In a dynamic general equilibrium framework with heterogeneous firms, this study analyzes the importance of informal credit markets in financial development and growth. By drawing instances from informal market we show that informal loans reduce the cost of credit constraints under regulated regime for small loans and foster growth by 1.1 percent. This higher growth rate can be attributed to the ability of the informal market to separate the high risk from the low risk firms due to their informational advantage. Following similar principle, we propose an alternative lending mechanism for banks and show that the formal sector can also achieve the same advantage if they follow an incentive based pricing mechanism. We show that an even higher growth path can be achieved by small enterprises when banks distinguish between high and low risk firms and set the price accordingly. With the help of household level data, the quantification of our model for India suggests that revelation of firms' type under our proposed regime can improve growth rate by 1.5 percent as compared to the existing regulated regime.
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Article provided by Department of Economics, Delhi School of Economics in its journal Indian Economic Review.