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Access to Capital in Rural Thailand: An Estimated Model of Formal vs. Informal Credit

Why do informal credit channels persist, even when formal or quasi-formal microfinance is well-developed, and what does it tell us about the nature of information and transactions costs in SME credit markets? These are the questions addressed by Xavier Giné in his new working paper on access to capital in rural Thailand. To explain the coexistence of borrowing from informal and formal sources, even by the same borrowers, Xavier examines the relative importance of two features:

  1. higher transactions costs to borrow from formal lenders – he finds that it costs on average about $30 to do so, whereas borrowing from an informal lender incurs negligible transactions costs and
  2. limited ability of formal lenders to enforce debt contracts.

A model is presented that embodies these features and implies that formal sources will be used more to finance fixed capital (because it can be used as collateral), informal to finance working capital. In order to estimate the relevant parameters, Xavi uses Townsend’s dataset of 2612 Thai households, comparing the behavior of different households depending on whether they self-finance, borrow only from formal or informal sources, or from both. Interestingly, it is the households who borrow from formal institutions that report they would be able to expand their business profitably, a response which he takes to imply credit constraints. Despite the nonnegligible average transactions costs, Xavi discovers that it is the enforcement problem that is by far the most important in affecting access. Armed with this finding, he points out the policy implications: subsidized lending will help little, but land-titling could be a valuable reform.

Review written by Michael Skully in DevFinance.

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