the use of alternative 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: Bars show estimated coefficients for commercial bank branches (used as a proxy for banking sector development) when regressed against DGE-based informal output as a share of official GDP. “High (low) trade openness” corresponds to countries where trade flows (i.e. imports plus exports) as a share of GDP are above (below) the median. Commercial bank branches are per 100,000 adults and instrumented by the average number of bank branches in the region (excluding country under consideration; discounted by distance). Data are between 2004 and 2018. *** indicates that the coefficients are significant at the 10% significance level.

political promise

For policymakers, this is a promising finding. Our results suggest that efforts to strengthen financial development, which are typically undertaken for reasons unrelated to informality, can also be an effective tool to reduce informality.

A wide range of policy tools have been identified to foster financial development and financial inclusion. These policies have often aimed to increase domestic savings and investment, reduce poverty and reduce financial vulnerabilities. They included, among many others, measures to strengthen credit registries; expand mobile payment and banking systems; digitize transactions and records; and increase competition among financial service providers while strengthening regulation and supervision. Our results show that such policies can also increase the attractiveness of formal mining, in part by removing information asymmetries and reducing financing costs. Therefore, financial development can be an effective part of a broader policy program aimed at reducing informality.

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