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| Formal and Informal Finance: Institutions, Efficiency, and Empirical Challenges |
| GAO Ming, HU Conghui
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School of Economics, Peking University;
Business School, Beijing Normal University |
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Abstract The relationship between formal and informal finance is not only an important academic issue but is also crucial for China's financial system reform. Formal finance has been extensively examined because of its primary role in financing, stabilizing markets, and promoting economic growth. The policies of many emerging economies are aimed at replacing informal with formal finance. However, although informal finance carries a potential risk, it is widespread and important to small and medium-sized enterprises, households, and developing countries, particularly when the financial market is incomplete or has stringent financing restrictions. Thus, clarifying the value of informal finance is important when formulating regulatory policies.
In this study, we discuss the relative efficiency of formal and informal finance and their determinants by establishing a theoretical framework from the perspective of institutions of information and enforcement. We also clarify their roles in the various stages of economic development, and note the contributions and challenges in the empirical literature. We then discuss how to improve the efficiency of formal and informal finance by considering China's unique features, and conclude with suggestions for future research. The institutional perspective reflects the financial attributes of formal and informal finance and provides a basic framework for studying related academic and policy issues.
We suggest that formal finance involves a relatively complete credit system and relies on the legal system as its enforcement institution. Informal finance generally does not have standardized procedural information and enforcement institutions, and it depends on reputation, relationships, and social networks. Formal and informal finance both have unique advantages because of these differences in information and enforcement institutions. Formal finance is easy to regulate and expand, but it is relatively slow to adjust. Informal finance can easily be adapted to economic changes but is difficult to regulate and limited to regional and interpersonal networks. The relative efficiency of formal and informal finance depends on the corresponding social network and the credit and legal systems at the various stages of economic development. The inconsistencies in the literature are mainly due to differences in classification methods, sample limitations, and identification.
Developed economies have high degrees of predictability, relatively effective credit systems, and highly efficient legal systems. Thus, formal finance plays a major role in supporting economic activity and development and thus substitutes for informal finance. Rapidly developing economies often have unpredictable shocks, and so informal finance can be more easily adapted to the changing market environment without persuading the legislature to amend laws. Historical social networks and business relationships are also important foundations of informal finance. Thus, informal finance is an important financing channel in rapidly developing economies and complements formal finance. In underdeveloped areas, formal financial systems and capital markets are typically undeveloped. Both formal and informal finance are therefore important for economic development and should be encouraged.
Finance and growth are subjects of debate in both academic research and policy discussions. The efficiencies of formal and informal finance are typically compared in terms of their contributions to enterprises and economic growth; few institutional analyses of formal and informal finance in the different stages of economic development have been conducted. Establishing institutional measurements for formal and informal finance can thus be of benefit to investigate the mechanisms that affect their relative efficiency in different stages of economic development.
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Received: 20 August 2020
Published: 01 June 2022
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