Financing development through informal sector resources

Context

Alongside the formal financial system, there exists in most developing countries, and particularly in the poorer countries, a dynamic informal financial sector which undertakes mobilization of savings as well as extension of credit. The existence of this informal sector poses policy challenges to governments, as their activities often do not imply any legal status and, thus, escape regulatory control, whether by the Central sank or fiscal authorities.

Financial dualism affects economic development through the dichotomization of resource accumulation and distribution processes. Sectoral and regional disparities are created with respect to the mobilization and allocation of funds; this results in a growth rate differential between sectors, as their development depends on their access to different sources of credit.

Therefore, it is important to study the functioning and distribution of these informal financial activities, with a view to understanding the complementarities between formal and informal financial sectors and for finding ways and means to link the two sectors, so as to increase the availability of finance for development, while minimizing costs.

It is a well-known fact that the cost of informal finance is often exorbitantly high. Accurate estimates of interest rates on informal markets do not exist; however, there are indications that these rates can be as high as 100 per cent per annum or more.

The informal sector usually makes small loans of very short terms, which in general are more expensive than long-term loans bigger in size. Clients of the informal sector are small or micro-enterprises or poor individuals, who carry higher risks than clients of the formal sector. While the opportunity costs of funds may also be higher for individual money-lenders, however, the transaction cost of lending in the informal sector is lower than in the formal sector, which has to incur high intermediate input and administrative costs, to acquire information about borrowers, to monitor loans and fiscal charges. On balance, then the high interest rate of the informal sector might result more from the monopoly position of informal lenders, because small borrowers seldom have other alternatives.

Despite the absence of any regulatory framework and the minimum collateral requirements, the informal sector exhibits lower default rates. Closer screening of applicants and stricter monitoring of loans may explain this result. The proximity of residence and work place of lenders and borrowers may enable the former to obtain information on the true financial situation of their clients and to monitor continuously their whereabouts and business activities. Pressure by other members of the community ("peer pressure") on bad payers to force them to pay in order to preserve the creditworthiness of the community is also effective in exerting discipline on debtors.

Claim

The informal financial sector - often characterized by flexibility and speed, but also by high costs of transactions - responds to the needs of those segments of the population excluded from the formal sector or wishing to take advantage of the services offered by the informal sector. Thus, its clientele includes people who do not have access to formal finance because of their low level of income, those who do have access to formal sources but nevertheless seek to supplement bank loans with informal borrowing or to take advantage of the speed of delivery of informal credit or to better integrate themselves into their community. By and large, SMEs, and particularly micro-enterprises, form the core of this clientele. Small borrowers or new borrowers proposing risky ventures or possessing few assets to offer as collateral or for whom speed of credit delivery is essential have recourse to informal sources of finance.