Interaction between the formal and informal financial sectors: The Asian experience

The nature of the interaction between the formal and informal financial sectors in developing countries is a subject with important policy implications. It has implications for the future of informal finance as the formal sector expands in the long term—will the informal sector wither away, as the traditional view of financial dualism assumes, or will it continue to play an important complementary role, perhaps even growing in absolute size? Second, the pattern of two major policy approaches often advocated toward the informal sector—offering it stronger competition so as to induce it to improve its terms, and promoting linkages with it so as to take advantage of its lower transactions costs in reaching smaller and poorer borrowers. Third, the existence of a large informal sector has implications for the efficacy of monetary and credit policy in achieving stabilization objectives. Fourth, the interaction between the formal and informal financial sectors also has implications for the effects of financial liberalization through removing restrictions on the deposit rate of interest. This paper draws on the experience of Asian countries to address these issues.