tions
Despite the fact that several financial reforms have facilitated the diffusion of formal credit institutions in developing countries, we still observe the persistence of both formal and informal credit sectors in the same areas. This section aims to explain how the coexistence of formal and informal credit institutions occurs. The literature typically focuses on two research areas, the “spillover” or “residuality” theory and the market segmentation theory. Whilst an overview of both theories will be given, this thesis specifically tests the former theory.
2.7.1 The “residuality approach” or “spillover theory”
The so-called “residuality approach” or “spillover theory” maintains that the infor- mal sector exists to satisfy the unmet demand for credit resulting from credit rationing in the formal sector [for example, Banerjee and Duflo, 2001; Bell et al., 1997; Besley, 1994; Bose and Cothren, 1997; Eswaran and Kotwal, 1989].
The spillover theory is linked to the market failure view and compatible both with the Stiglitz and Weiss (1981) and de Meza and Webb (1987) hypotheses outlined in sub-section 2.6.1. Quantity-constraints on banks’ loans, as a result of the lack of col- lateral and of information problems, induce borrowers to resort to the informal sector. This view is based on the assumption that formal institutions are the cheapest available source of credit. Therefore, there is a natural ordering of credit sources whereby a bor- rower who uses secondary sources (informal credit) is assumed to be unable to satisfy his/her financial needs from the primary source (formal credit). The borrower is said to experience credit rationing with regard to the primary source11.
The spillover hypothesis implies that a test of credit rationing is necessary. A direct test of credit rationing has been developed by Diagne (1999) and by Diagne et al. (2000) by using data on the maximum credit limit that the lender is willing to offer. This credit limit is used to detect whether formal credit markets are rationed.
Bell (1990) examined the interactions between institutional and informal credit sources in India. The model shows that, if formal credit is rationed and the informal lender is able to offer a contract which is preferred by the borrower, there is a spillover of demand from the formal to the informal market. This implies that if institutional lenders do not give as much credit as a borrower desires, the borrowers will turn to informal lenders. By using data from the Punjab region in India, Bell (1990) supported the conclusion
of the model. The informal interest rate in equilibrium may be higher than the formal interest rate depending on the default rate, the cost of entry for new moneylenders and, consequently, on the level of competition.
Banerjee and Duflo (2001) showed that an expansion in the availability of bank credit leads to a fall in the firm’s borrowing from the market as long as the bank is the cheapest credit source.
Boucher and Guirkinger (2007) demonstrated that the informal sector is the recipi- ent of the spillover in demand for households with an intermediate level of wealth. The informal sector has the effect of relaxing the formal sector’s quantity-rationing for these households.
2.7.2 Market segmentation
Rather than assuming perfect fungibility of credit (whether it be formal or informal), the second explanation for the coexistence of formal and informal credit sources main- tains that markets are segmented. This means that no single type of credit can meet the needs of potential borrowers, and no single type of credit is accessible to everyone [Hoff and Stiglitz, 1990]. The reason for market segmentation, according to this theory, is not formal quantity-constraints on credit supplies, but the unique characteristics of the formal and informal sectors that inhibit the substituting of one credit source for the other12.
The concept of segmented markets typically refers to the variation in preferences among consumers in different economic strata, for example consumers will use a loan in differing ways [Aryeetey and Udry, 1995; Barslund and Tarp, 2006; Mohieldin and 12Arguably, the spillover of formal credit demand to the informal sector leads to market segmentation.
In this thesis, the author takes the view that market segmentation can itself be a cause, and not a consequence of the coexistence of formal and informal credit. As market segmentation can arise independently of spillover effects, it is separately treated as a theory for the coexistence of formal and informal credit.
Wright, 2000].
Aryeetey and Udry (1995) in their study of Ghana pointed out that “the variation in the types of informal financial units derives from the fact that such units are purpose- oriented”. Mohieldin and Wright (2000) found that in Egypt the formal sector services loans for investment purposes, while the informal sector provides loans to aid consump- tion smoothing. Barslund and Tarp (2006) evidenced that in rural Vietnam formal loans are used almost entirely for production and asset accumulation, while informal loans are used for consumption smoothing.
Market segmentation may also arise as a result of asymmetric information between lenders. Indeed, a lender may have better knowledge about a potential borrower’s cred- itability, or have better access to this information. This kind of information asymmetry may limit competition between lenders and may lead to a monopoly in particular seg- ments of the market.
Social factors affecting the demand and supply of credit may also provoke market segmentation. In line with the cultural or sociological approach previously described, the importance of networks of personal relations and the degree of social capital in a community are factors that contribute to the segmentation of formal and informal credit sources.