Working Paper: CEPR ID: DP17565
Authors: Salvatore Capasso; Franziska Ohsorge; Shu Yu
Abstract: Financial development reduces the cost of accessing external financing and thus incentivizes investment in higher-productivity projects that allow firms to expand to the scale needed to operate in the formal economy. It also encourages participants of the informal sector to join the formal sector to gain access to credit and other financial services. This paper documents two findings. First, countries with less pervasive informality are associated with greater financial development. Second, the impact of financial development, and especially banking sector development, on informality is causal. This causal link is established using a novel instrumental variable for domestic financial development: financial development in other (neighboring) countries. The causal link between informality and financial development is stronger in countries with greater trade openness and capital account openness. The findings are robust to alternative specifications.
Keywords: Informal economy; Financial development; Cross-border financial integration; Emerging market and developing economies
JEL Codes: E26; G20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Greater trade openness (F19) | Financial development (O16) |
| Greater capital account openness (F32) | Financial development (O16) |
| Financial development (O16) | Informality (J46) |
| Financial development in neighboring countries (F65) | Financial development (O16) |