Formal Credit and Informal jobs: Micro evidence from Brazil

1. Formal Credit and Informal jobs: Micro evidence from Brazil Luis Catão Carmen Pagés M. Fernanda Rosales Feb 2009

2. Road Map • Introduction • Prima facie evidence • Econometric results • Links with Productivity (very preliminary) • Conclusion

3. Introduction • Formality is an optimizing decision of firms based on benefits and costs of being formal. • However informality may have important costs for aggregate welfare and productivity. • Increased supply of credit increases opportunity cost of being informal • If given only to formal firms.

4. Introduction II • Brazil is an interesting case to look at because improved macroeconomic conditions have led to a substantial increase in the aggregate supply of credit. • Plus has a rich household survey dataset that has not been used to look at links between formal credit and job informality. • Key question we ask: to what extent increased supply of credit has led to higher formality, controlling for other factors.

5. Introduction III • Increase formality may be driven by: • Informal firms go formal (“within”) • Formal firms that hire informal workers stop doing so and/or formalize existing ones (“within”) • Formal firms expand faster and crowd out informal firms (“between”)

6. Stylized Facts • Macro: Rapid Credit Expansion Lower Interest Rates Huge REER Appreciation • Labor Market: Significant Rise in Formalization Rates (2 definitions) Weak (Labor) Productivity Growth

7. Credit (as % of GDP) has increased substantially since 2004…

8. And interest rates have gone down…

9. Since 2004 formality rates have increasedCarteira-salaried workers

10. Since 2004 formality rates have increasedShare with social security-all workers

11. And this took place amidst strong currency appreciation which shifts resources to non-tradables where informality is deemed higher…

12. Formality rates can be decomposed in: Yielding: Within L Between L Within S Between S Where: “L” = >11 employees “M” = between 2 and 11 employees “S” = self-employed

14. Can the increase in credit explain increasing formality rates?

15. Methodology • Examine whether sectors “structurally” more dependent of external financing formalize more when credit becomes more abundant. • Following Rajan and Zingales (1998), we measure external dependency of financing as: FDj=(K invj-cash flowsj)/K invj

16. Methodology • Where c=size categories: (1); (2-10); (10+)

20. Bottom-line of “within” regressions: • Expansion of aggregate formal credit significantly fosters formalization within each size category. • The results are robust to the alternative definitions of formalization. • Effects are much stronger for “middle-sized” and “larger” firms [consistent with the unconditional decomposition exercise of Table 1]. • Results also robust without breaking by size (log spec.): e is higher the lower F/E, so stronger for smaller caps.

23. Bottom-Line of Between Regressions • Greater credit availability tends to shrink the self-employment in the size distribution • Since much of the self-employment business is informal, this helps lower aggregate informality. • Conversely, the shares of upper sizes are boosted. • In particular, effect more significant among larger firms. • This may mean that credit allows firms to expand into higher size segments but we can’t test that with this dataset with no information on gross flows.

24. Link with Productivity [very preliminary] • Greater availability of formal credit facilitates entry and growth of smaller firms. • To the extent that these firms have a lower ratio of capital to labor, aggregate labor productivity is dragged down. • All the analysis here is from PIA which only covers industry and excludes informal firms. • And eliminates most firms with <30 employees

29. Conclusions • Highly imperfect credit markets seem to be a factor behind high informality rates. • The evidence suggests that improved access to credit has led to higher formalization. • Much of reduction of informality takes place via “within” effects: holding relative sector size constant, firms within each sector have an incentive to formalize their employees as credit becomes more abundant.

30. But also some evidence of a significant between effect – i.e. crowding out of self-owned firms by larger formal firms and faster expansion of the largest size segment during the credit boom period 2004-2007. • This is consistent with self-owned firms dying out and/or simply becoming bigger and moving to the larger size segment. • The same applies to the middle segment, which does not expand relatively much.

31. This is not necessarily with inconsistent with a literature on credit constraints and firm size (Bernanke et al, 1995), since our larger size category (>11) still encompasses a number of small firms. • And what is typically meant “large” in a LA context is small on a world scale (Herrera and Lora, 2003). • Alas, the PNAD does not allow a less coarse size breakdown, nor to look at gross entry/exit.

32. So, using alternative data sources to gauge the size composition effects of financial deepening is left for future research. • In any event, to the extent that wider credit access and formalization boost long-run productivity, our findings suggest that financial deepening can have far-reaching effects on long-term economic growth. • Our findings also highlight the importance of sound macro policies:

33. As you reduce macro volatility and keep inflation stable, this boosts credit supply, lower risk and hence interest spreads, thus fostering formality. • So, there is clear a link between informality, productivity and macroeconomic policy that is typically overlooked in the macro literature and policy debate. • Yet, such a positive association between credit and (labor) productivity may be tempered in the short-run.

34. This is because, abundant credit seems to favor the entry of smaller and lower cap firms which typically have lower labor productivity to begin with. • What happens to TFP needs to be documented. • At any rate, to the extent that credit is allocated efficiently, this (-) effect on labor productivity should be gradually overcome in the longer-run. • But this again is a matter for further research.