From Financial Development to Informality : A Causal Link

Financial development reduces the cost of accessing external financing and thus incentivizesinvestment in higher-productivity projects that allow firms to expand to the scale needed to operate in the formaleconomy. It also encourages participants of the informal sector to join the formal sector to gain access to creditand financial services. This paper documents two findings. First, countries with less pervasive informality areassociated with greater financial development. Second, the impact of financial development, and especially bankingsector development, on informality is causal. This causal link is established using a novel instrumental variable fordomestic financial development: financial development in other (neighboring) countries. The causal link betweeninformality and financial development is stronger in countries with greater trade openness and capital accountopenness. The findings are robust to alternative specifications.