Can Informal Firms Hurt Registered SMEs’ Access to Credit?

Using firm-level survey responses from 2009 to 2012, we examine whether competitors from the informal sector affect the credit constraints of registered SMEs in 86 countries worldwide. We also investigate the role played by the quality of institutional environment in exacerbating or in alleviating such effect. A weak quality of institutional environment strengthens inter-linkages between the formal and the informal sectors, increases the costs and decreases the benefits assumed by formal firms, and reduces the costs attributed to informality. Moreover, it also results in a large informal economy, which influences perceptions about the substitutability between formal and informal goods, and law evasion. Our findings indicate that registered SMEs facing competition from informal firms are more likely to be credit-constrained than other formal SMEs that are not confronted with such competition. This result is consistent with the “parasite” view and the entrepreneurial perspective of informality, which assert that informal firms are capable of competing against registered SMEs and hurting the latter’s profits. Further, we find that such adverse impact manifests only in countries with weak rule of law and high degree of corruption and bureaucracy. Our results also show that registered micro and small firms are more likely to be affected by the presence of informal firm competitors than medium-sized firms. This is because the benefits of formality that include access to credit from financial institutions, increase with firm size. On the whole, our findings suggest that governments must enhance their role in increasing access to credit to smaller firms and in providing incentives for informal firms to be integrated in the formal economy. Moreover, in order to achieve inclusive growth, our results highlight the importance of improving the business environment, which affects all entrepreneurs.