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C H A P T ER 6
T H E L O NG S HA D O W O F I N F O R MA L I T Y
BOX 6.1 Financial development and the informal economy
Financial development reduces the costs of accessing external financing and thus incentivizes firms and households to invest, including in higher-productivity projects. It also incentivizes participants of the informal sector to join the formal sector. In emerging market and developing economies (EMDEs) with above-median informality, a significantly larger share of firms relies on internal finance and identifies access to finance as a major business obstacle than in EMDEs with belowmedian informality. Also, in EMDEs with more prevalent informality, a significantly smaller share of households has access to commercial bank branches, automated teller machines (ATMs), and credit. Over the past three decades, growing access to financial services and credit has coincided with a falling share of the informal economy.
Introduction In recent decades, much research has been devoted to understanding the determinants of informal economic activity, including the role of financial development (Loayza 2018; Ulyssea 2020). Financial development can influence firms’ and individuals’ choices to engage in informal activity and may also, conversely, be affected by the level of informality (for instance, Capasso and Jappelli 2013; Elgin and Uras 2013; Straub 2005). Easier access to non-cashbased payments—whether via mobile phones, cards, or online—can improve the government’s ability to reach and support informal participants during a recession like COVID-19 (World Bank 2019c).a Firms in the informal sector are typically characterized by small scale, low capitalto-labor ratios, lack of investment, a low propensity to implement new and even high-return technologies, and unskilled managers (Capasso and Jappelli 2013; Dabla-Norris, Gradstein, and Inchauste 2008; Quintin 2008). By influencing firms’ behavior, financial development can encourage capital accumulation and productivity improvements, and thus enhance long-run economic growth, particularly in the presence of informality (Antunes and Cavalcanti 2007). Against this background, this box addresses the following questions: •
What links between informality and financial development have been identified by the literature?
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How does financial development differ between EMDEs with high and low informality?
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How has financial development in EMDEs evolved? Note: This box was prepared by Salvatore Capasso, Franziska Ohnsorge, and Shu Yu. a. Also see Fang, Kennedy, and Resnick (2020) for detailed examples.
