World Development, Vol. 20, No. 6, pp. W-872,1992. 0305-750x/92 $5.00 + 0.

00
Printedin Great Britain. 0 1992 Pergamon Press Ltd

Interaction Between the Formal and Informal

Financial Sectors: The Asian Experience

P. B. GHATE*
Consultant

Summary. - The nature of the interaction between the formal and informal financial sectors in
developing countries is a subject with important policy implications. It has implications for the
future of informal finance as the formal sector expands in the long term-will the informal sector
wither away, as the traditional view of financial dualism assumes, or will it continue to play an
important complementary role, perhaps even growing in absolute size? Second, the pattern of
interaction between the two sectors has important implications for the prospects of success of the
two major policy approaches often advocated toward the informal sector - offering it stronger
competition so as to induce it to improve its terms, and promoting linkages with it so as to take
advantage of its lower transactions costs in reaching smaller and poorer borrowers. Third, the
existence of a large informal sector has implications for the efficacy of monetary and credit policy
in achieving stabilization objectives. Fourth, the interaction between the formal and informal
financial sectors also has implications for the effects of financial liberalization through removing
restrictions on the deposit rate of interest. This paper draws on the experience of Asian countries
to address these issues.

1. INTRODUCTION cial purpose development banks. It was implicitly

assumed that with development the informal
(a) Informal credit: Its importance and sources of sector would become insignificant.
comparative advantage The informal sector, however has proved more
resilient than was at first assumed. Along with
In the traditional view of financial dualism the formal financial sector there continues to
there was little interaction between the formal exist in most Asian countries a heterogenous and
and informal financial sectors. The modern and dynamic informal financial sector which is largely
traditional financial sectors that existed side by hidden from view but is almost as important in
side in most underdeveloped economies were aggregate terms. Table 1 summarizes the evi-
regarded as more or less discrete financial dence of some studies which include estimates of
enclaves. Dualism reflected the underlying pro- the relative size of informal credit. The general
duction structure and distribution of wealth of an conclusion is that the share of rural informal
economy. In economies characterized by large credit accounts for about one-third to two-thirds
primary and small industrial and commercial of total rural credit in Bangladesh and China,
sectors, the majority of borrowers consisted of
farmers, small industries, and small retailers and *This paper was presented at the International Con-
wholesalers, who required short-term loans, and ference on Savings and Credit for Development,
in relatively small amounts. The needs of such organized by the United Nations, the Danish Savings
borrowers were met by relatively atomistic finan- Bank Association, and the International Savings Banks
cial markets and by traditional financial institu- Institute, at Klarskovgard, Denmark, May 28-31 1990.
The author is grateful to the organizers for permission
tions (Cole and Park, 1983). At the same time,
to publish it here. He is also grateful to M. Quibria,
the needs of large industry, mines, plantation
Malcolm Dowling, Mina Paz and two anonymous
agriculture and export commerce were met by a referees for useful comments. Much of the material is
formal sector consisting of modern commercial based on Ghate and Associates, 1992. The views
banks. The growing financial requirements of the expressed are those of the author and not of the Asian
modern sector would be met by an expanding Development Bank. Final revision accepted: April 5,
network of commercial bank branches and spe- 1991.

859
860 WORLD DEVELOPMENT

Table 1. Share of informal credit, rural and urban, in selected countries

Share of
Informal Credit
Country (percentage) Remarks Source

Bangladesh
Rural One-third to Share of total volume of rural Range of estimates by Rahman,
two-thirds. borrowings. Chowdhury and Murshid (1989), Hussein
(1983) and Rural Credit Survey,
1987 (Bangladesh Bureau of Statistics,
1989).
China
Rural One-third to Share of borrowings, mid-1980s. Various studies reviewed by Feder et al.
two-thirds. (1989).
Iqdia
Rural 38 Share of outstanding household debt All-India Debt and Investment Survey,
owed to informal sector, 1982. 1981-82 (Reserve Bank of India, 1988).
Urban 40 Share of outstanding household debt All-India Debt and Investment Survey,
owed to informal sector, 1982 1981-82 (Reserve Bank of India, 1988).
Korea
Rural 51 Share of average outstanding Yearbook of Agriculture & Forestry
liabilities held by farm households. Statistics, 1982, Ministry of Agriculture &
Forestry.

Malaysia
Rural 75 Share of borrowings. Wells (1980).

Nepal
Rural 76 Proportion of farm families borrowingAgricultural Credit Review Survey (Nepal
from informal sector, 1976-77. Rastra Bank, 1980).
Pakistan
Rural 69 Share of borrowings, 1985. Pakistan Rural Credit Survey, 1985.

Philippines
Rural 70 Share of borrowings, 1987. Social Weather Stations Inc. as reported in
Agabin ef al. (1989).

Urban 45 Share of borrowings, 1987. Social Weather Stations Inc. as reported in

Agabin et al. (1989).

Sri Lanka
Rural 45 Share of borrowings among paddy Survey of Credit and Indebtedness Among
farmers, 1975-76. Paddy Farmers (Sri Lanka, Central Bank,
1976).

Thailand 44 Share of debt outstanding, 1987. Poapongsakorn and Netayarak (1989).

Source: Asian Development Bank (1990).

about two-fifths in India, Sri Lanka and Thailand than formal. While the estimates are approxi-
and two-thirds to three-quarters in Malaysia, mate, adopt different criteria to measure size,
Nepal, Pakistan and the Philippines. Moreover, include a large component of noncommercial
informal credit comprises about two-fifths of credit from friends and relatives, and in some
total urban credit in India and the Philippines. cases are rather old, they indicate the order of
The proportion of the total number of informal magnitude of the informal credit sector.’
loans, or of households borrowing from the Further, it has become clear that instead of
informal sector, is higher in most cases than these constituting two discrete financial enclaves, the
volume-based estimates suggest, since informal two sectors, or rather the many submarkets
loans tend to be smaller and of shorter duration within each, form a continuum in terms of degree
 FORMAL AND INFORMAL FINANCIAL SECTORS 861

of formality. At the informal end of the con- strength of community ties. Alternatively the
tinuum, submarkets (and lenders) are characte- lender may be in a position to devise collateral
rized by highly personalized loan transactions substitutes such as the interlinkage of credit with
entailing face-to-face dealings with borrowers, marketing, employment or leasing transactions.
and flexibility in respect of loan purpose, interest Interlinkage, instead of serving as a substitute for
rates, collateral requirements, maturity periods collateral, may even be used as a preferred
and debt rescheduling. At the other end is the alternative to it, since it has the advantage of
formal sector in which the scale of operations of reducing transactions costs which are now shared
individual lenders is much larger, transactions between the credit transaction and the marketing
are usually arms length, and loan terms more or other interlinked transaction. This gives inter-
standardized. Moreover, the formal sector is linking lenders such as produce traders, input
subject to a variety of regulations relating to dealers and raw material suppliers an advantage
capital, reserve and liquidity requirements, ceil- in extending crop production loans to farmers,
ings on lending and deposit interest rates, man- and working capital loans in kind to enterprises.
datory credit targets, and audit and reporting Second, the loan may be a small or short-
requirements. Together with constraints imposed duration loan, for which the transactions cost
by the internal bureaucratic procedures of large- may be so high as to place it beyond the
scale formal sector institutions, these require- profitable reach of the formal sector. For both
ments raise transactions costs in the formal sector these reasons, informal finance tends to be
to levels usually well above that in the informal. particularly suited to the requirements of small
Since informality as characterized above is a and poor borrowers, including small farmers,
matter of degree, the exact location of the microentrepreneurs and petty traders, and is
dividing line in the formal-informal continuum more equitably distributed than formal credit.
demarcating the two sectors is a matter of choice There are, however, other features of informal
and convention. Thus some institutions such as finance that are advantageous irrespective of the
pawnshops and some nonbank financial interme- size of the borrower. For instance wherever
diaries are regarded as formal in one country and timeliness is crucial (as in emergencies, or
informal in another. Indeed different types of the whenever a business opportunity must be seized
same institution may fall on different sides of the immediately) the speed with which the informal
line in the same country, such as regulated and sector can make loans gives it an advantage over
unregulated pawnshops. Since the grey area the formal. Further, credit controls may prevent
between the two sectors can be regarded as semi- the formal sector from making loans for a variety
formal, it is sufficient for most practical purposes of purposes, including consumption loans, so that
to regard the two sectors as constituting the two the borrower has no alternative but to approach
ends of a continuum, shading into a grey area in the informal sector.
between. Formal finance, on the other hand, is more
In order to examine the pattern of interaction readily able to accommodate large and long-term
between the two sectors it is useful to think of the loans because of its greater reliance on the
submarkets as constituting another continuum, pooling of deposits and maturity transformation.
arranged in declining order of degree of require- It thus enjoys greater economies of scale, and of
ments met by the formal sector. Each submarket scope, although not necessarily of specialization.
is defined by a complex of interrelated variables Modern telecommunications and data processing
such as borrowing purpose, loan size, loan technology enable it to transmit claims over long
duration, the borrowers’ income and asset posi- distances almost instantaneously. Formal finance
tion, and so on. In Figure 1, the segment of the is better suited to the needs of large and medium-
continuum on the left consists of submarkets scale industry, organized trade and commerce,
which are catered to entirely by the formal and well-to-do urban households.
sector, while those in the segment to the right are
catered to entirely by the informal. In between
the two sectors is a range of submarkets which (b) Complementarity with formal finance
are catered to by both sectors.
There are several features of borrowers, or Clearly, in their respective areas of compara-
their credit needs, that explain why they belong tive advantage the two sectors are complemen-
to submarkets in the informal segment. First, tary. In the middle segment the two sectors often
they may possess no collateral, in which case the compete with each other, but sometimes also
informal sector may be in a position to lend to enjoy a complementary relationship, so that both
them without collateral, merely on the basis of grow together in absolute size.’ A well-known
first-hand information on the borrower, or on the case of complementarity is that described by Cole
 862 WORLD DEVELOPMENT

Form01 sector Both sectors Informal sector

A = Submarket catered to entirely by formal sector, e.g., long-

term loans for fixed investment in large industry.

0 = Submarket catered to by both formal and informal sector e.g.,

crop loans or working capital for small enterprises.

c q Submarket catered to entirely by informal sector, e.g., small

short-term loans to poor borrowers with no collateral.

Figure 1. Submarkets arranged in declining share of credit needs provided by formal sector.

and Park (1983) relating to South Korea in the should the borrower default, since they deal in
1960s and 1970s when large-scale industry met the same product.
its fixed investment requirements from the for- For all these reasons, as the supply of formal
mal sector but borrowed part of its working credit increases for one purpose, in this case fixed
capital requirements in the curb market. Fixed investment, the demand for informal credit
investment has a longer gestation period than increases for the complementary purpose, work-
working capital and requires longer term loans, ing capital. Thus both by virtue of specializing in
which as noted above, the formal sector is in a one end of the continuum of submarkets, and by
better position to provide through the pooling of financing the credit needs of complementary
deposits and maturity transformation. Since the purposes in the middle segment of the con-
informal sector relies more on its own funds than tinuum, informal finance is complementary to
on deposits, or provides brokerage services by formal finance. It sometimes also complements
bringing lenders and borrowers together in direct formal finance in financing the same borrowing
finance, it is less able to undertake maturity purpose. Thus there is often just not enough
transformation. Second, informal lenders are formal credit to go around. Borrowers may then
often reluctant to lend over the long-term be- have to top up their requirements with informal
cause they are unwilling to endanger their credit. Apart from being short of funds, banks
anonymity for tax or legal reasons. This factor may have to ration credit to comply with credit
operated with particular force in South Korea in controls, or to minimize the risk of adverse
the 196Os, and 1970s where there were occasio- selection. Banks may also have “margin money”
nal crackdowns on informal finance. requirements. Borrowers may meet these by
A third reason, that applies in most countries, borrowing informally, while disguising such bor-
is that it is easier for banks to make long-term rowings as equity.
loans to small enterprises with no security to A third important sense in which the two
offer except that of the fixed assets created with sectors are complementary are the considerable
the loan (e.g., an item of equipment) than it is to flows of funds, or “linkages” that already exist
make long-term loans against inventory, which between the two sectors. These funds flow in
can be more easily disposed of by borrowers both directions, although in rural credit the
should they choose to default. It is also easier for predominant flows seem to be from the formal to
input suppliers or product purchasers to provide informal sector. Thus the banks are often an
working capital than it is for the banks, since important source of funds for traders and
product market dealers are already in possession moneylenders who onlend informally. A recent
of good information on borrowers through long- study from Bangladesh (Alam, 1989) found that
standing marketing relationships and are in a one half to two-thirds of rural informal loans
much better position to dispose of inventory originated with the banks and was onlent by
 FORMAL AND INFORMAL FINANCIAL SECTORS 863

informal lenders. In the Philippines Larson sidized agricultural credit has expanded in the
(1988) found that 70% of his sample traders last two or three decades, reducing the share of
obtained 60% of their funds from the banks. In informal credit. Thus, in India, the decennial All-
India, traditional or “indigenous” banks actually India Rural Credit Surveys show a steady decline
obtained refinancing from the banks, although in the relative importance of informal rural loans
this has now been discontinued (Timberg and over the past few decades. In 1962, debt out-
Aiyar, 1984) and (Government of India, 1972). standing to informal lenders made up 85% of
A great deal of informal trade credit originates in total rural indebtedness, but this declined to less
the formal sector, taking advantage of the fact than 40% in 1982, largely reflecting the rapid
that marketing intermediaries higher up in the expansion in rural banking. Fragmentary infor-
distribution chain have superior access to the mation from Thailand (Onchan, 1989) and Sri
banks. In the reverse direction, the banks are Lanka (Sanderatne, 1989) suggests a similar
repositories of funds that flow in from informal trend there. Indeed, the share of informal rural
lenders. Rotating savings and credit associations credit is declining in most countries.4 Where the
(Roscas), which are ubiquitous in Asia and process, however, has depended on the expan-
mobilize considerable savings, often deposit idle sion of credit from the central bank it has often
funds in the banks.3 So do credit unions, savings come to a stop when such credit has dried UP.~
groups and moneylenders. These funds are “on- Thus in the Philippines, a substantial contraction
lent” formally. of informal credit took place in the 1980s. An
Given its complementarity with formal fi- earlier expansion had taken place in the 1970s
nance, informal finance is likely to continue to with the Masagana 99 and other programs, but
form an important part of the financial landscape met with large-scale loan repayment problems,
in developing countries. To the extent the lower after which cheap rediscounting from the central
transactions costs of the informal sector are the bank was discontinued. This, and the economic
outcome not only of the absence of regulation, crisis of 198>85, led to the closure of a large
but also of the smaller scale of operation of number of rural banks which, along with negative
informal lenders, specialization, and freedom real interest rates, drastically reduced the supply
from principal-agency problems, all of which of formal credit. Informal lenders made a come-
reduce its transactions costs, there will continue back, and by the mid-1980s had reclaimed their
to exist an informal sector at the one end of the 1960s share of total rural credit (Agabin, 1988).
financial spectrum. In the middle segment infor-
mal finance, both complements and competes
with formal finance. It is to the latter relationship (a) The two approaches: An illustrative case
that we will next turn.
(i) Promoting competition
The expansion of formal credit at the expense
2. POLICY APPROACHES: PROMOTING of informal is often mistakenly assumed to be an
COMPETITION AND LINKAGES end in itself. Thus the success of such policies is
often discussed in terms of changing relative
When the two sectors compete with each other shares. Their true rationale, however, is to
in meeting the same borrowing purpose, e.g., “compete” the terms of informal credit down by
crop loans (as against complementing each other providing an alternative. To see how the compet-
in fulfilling the credit needs of complementary ing approach works we will consider the example
purposes) the availability and terms on which of the “moneyshop” experiment in the Philip-
loans of the two types are available determines pines where the central bank allowed the Philip-
the choice of sectoral source. If there is an pine Commercial and Industrial Bank in 1973 to
improvement in the availability of the source open moneyshops in the public markets and offer
with the better terms, borrowers switch from the loans at a high enough rate to cover the high
other source as their existing loans mature and transactions costs of making small and short-
they need r&w loans. In this simple substitution duration loans to stallholders. When interest rate
model, the quantity of credit in a particular ceilings were removed generally in 1983 many
informal submarket (i.e. the size of the submar- rural banks also opened moneyshops in public
ket) is the difference between the total demand markets. Rates on informal loans to stallholders
for loans of that type, and that part of total are reported to have declined considerably
demand supplied by the formal sector. As formal (Agabin, 1988).6 Informal lenders, however,
loans become more easily available they displace could not be competed away entirely. The
informal loans. This indeed is what has happened moneyshops soon learned that they could not
in the large number of countries where sub- compete with informal lenders for the business of
864 WORLD DEVELOPMENT

the particularly high-risk borrowers in the public
markets such as ambulant vendors and those
selling perishables.
To see why, we will consider the illustrative
case in Figure 2 in which A and B represent
informal loans of two among several types of
loans prevalent in the public markets, the differ-
ence in their interest rates being due to the much
higher risk premium of 8% on type B loans as
against 2% in type A loans. The monopoly
profit, or rent, component of interest rates is
assumed for the sake of simplicity to be the same
in each case.’ The cost structure of the
moneyshop loans is assumed to be as in C. Their
transactions costs and risk premia are higher than
those of informal lenders, but their opportunity
cost of funds is lower. Their transactions costs are
higher because of higher overheads (staff, prem-
ises, paperwork) although these are much lower
than that of regular bank branches. Their risk
premia is higher because of their assumed higher
default rate despite location in the public market
which gives them much better access to informa-
tion. Their opportunity cost, which can be
regarded as the cost of raising deposits, is lower
than that of informal lenders, who have a variety
of other investment opportunities open to them,
paying a return of at least 8% in this case. A
normal level of profits is included in the oppor-
tunity cost for both types of lenders.
Unless the moneyshops are allowed to charge
an interest rate of at least 12% they will not lend
at all. Assuming they are allowed to do so, they
will succeed in attracting some type A borrowers
away from informal lenders.* Much more impor-
tant, however, all type A borrowers will now pay
a rate lower by 6%, whether they switch to the
formal sector or not, because informal lenders
are no longer able to earn rents. Type B
borrowers on the other hand will continue to pay

A 0 C 0 E F

MP6

MP6
oc 8 oc8

oC5

ace
RPS RP8
RP3

RP2
TC 4
TC 2 TC2 TC 2
i
I8 24 12 18

A = Informal loan, type A

B = Informal loan, higher risk, type B
c = Moneyshop loans to type A borrowers
0 = Informal loan, type B, after competition
E = Moneyshop loans to type B borrowers
F = Informal loan, type B, after receiving formal funds

TC = Transactions cost
RP = Risk premium
oc = Opportunity cost of funds
MP = Monopoly profit

Figure 2. Hypothetical cost structure of formal and informal loans (in percentage).
 FORMAL AND INFORMAL FINANCIAL SECTORS 865

24% .9 The formal sector can compete their rates own higher cost funds to lend at 18%.” The
down only if it is permitted the flexibility by the crucial assumption for this approach to work is
central bank and its own intra-agency policies to that there are enough informal lenders with
charge type B borrowers 18%.” sufficient access to formal funds for competition
While the numbers in this simple example are between them to keep down the onlending rate
illustrative, their relative magnitudes are not un- down to 15%. Which set of conditions applies (or
representative. It should be noted that the result can be made to apply) is an empirical question,
holds for any combination of numbers in which and depends on the submarket concerned.13
the sum of the three nonrent components is lower We have seen that considerable lending
for informal finance than for formal or, in other already takes place by the banks to informal
words, whenever the lower cost of,formal funds lenders - a practice sometimes referred to in the
fully offsets higher formal transactions costs and literature as “wholesaling” (Rozental, 1970).
risk premia. Even if moneyshop costs are higher Onlending on the basis of these funds, however,
than 12%) however, any interest rate lower than is usually not conducted openly - “supervised”
18% which allows them to recover their costs will credit programs attempt to lend directly to the
reduce rents by the difference between the ultimate user of funds in an attempt to control
moneyshop rate and 18%. their use (an attempt made somewhat difficult
The example also illustrates the limits of the because of fungibility) and to ensure that the
“promoting competition” approach. While the credit disbursed stays “cheap.” There is a con-
moneyshops will succeed in attracting some of siderable literature documenting the failure of
the more “bankable” borrowers away from the this approach in reaching small borrowers (see
informal sector at a lower rate, and in doing so Adams, Graham and Von Pischke, 1984). The
will also benefit some borrowers left behind in time may have come therefore to acknowledge
the informal sector, they cannot reach all that informal lenders can get money out to small
informal borrowers. To reach all the borrowers borrowers in greater amounts and at lower cost
left behind in the informal sector they must be than the banks, and to allow them to do so
prepared to raise their rates to cover the higher openly, subject perhaps to the setting up of
real transactions costs and risk premia of doing suitable mechanisms to monitor onlending rates.
so.” Moreover, where informal markets are Access to formal sector funds on the part of
competitive and interest rates are high not informal lenders in this way will promote com-
because informal lenders are earning rents but petition in informal markets and exert downward
because the cost of informal funds is high, pressure on interest rates, although here again
promoting competition will not bring down rates. without necessarily reducing shares. Thus a
Promoting linkages on the other hand, may do recent study in Thailand (Poapongsakorn and
so, given the first, or preferably both of two Netayarak, 1989) found that the short-run effect
conditions - the opportunity cost of funds of of an expansion of credit by the Bank of Agri-
formal lenders is lower than that of informal culture and Agricultural Cooperatives (BAAC)
lenders, and their transactions costs or risk was to reduce the share of informal lending. In
premia are higher. the longer run, however, the informal share went
up again. l4 The study found the informal rural
(ii) Promoting linkages credit market to be quite competitive, with about
An illustration of linkages between the formal 22% of informal rural credit being sourced from
and informal financial sectors can be seen in the banks. The explanation of the failure of the
Figure 2. Assume the formal sector is indeed informal share to go down probably lies in
allowed to charge 18% on type B loans and onlending in subsequent years by those who
succeeds in eliminating rents that were previously received formal credit.
being earned by informal lenders on type B This possibility is illustrated in Figure 3. In
loans, so that their loans now have the cost year one a bank branch lends to two traders in its
structure shown in D. Formal loans, however, area and to a large farmer. These constitute the
have the cost structure shown in E. Their formal loans. One of the traders uses the loan to
opportunity cost of funds is lower but their make purchases of grain for cash, while the other
transactions cost and risk premia are higher. To onlends to farmers in the sowing season against
bring down rates on loans to type B borrowers promises to repay in kind at harvest. Loans to the
further, the moneyshops could make funds avail- farmers are informal (and are shown below the
able to informal lenders by lending to them at 5% dotted line in Figure 3). In year two after an
instead of lending to borrowers directly. Informal expansion of formal credit the traders get larger
lenders would then be able to onlend at loans, and in addition the coverage of the formal
(5+8+2=) 15% as in F, instead of using their sector goes up to include direct lending to a small
 866 WORLD DEVELOPMENT

Year I Year 2 Year 3

Bank Bank Bank

4-l l+--n r+ll

Formal Trader Trader Large
~______~_,__~~~~~___~~~~~T~~~~~~_e_~~r_~~~~~~~~~__~_~~

Informal Small farmers Smoll farmers Small farmers Small farmers

Figure 3. Changing shares of formal and informal sectors with onlending.

farmer. Thus the share of the formal sector goes other investment opportunities, the cost of funds
up. In year three, however, the first trader becomes income from other opportunities fore-
expands his operations by emulating his col- gone. Banks on the other hand rely on deposits,
league and onlending to small farmers insCad of and lending is their major activity. Deposits with
purchasing grain for cash. Moreover, the second banks generally have higher liquidity (a function
trader increases the number of small farmers he of the pooling of deposits and maturity transfor-
lends to. Thus in year three the informal share mation) and are often perceived to be safer than
has gone up in terms of number of borrowers, deposits with informal lenders. These advantages
number of loans and most importantly, in terms are offset at times by the lower convenience and
of volume of end-use of credit. accessibility, or higher saver’s transactions costs,
If the grain market is competitive with freedom of bank saving facilities, which is a particular
of entry for new participants the interest rate at deterrent to the making of the kind of small and
which credit is received by end-users (the far- frequent deposits the informal mutual institu-
mers) is likely to be lower than the rate that tions specialize in. Moreover, there is also
would have to be charged by the bank attempting frequently a lack of “reciprocity” in bank savings,
to reach individual borrower directly. This is or the assurance of access to credit when re-
because the transactions costs and risk premia of quired, which is particularly important to the
the traders are much lower than that of the bank small saver. The advantages, however, appear to
attempting to appraise risk and handle disburse- offset the disadvantages, except for very small
ments and recoveries individually. At the same savers, and the banks are generally in a position
time their cost of funds is now the same as that of to attract deposits at a lower interest cost than
the banks plus a small margin to cover the bank’s the informal sector. It certainly appears to be the
transactions costs in lending to the traders. The case that the banks are in a better position to
attractions of the approach depend on the mobilize deposits than they are to make small
difference between the cost of funds of the two loans. This being the case, the promotion of
types of lenders. linkages combines the strengths of both sectors to
supplement the resources of the informal sector.
It also reinforces the complementarity of the two
(b) Why the costs of funds differ sectors. Thus the situation on the deposits side is
analogous to that on the credit side. While the
It is useful to consider here briefly why the cost two sectors enjoy a comparative advantage in
of funds is generally lower in the formal sector attracting deposits at the two ends of the con-
than in the informal. While informal mutual tinuum of submarkets, they compete for savings
lenders such as Roscas, credit unions and in the middle, through differences in yield,
informal savings groups mobilize considerable safety, convenience, liquidity and reciprocity
subscriptions and deposits (in fact, being mutual (Vogel and Burkett, 1986).
financial institutions, these subscription and To conclude, the promoting competition
deposits are their only source of funds), other approach is appropriate where informal lenders
types of informal lender15 rely mostly on their exercise market power and earn rents on the
own funds, although some of them do supple- information they possess on borrowers. On the
ment own funds with deposits. Many of these other hand, where informal markets are competi-
lenders are not primarily in the business of tive but the cost of funds is high, the formal
moneylending, and since most of them have sector can seek through the promotion of link-
 FORMAL AND INFORMAL FINANCIAL SECTORS 867

ages to pass on the benefit of lower cost funds by controls. He feels, however, the impact is likely
using informal lenders as conduits and taking to be stronger on the availability rather than
advantage of their lower transactions costs.r6 the price of informal credit given the semi-
monopolistic position of lenders. A recent Indian
study concludes that although the presence of the
3. IMPLICATIONS FOR STABILIZATION informal sector leads to a weakening of the
POLICY impact of monetary and credit policy, and to
greater unpredictability in the impact of the
The nature of the interaction between formal relevant multipliers, complete frustration of
and informal sectors also has important implica- monetary policy cannot be inferred from the
tions for another area of policy concern, namely evidence (Das-Gupta, 1989).
the efficacy of monetary and credit policy in the It is interesting to consider again the complica-
presence of an informal sector. In this case what tion introduced by the fact of linkages, or flow of
is involved is usually a short-run contraction of funds, between the two sectors. In Thailand,
formal sector credit in pursuit of stabilization Vongpradhip (1985) reports that the source of
objectives rather than a long-run expansion (as 48% of the subscriptions in business Roscas was
often seen in rural credit). the formal sector itself, with participants borrow-
ing from the banks to finance their subscriptions.
There was thus a boom of “share games”21 in
(a) Znteraction on the credit side 1983 when credit from the banks was easy
(Onchan, 1985). (Similarly 22% of the funds
There are some studies that describe instances used in check discounting came from the banks.)
of the informal sector expanding as the formal The contraction of bank credit in 1984 not only
contracts, as the substitution relationship would increased the demand for Rosca credit, it also
lead one to expect. Thus Harriss (1983) docu- decreased the supply of informal credit flowing to
ments the spawning of pawnshops and salaried Roscas. Hence the effect of linkages was to
officials as moneylenders in a district in south reinforce demand forces in raising interest rates
India when trade credit dried up.” There is also and increasing the effectiveness of monetary
evidence that the availability of credit in the policy. It is likely that trade credit in particular
intracorporate funds market in India responds to tends to decrease or increase with formal sector
changes in the availability and terms of bank credit, since a particularly large share of informal
credit (Das-Gupta, 1989). While it is not clear in trade credit originates in the formal sector, from
such cases what happens to total credit availabil- where it percolates down supply and distribution
ity from the two sectors combined, which is after networks informally.
all what monetary and credit policy seeks to
affect, the rising informal rates frequently
observed indicate that the net impact is still (b) Interaction on the deposit side
contractionary. It is significant that interest rates
in business Roscas18 in Thailand went up by 5O- In the cases considered so far we have exami-
100% in 1984 during the credit squeeze of that ned the impact of credit expansion and contrac-
year (Onchan, 1985). l9 In India, Acharya and tion in the formal sector on the quantum and
Madhur (1983) show that a restrictive credit price of credit in the informal. We will next be
policy in the formal sector creates excess demand concerned with the relationship between the two
for funds which spills over to the informal sector sectors on the deposits side, and in particular
and also bids up the cost of funds in the informal with the middle segment of the continuum of
sector. Thus monetary policy is effective in submarkets where the two sectors compete for
restricting the total supply of credit, and not just deposits. In considering the evidence relating to
the supply of credit in the formal sector.” In the the impact of changes in the difference in the
lively debate that ensued on the Acharya and deposit interest rate between the two sectors, we
Madhur article, Sundaram and Pandit (1984) will in the remaining part of this section look at
questioned the evidence, and argued that the cases in which the differential increases as a result
presence of highly elastic supplies of black of an increase in the rate of inflation in a situation
liquidity in the Indian economy swamps any in which formal sector rates are not allowed to
weak upward pressure on interest rates transmit- adjust because of interest rate controls. Holding
ted from the formal sector. Chandavarkar (1985) the deposit rates of interest below equilibrium
agrees with Acharya and Madhur that informal market clearing rates is one of the defining
credit markets (ICMs) are not insulated from at characteristic of “financial repression.” We will
least the indirect impact of aggregative credit then consider in the next section what happens
868 WORLD DEVELOPMENT

when the differential between deposit rates its deposits grow as a result of deposits diverted
decreases as a result of policy-induced increases from the banks on one hand (seeking higher
in the nominal rate of interest on deposits, which returns) or as a result of currency deposited with
is one of the major planks of financial liberaliza- it on the other (as the cost of holding idle
tion. balances grows). Since finance companies do not
With inflation, real deposit and lending rates in have to maintain required reserves and their
the formal sector decline while the informal customary requirements are low, a shift in
sector maintains real rates by increasing its deposits will lead to an overall increase in credit,
nominal rates. As the differential in real rates and their growth relative to the banks to an
increases, an increasing share of deposits flows to increase in the overall credit multiplier.23 On the
the informal sector which grows more rapidly other hand to the extent their transactions are
than the formal. Thus inflation was one of the mediated in currency, as they often are for tax
factors behind the recent mushrooming of private reasons, their expansion can raise the average
finance companies in Pakistan. In 1988, the ratio of currency to money supply and thereby
banks in Pakistan were offering a return of 6-7% dampen the credit multiplier (see Chandavarkar,
on one-year deposits, when inflation was running 1985). Thus their major impact, as noted above,
at 12% per month and finance companies were is likely to be not on aggregate credit but on
offering “profit-sharing” returns of 68% a credit to selected sectors.
month (Haqqani, 1988). The informal sector
tends to grow particularly rapidly when inflation
is accompanied by a surge in remittances, which
go disproportionately to the informal sector. This 4. IMPLICATIONS FOR FINANCIAL
was a factor behind the earlier episode of the LIBERALIZATION
mushrooming of finance companies in Pakistan
in 1979 (Hamid and Nabi, 1989), and that in Finally, we will consider cases in which the
Kerala India in 198687 (Das-Gupta, Nayar and differential in the deposit rate of interest de-
Associates, 1989). creases as a result of a policy-induced increase in
Inflation also increases the demand for credit the nominal rate of interest on deposits. Raising
for investment in real estate, stock-building and the deposit rate of interest has been one of the
real assets generally. Since selective credit major recommendations of the McKinnon-Shaw
controls are often imposed on lending for these analysis of financial repression and of the move-
purposes, demand pressures have to be accom- ment for financial reform stemming from it.
modated entirely by the informal sector, increas- Raising the deposit rate of interest to its competi-
ing its lending and deposit rates, and attracting tive free-market level increases financial savings,
funds into the informal sector. Private invest- the level of intermediation, investment, invest-
ment houses were seen to be fueling both ment efficiency, and growth. In this model, as the
demand pressures in these markets and volatility real rate of interest on time deposits increases,
in the stock market in Taiwan in 1989, and this savers shift out of currency and unproductive
was one of the main reasons for the efforts to inflation hedges into bank deposits, thereby
make deposit-taking illegal and bring the invest- raising the real supply of credit. More recently,
ment houses under regulation. Thus while the however, it has been argued by van Wijnbergen
informal sector is responsive to global or aggre- (1983) and others that in countries with an
gative credit policy it does tend to frustrate important informal or curb market, substitution
selective credit controls. This disadvantage, between assets in the informal market and time
however, should be recognized as the other side deposits is of greater importance than that
of the coin of the advantage represented by its between currency and time deposits. Savers shift
“safety valve” role, in which it ameliorates the out of the curb market (rather than cash) as time
worst inefficiencies arising from attempts to deposit rates go up. Thus the supply of informal
control credit too tightly through selective credit credit goes down, while reserve requirements in
controls. In fact the improvement in allocative the formal sector prevent formal credit from
efficiency the informal sector brings about increasing by an offsetting amount.
generally is one of its major benefits, along with There has been considerable debate on this
its equity impact (see, for example, Cole and “crowding out” hypothesis and on the empirical
Park, 1983). question of whether increased demand for time
While the rapid growth of the informal sector deposits reduces the demand for currency or for
will affect the allocation of credit and could also curb market assets (see Fry, 1988). In the former
have prudential implications,22 its impact on total case, curb market rates should decrease, in
credit expansion depends on the extent to which accordance with the substitution model, as the
 FORMAL AND INFORMAL FINANCIAL SECTORS 869

formal sector expands. Curb market rates did not 5. CONCLUSION

in fact come down after the interest rate reforms
of 1965 in South Korea until as late as 1967, To conclude, informal finance constitutes an
although they did drop in Taiwan after a similar important share of rural and urban finance in
increase in deposit rates there in 1950 (Fry, Asian developing countries, and is likely to
1988). Using more recent quarterly data from continue to grow in absolute terms, although its
South Korea, Edwards (1988) shows that there is share of total finance may decline. It not only
in fact a positive relationship between time dominates certain credit submarkets - those
deposit and curb market rates, an increase of one that cater to the requirements of small, poor, and
percentage point in the former leading to a 0% risky borrowers, and also often those in which
0.4 percentage point increase in the latter, credit can be interlinked with marketing transac-
lending support to the “crowding out” hypoth- tions - it also competes with and complements
esis. He also estimates an investment function formal finance in other submarkets. These pat-
showing that higher curb market rates discourage terns of interaction underlie each of the two
investment. Since he also finds, however, that broad policy approaches to the informal sector
investment is positively associated with the identified in the paper as promoting competition
growth of formal sector, it is not clear what the and linkages. Where informal lenders exercise
net impact of raising the time deposit rate is on market power and earn rents, the formal sector
total investment. can compete away part at least of these rents and
Van Wijnbergen (1983) goes further to argue bring informal sector rates down by increasing its
that there is a distinct possibility that the expan- own rates (provided it is allowed to do so).
sion of the formal sector in South Korea after the Higher formal sector rates are necessary to cover
interest rate reforms of the mid-1960s may the higher transactions costs and risk premia of
actually have had a perverse effect on investment making information-intensive and typically un-
and economic growth, at least in the short run, by collateralized loans in these markets. Where on
drawing resources away from the more efficient the other hand informal markets are competitive
informal sector. The medium to long-term out- the formal sector can through the promotion of
come would depend on whether the effect of the linkages seek to pass on the benefit of lower cost
increase in the savings rate (stimulated by higher funds by using informal lenders as conduits and
time deposit rates) dominates the short-run taking advantage of their lower transactions costs.
output depressing effect. Cole and Park would The substitution relationship between formal
presumably argue on the other hand that in view and informal credit, and between formal and
of the complementary relationship between for- informal savings, in particular submarkets, dam-
mal and informal credit in South Korea, and pens the efficacy of selective credit controls. It
implicitly in all other countries where industries also, however, ameliorates the worst inefficien-
finance fixed capital through the commercial cies arising from attempts to control credit too
banks and residual working capital requirements lightly. As regards overall or aggregate credit
from the informal sector, it is likely that instead supply, there is evidence in some countries that
of getting crowded out, the quantity of informal the informal sector does respond to monetary
credit actually increases, along with that of and credit policy measures with a lag. Where the
formal. The increase is based on extra savings in informal sector is itself an important source of
both sectors, in response to higher interest rates, funds for the informal sector, the contraction of
and finances the increase in total investment. flows from the formal sector following formal
The debate on the short-run effect of the sector credit tightening, reinforces demand pres-
presence of a large informal sector on the result sures by restricting informal sector credit supply.
of financial liberalization consisting of raising the It has been argued that the substitution relation-
deposit rate of interest is therefore inconclusive. ship also frustrates, at least in the short run,
In the longer run it seems likely that allowing the efforts at financial liberalization through the rais-
deposit rate to rise to equilibrium market clear- ing of deposit interest rates. The evidence here,
ing levels would lead to a lowering of the however, is inconclusive. In the longer run,
differential in the interest rates between the two financial liberalization is likely to lend to progres-
sectors, and the differential would come increas- sive integration of the two sectors, with each
ingly to reflect differences in risk and transac- continuing to play a role in its area of compara-
tions costs. In other words the two sectors would tive advantage. Given its intrinsic characteristics,
become increasingly integrated. To repeat our Gowever, there is always likely to remain at one
earlier conclusion, however, there will always end of the continuum of submarkets an informal
remain a sector that is relatively informal at one sector, whose economic rationale stems from
end of the financial continuum. more than just the absence of regulation.
870 WORLD DEVELOPMENT

NOTES

1. Only a few of the studies (e.g., those relating to but usually not by enough to offset the difference in the
India) use stratified random sample surveys designed to cost of funds.
yield size estimates. In most cases arriving at size
estimates was not the main purpose of the studies. 13. It should be noted that not all rents can be
competed away entirely or immediately. Rents are
2. Only if they grow at the same rate will their shares returns to information acquired over time and may be
remain the same. unique to a particular relationship. By investing in
information, however, potential competitors (in this
3. Bouman (1979), Nayar (1973) and Angel, De case moneyshops) can over time provide opportunities
Goede and Sevilla (1978) are useful sources on Roscas, to borrowers to shift (see Poapongsakorn and
and Bouman (1989) and Maloney and Ahmed (1988) Netayarak, 1989).
on nonrotating savings groups.
14. In the year formal credit increased, 58% of the
4. It should be noted again that changing shares do sample either reduced loan value or stopped borrowing
not necessarily imply displacement or substitution in an from the informal sector while only 13% increased loan
absolute sense. The relative size of the two sectors will value. In the subsequent year, however, 41% inceased
also change in a complementary relationship when one informal loan value while only 42% reduced it.
is growing faster than the other. Thus it cannot be
inferred that informal rural credit has contracted in 15. For a typology of informal lenders see Asian
absolute terms. Development Bank (1990) and Ghate and Associates
(1990).
5. As Wai (1980) points out, the growth of the
informal sector’s own funds depend on savings whereas 16. This approach is as applicable to nonlinking
that of the formal sector is assisted greatly by the lenders. For a recent experiment in Sri Lanka see
expansion of central bank credit. Sanderatne (1989).

6. Attempts to compete in the check discounting 17. In this case the trade credit was part of the
market also met with partial success in competing informal sector itself. A large part of it, however,
interest rates down (Lamberte and Abad-Jose, 1988). originated in the formal sector and was responding to
developments in that sector.
7. The total interest rate on each type of loan is
determined by supply and demand for each type of 18. A variety of Rosca found in Thailand, India,
loan. The rent is a residual earned by the lender after Pakistan, the Philippines and other Asian countries,
subtracting the other cost components from the interest which has evolved to accommodate the need for
rate thus determined. The decomposition of interest business credit on a large scale through the auctioning
rates here follows Bottomley (1975). of funds to the highest bidder in a particular round of
the rotation. The bids are distributed among the other
8. The proportion of borrowers who switch will participants as interest paid in that round. In simple
depend on the relative nonprice terms (such as conveni- Roscas, on the other hand, the sequence of the rotation
ence) of the two types of lenders. is determined by drawing lots, or by consensus.

9. This simple example illustrates that there is 19. The Philippines provides an interesting case of
usually a hierarchy of interest rates in informal credit informal rural rates rising sharply in 1985 and 1986
depending on loan purpose, collateral provided, the when credit was very restricted during the financial
borrowers’ income level and reputation and so on and crisis in the mid-1980s Inflation may also, however,
that it is misleading to talk of interest rates except in have been a factor. with lenders charging an inflation
relation to a particular homogenous group of borrowers premium, even in short-term informal credit. Con-
or loan types. versely during 197>76 when Masagana 99 and other
formal subsidized credit programs were active informal
10. To take advantage of this flexibility the formal rates were very stable (Agabin et al., 1989).
sector must be able to categorize borrowers into
homogenous risk groups, as informal lenders do. A 20. Ghatak (1975) also found some evidence that
large bank branch may not be able to do so, whereas a bank interest rates influence with a lag the “bazaar”
small moneyshop located in a public market might. rate, or the rate at which the bills of small traders are
discounted by shroffs (Gujerati indigenous bankers).
11. The case for subsidizing the formal sector to meet
these costs depends on a value judgment that it is more 21. Another term for Roscas in Thailand.
equitable for society to bear the subsidy than for the
erstwhile informal borrowers to pay the rents. 22. See Asian Development Bank (1990).

12. We are ignoring here the fact that there will also 23. In this respect their impact is similar to nonbank
be transactions costs for moneyshops in making loans financial intermediaries in developing countries. See
to informal lenders. These will raise the onlending rate, Thorn (1958).
 FORMAL AND INFORMAL FINANCIAL SECTORS 871

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