The Role of Formal and Informal Finance in Economic Development

Abstract

There is an apparent assumption amongst policymakers despite evidence of heavy and increasing reliance on informal finance, the co-existence of formal and informal financial markets, and linkages between informal finance and economic outcomes that, formal rather than informal finance, is needed for economic development. The objective of this study is to examine the role of formal and informal finance in Economic Development. We use White Heteroscedasticity Adjusted and Two-Stage Least Squares Regression for the estimation, with measures of the regulatory framework for protecting financial consumers as instruments. We find that, while access to formal financial services has a positive effect on economic development irrespective of a country’s income status, access to informal financial services may positively or negatively affect economic development depending on its source. Further, while formal finance on economic development is positive irrespective of a country’s level of development, informal finance is unfavourable for high and middle-income economies. Our findings indicate that the policy choice of broadening access to formal rather than informal financial services is in the right direction. Policymakers should thus intensify efforts at expanding access to formal financial services for enhanced economic development. Nevertheless, policymakers should be mindful of the source contingent impact of informal finance on economic development.