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Monday, 28 April 2008

Informality and Bank Credit...

A new paper provides further evidence that high tax compliance costs and weak legal institutions creates barriers to the access and use of bank credit by informal firms.

Our paper provides empirical evidence of a strong negative association between informality and bank credit. In line with our model, we find that a firm’s reliance on bank credit is positively associated with the quality of the legal environment and is negatively associated with weaknesses in tax administration, as proxied by bribes to tax collectors and the severity of tax administration constraints. By contrast, weaknesses in tax administration are positively associated with the use of informal credit and with the probability that firms self-report the availability of financing as a major obstacle to their operations. Moreover, we find a differential impact of the legal environment and tax administration constraints on access to bank and informal credit by formal and informal firms. In particular, we find that an efficient and well-functioning legal system increases access to bank credit even for financially opaque informal firms while lowering reliance on informal credit by formal firms. Finally, we find that weaknesses in tax administration increase reliance on informal credit by informal firms more significantly than for formal firms.

A very important issue for Zambia. About 69% of Zambians operate in the informal sector. Agriculture accounting for the largest share at 87%. Its widely accepted that apart from reducing government revenue, informality discourages firm performance and reduces firm growth and innovation. If we are going to make progress in this area, we need to do more than just subsidise cheaper credit, we also need to alter the incentives that prevent people from using credit markets in the first place. Government policies are needed that reduce tax and regulatory constraints and improve the legal environment (especially in rural areas). This would reduce the incentives for firms to operate informally, both by increasing the benefits of accessing formal credit markets and by reducing the costs of doing business.

25 comments:

  1. This would reduce the incentives for firms to operate informally, both by increasing the benefits of accessing formal credit markets and by reducing the costs of doing business.

    which would in return, broaded the tax base and generate government tax revenue.. of the good, non-distorting kind.

    But how do you improve the legal environement ? Is it improving enforcement ? Is it improving the quality of the judicial system ? Or is it improving the law(s) itself ?

    The other day I read about how the lack of formal adresses is one of the constrains that make formality difficult. Do you change that ?

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  2. "But how do you improve the legal environement ? Is it improving enforcement ? Is it improving the quality of the judicial system ? Or is it improving the law(s) itself ?"

    The paper actually construct an additive index which combines three separate questions on the efficiency of the legal system. Businesss where asked to evaluate how the country's courts ENFORCED decisions, whether the courts were HONEST, and whether they were viewed as being FAIR and IMPARTIAL. So in this context, improving the legal environment is mainly about enforcement and being SEEN as impartial.

    I think thats fine, because enforcement and impartiality really are the two problems in Africa. The laws are there, but the judicial system is corrupt! Or may be its just lacking in resources.

    "The other day I read about how the lack of formal adresses is one of the constrains that make formality difficult. Do you change that ?"

    Yes the lack of a post code system in Africa is a problem. It infact presents the viability of a publicly accessible electoral registers. But I wander to what extent this s more of a problem about the incredible mobility of poor temporary workers, than lack of addresses per se? And of course there's the obvious reverse causality...

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  3. I think thats fine, because enforcement and impartiality really are the two problems in Africa. The laws are there, but the judicial system is corrupt! Or may be its just lacking in resources.

    I'm really not sure that the laws are there. Of course there is a lot of variation between and within countries. But the laws themselves could use some improvement. And of course, enforcement and impartiality are nice but as we discussed before, the lack of registration makes it more complicated.
    To put it quite simply: how does a bank know that you really own that company or that piece of land you're using as collateral and that they won't discover that the contract is null and void when they try to repossess it ?

    Yes the lack of a post code system in Africa is a problem. It infact presents the viability of a publicly accessible electoral registers. But I wander to what extent this s more of a problem about the incredible mobility of poor temporary workers, than lack of addresses per se? And of course there's the obvious reverse causality...

    Is it limited to poor temporary workers in Zambia ? In places I've visited, it's a widespread problem.
    I wonder to which extend it's all resolvable by putting some semi-tough incentives in place ? Limiting voting rights to taxpayers for instance ? (that's a pretty nasty solution)

    A few months ago, I was discussing the License Raj with an Indian friend. And as we went we both realized that using licenses was probably the most efficient way to collect taxes at the time. Of course, the system was distorting growth but they didn't have much choice. It made me check the history of tax system and I realized that widespread banking and use of credit preceeded income taxes in most western countries. Between the need to access credit, the emmerging stock market and the limited voting rights, there were strong incentives for individuals and companies to actually keep a papertrail and publish it and declare as much revenue as possible.
    We didn't go through that phase, colonial governments used licencing/export tax system to finance themselves and the post-colonial government could not do without universal franchise.
    So yeah, how do we build an environment where individuals and companies keep a papertrail and the legal environment protects their rights ?

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  4. Cho,

    Glad you are coming over to see things my way. :)

    How about a nationwide 'free enterprise zone' for all Zambian owned MSMEs?

    Its well acceptable that apart from reducing government revenue, informality discourages firm performance and reduces firm growth and innovation.

    It certainly eliminates access to so-called traditional sources of financing, including the equities markets. And access to education for entrepreneurs and employees.

    If we are going to make progress in this area, we need to do more than just subsidise cheaper credit, we also need to alter the incentives that prevent people from using credit markets in the first place.

    I completely agree. Also, there should be forms of finance that are tailored to SMEs. Low interest loans, non-interest loans (as in Islamic banking), grants, better organisation for angel capital.

    At the same time, as SMEs are the major source of employment, the government could create tax exemptions for them, the way they did for the mining companies through the development agreements.

    Legislatively, there could be a nationwide registry for companies, so every entrepreneur has an ID. This would make it easier to track fraudsters and individuals with bad credit. Which would increase the banking sector's confidence, leading to lower interest rates. In fact, a national credit registry wouldn't be bad.

    Government policies are needed that reduce tax and regulatory constraints and improve the legal environment (especially in rural areas).

    I completely agree. The problem has been that in true neoliberal style, this government has shifted the tax burdon from businesses to the workers.

    I think the mines should be heavily taxed, while indigenous business should be very lightly taxed, if at all.

    This would reduce the incentives for firms to operate informally, both by increasing the benefits of accessing formal credit markets and by reducing the costs of doing business.

    At the same time, the government could be proactive in it's approach to SMEs. It could set up more business and agricultural schools, business incubators, set up a mentoring system using existing entrepreneurs to transmit their skills and knowledge.

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  5. I completely agree. Also, there should be forms of finance that are tailored to SMEs. Low interest loans, non-interest loans (as in Islamic banking), grants, better organisation for angel capital.

    That's subsidising cheaper credit.

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  6. Random,

    " To put it quite simply: how does a bank know that you really own that company or that piece of land you're using as collateral and that they won't discover that the contract is null and void when they try to repossess it ?"

    The problem is that this does not disappear with registration! The problem as I pointed previously is that even with registration the law courts are often slow to enforce the Bank's claims.

    "Is it limited to poor temporary workers in Zambia ? In places I've visited, it's a widespread problem."

    Its not "limited" to the poor workers, but arguably its much more of the problem for them and society as a whole. After all it’s the very poor that we want to empower. Incidentally temporary workers already show the desire to be empowered hence the risks they take, it suggests to me they represent a fertile bunch we should be helping!

    "Limiting voting rights to taxpayers for instance ? (that's a pretty nasty solution)"

    Solving one problem by creating another!

    "It made me check the history of tax system and I realized that widespread banking and use of credit preceeded income taxes in most western countries."

    Reading around South African history, we see the same trend during the gold and diamond rush. The incentive to keep record was there since they all had to source money from European bankers like the Rothschild etc.

    "So yeah, how do we build an environment where individuals and companies keep a papertrail and the legal environment protects their rights ?"

    Isn't the simple, but contraversial answer to this question simply to introduce a credit reference bureau? Zambia has recently introduced one, but apparently the Banks appear less interested in supplying information and actually using the system! You would have thought the incentives are there fore the banks but apparently not!

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  7. MrK,

    "Legislatively, there could be a nationwide registry for companies, so every entrepreneur has an ID. This would make it easier to track fraudsters and individuals with bad credit. Which would increase the banking sector's confidence, leading to lower interest rates. In fact, a national credit registry wouldn't be bad"

    I agree this would be an interesting idea. As I noted in my exchange to Random Zambian now has a credit burea - [see the latest report from the BOZ], unfortunately it appears to be struggling.

    The problem with CRB is that they penalise the very people they are meant to be helping. I would actually link the system to "national registration card" numbers so that people can be tracked across boundaries. In Europe however, such information would be considered too sensitive to be passed to third parties such as CRB.

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  8. The problem is that this does not disappear with registration! The problem as I pointed previously is that even with registration the law courts are often slow to enforce the Bank's claims.

    They're all problems. You have to have registration, enforcement and laws. Without any of them the system fails. And as it stands, most of the time, there's none of them.

    Its not "limited" to the poor workers, but arguably its much more of the problem for them and society as a whole. After all it’s the very poor that we want to empower. Incidentally temporary workers already show the desire to be empowered hence the risks they take, it suggests to me they represent a fertile bunch we should be helping!

    Not necessarily. The entrepreneurs who would establish successful business that would generate employment and growth will most likely not be found among the poorest. (although some may be).
    As we're discussing access to bank credit and innovation and performance, the goal is not to directly empower the poorest but to empower the people who will hire the poorest, right ?

    I don't really buy the whole idea behind microcredit and micro-entreprises. Sure it alleviates a lot of pain, but it doesn't produce growth and jobs and really can't.

    Isn't the simple, but contraversial answer to this question simply to introduce a credit reference bureau? Zambia has recently introduced one, but apparently the Banks appear less interested in supplying information and actually using the system! You would have thought the incentives are there fore the banks but apparently not!

    How does the credit bureau work ? What the incentives are ? Are the banks, the ones that are supposed to report ?

    There can be lots of different reasons why they're not interested in supplying the system. And I'm sure you can think of even more.
    Do the banks really want to publish the discounted rates they give to politically-connected clients ? Do the banks really want the high interest rate they charge to the State and State-owned ventures to be known (especially if it connects with the low interest rate individuals got as part of the deal) ? etc..etc..


    "Limiting voting rights to taxpayers for instance ? (that's a pretty nasty solution)"

Solving one problem by creating another!


    Not if filling a tax declaration instead of actually being taxable is a requirement.
    But there are alternatives.
    For instance, only people who have filled for their taxes get the stimulus check this year in the US. One can imagine goodies that would make people want to at least get into the system (and punitions for those who don't).

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  9. Cho,

    Isn't the simple, but contraversial answer to this question simply to introduce a credit reference bureau? Zambia has recently introduced one, but apparently the Banks appear less interested in supplying information and actually using the system! You would have thought the incentives are there fore the banks but apparently not!

    So what is going on with the banks?

    Chibamba Kanyama has claimed that there is 'an invisible cartel' that exists concerning the banking sector.

    "Only a few selected clients access these funds and at rates much lower than what is available to everyone,” he said.

    Kanyama wondered whether Zambia’s economy would ever grow with such a small number of players participating in the economy.


    There is something going on. With inflation below 10%, you would expect interest rates to follow inflation down to single digits too.

    Could it be that politicians and their corporate friends have monopolized the banking system?

    Could the banks be holding interest rates artificially high in order to control the economy and keep competition down?


    http://maravi.blogspot.com/2007/10/makungu-attributes-low-interest-rates.html

    Several banks have reduced interest rates from over 40 per cent to below 20 per cent and the rate of inflation currently stands at 10.7 per ecnt.

    The EAZ stated that shortage of capital to finance and expand businesses in Zambia had been the major obstacle stifling economic growth.

    “The big banks have played the role of influencer in issues of interest rates and they have refused to reduce even when inflation rates went down and also when Felix Mutati was deputy at finance ministry, he used every fora to plead for the reduction of base rates but to no avail,” it stated.

    “So one has to believe that there has been an invisible cartel among these banks which ZNCB has literally broken down and it seems this is the only solution that will work since the rest of the banks will follow.”

    The EAZ observed that about 75 per cent of all businesses in the country fail to take off because of high capital costs offered by commercial banks.

    “There is a lot of viable business plans in the country and almost every sector needs capital injection for expansion but high costs of capital offered by these banks is stifling the intended economic growth and we hope this reduction of base rates will improve things,” it stated. “And owing to these high costs companies literally work for banks to liquidate the high interest loans and given this scenario no economy can grow.”


    So why aren't there low or zero percent interest rates for SMEs?

    Perhaps Islamic banking is the option, where the borrower pays no interest rates at all (charging interest being illegal in Islam), but instead pays part of the profits to the borrower. Meanwhile, the lender can park the repayments in banks that do pay interest.

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  10. First of all, if the inflation is 10%, don't expect single digit interest rates, that wouldn't make any sense.

    But you're probably right, there are things going on that explain why the real interest rate is around 10%.

    You may want to look at the savings rate, see how much money is there to lend to start with and see what kind of interest rates banks offer to attract savings.
    Then you may look at how much of that money is lended to the government itself (through buying securities for instance).
    Then you may look at how much of that money is lended at artificially low rates to politically connected people, probably in exchange for the governments loans.
    Then, you may want to look at transaction costs, the level of risk involved with lending to new clients, the information assymetries between banks and loan-seekers, and a few other things and I bet you'll find out why there's no zero interest rate loans for SMEs.

    No need for conspiracy theories and cartels who want to stiffle growth.

    Nothing proves islamic banks would cost less. Interest rate, equity or fees are just words for cost of money.

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  11. “You have to have registration, enforcement and laws. Without any of them the system fails.”

    I agree. They all need to be present at once to reap full benefits. But “laws” are incremental, and respond to changing circumstances. So I would have “registration and enforcement” as crucial priors to success.

    ”As we're discussing access to bank credit and innovation and performance, the goal is not to directly empower the poorest but to empower the people who will hire the poorest, right ?”

    Yes, lending to the entrepreneur helps empower the people who will hire the poorest, but equally so does widening credit to the people at the bottom. It will create demand for goods and services, etc that will ultimately benefit the roving entrepreneur. I think this is really an empirical question rather than a theoretical one. Do we really have a theoretical basis for believing that widening credit to a firm that employs 10 people is better than widening credit to a 5 firms that employs 2 each?

    ”How does the credit bureau work ? What the incentives are ? Are the banks, the ones that are supposed to report ?”
    According to BOZ, the system was launched in February by Credit Reference Bureau Africa Limited, which installed software and connected at 10 commercial banks. Apparently so far only 4 can actually use the system as they are the only banks that have paid as the system operates on a prepaid basis. The idea is for banks to provide information to the CRB, and then use the information from the CRB as the basis for making credit decisions on customers. I think the reasons is just that CRB may be costly as a basis for providing credit in rural areas. It may be useful for larger loans, but probably not for small ones.

    ”For instance, only people who have filled for their taxes get the stimulus check this year in the US. One can imagine goodies that would make people want to at least get into the system (and punitions for those who don't).”

    I generally prefer positive incentives, rather than punitive ones which restrict existing choices :)

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  12. So I would have “registration and enforcement” as crucial priors to success.

    Agreed.

    Yes, lending to the entrepreneur helps empower the people who will hire the poorest, but equally so does widening credit to the people at the bottom. It will create demand for goods and services, etc that will ultimately benefit the roving entrepreneur.

    hmmm.. Consumer credit ? I don't know.
    We all know that demand shocks only create supply in certain circumstances. Otherwise, it's either inflation or rising imports, or both.

    I think this is really an empirical question rather than a theoretical one. Do we really have a theoretical basis for believing that widening credit to a firm that employs 10 people is better than widening credit to a 5 firms that employs 2 each?

    Hmmm.. Capital investment ?
    Of course, it's not exactly a matter of size but if we want growth, it could be a good idea to loan money for productive investments.

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  13. "We all know that demand shocks only create supply in certain circumstances. Otherwise, it's either inflation or rising imports, or both."

    I assume you assuming there's full employment? Which as you know is not the case in developing nations.

    "Hmmm.. Capital investment ?"

    That again is an empirical question since it will vary sector by sector :)

    "Of course, it's not exactly a matter of size but if we want growth, it could be a good idea to loan money for productive investments"

    I agree, but that goal can be achieved without tackling informality!

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  14. I assume you assuming there's full employment? Which as you know is not the case in developing nations.

    No, I'm assuming there has to be some unused capacity or at least some elasticity in the supply which there isn't for a bunch of reasons.


    I agree, but that goal can be achieved without tackling informality!

    Oh we're in a total agrement on that one.
    I'm really wondering how it could be tackled though.

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  15. "No, I'm assuming there has to be some unused capacity or at least some elasticity in the supply which there isn't for a bunch of reasons."

    Thats the same as assuming the economy is operating at full employment :)

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  16. Thats the same as assuming the economy is operating at full employment :)

    Is it ?

    http://delong.typepad.com/sdj/2008/04/delong-and-eich.html

    ^^^ that's one of the danger with subsidizing consumption that I had in mind.

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  17. I'll take a look at what De Long is saying...never been a reader of anything De Long writes :)

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  18. On the question of enforcement and laws..this World Bank paper on "When Do Creditor Rights Work"? strongly suggests that creditor rights and bank credits are stronger with more efficient legal systems.

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  19. The abstract of the paper says:


    "The analysis finds that firms have more access to
    bank credit in countries with better creditor rights, but
    the association between creditor rights and bank credit
    is much weaker in countries with inefficient courts.
    Exploiting the panel dimension of the data and the fact
    that creditor rights change over time, the authors show
    that the effect of a change in creditor rights on change
    in bank credit increases with court enforcement. In
    particular, a unit increase in the creditor rights index
    will increase the share of bank loans in firm investment
    by 27 percent in a country at the 10th percentile of the
    enforcement time distribution (Lithuania). However,
    the increase will be only 7 percent in a country at the
    80th percentile of this distribution (Kyrgyzstan). Legal
    protections of creditors and efficient courts are strong
    complements."


    Which implies that better enforcement have a multiplier effect, making improvements in Creditor Rights result in stronger credit access.

    We still don't disagree, lol.

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  20. Well its true "creditor rights" have to be there in the first place! The question is the "minimum requirements" before the "efficiency of the courts" imperative kicks in...

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  21. For political reasons, it may actually be a good idea to improve the enforcement first.

    Creditor Rights reforms are usually quite unpopular unless there are fast results, you end up with someone winning the election by arguing that those reforms are designed to exploit the people.

    Enforcement takes a long time to be improve while the law takes a day.

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  22. Of course we always have to treat these studies with caution. Proving strong association does not mean anything.

    But the paper aside, improving the efficiency of local courts is an expensive undertaking. You have to reduce corruption in the local courts etc. That would require introducing strong incentives there as well e.g. effective monitoring requirement, better recruitment, transparency, better wages etc.

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  23. But the paper aside, improving the efficiency of local courts is an expensive undertaking. You have to reduce corruption in the local courts etc. That would require introducing strong incentives there as well e.g. effective monitoring requirement, better recruitment, transparency, better wages etc.

    And most importantly it takes time.. a lot of time

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  24. I also think the court probably has unique sets of issues that makes it more difficult to tackle corruption. I mean it is not as simple as setting up a monitoring arrangements. You need harmonisation of standards etc. Its a mess, especially in rural areas. Monitoring must be challenging. Randomised monitoring may be the way forward if a way can be found for judging where corruption has taken place. But its very difficult.

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