The Unofficial Economy and Economic Development

macroeconomics, economy, economic development, formal firms, informal firms, finance

Related Lending

In many countries, banks lend to firms controlled by the bank?s owners. We examine the benefits of related lending using a newly assembled dataset for Mexico. Related lending is prevalent (20% of commercial loans) and takes place on better terms than arm?s-length lending (annual interest rates are 4 percentage points lower). Related loans are 33% more likely to default and, when they do, have lower recovery rates (30% less) than unrelated ones. The evidence supports the view that rather than enhance information sharing, related lending is a manifestation of looting.

The Regulation of Entry

We present new data on the regulation of entry of start-up firms in 75 countries. The data set contains information on the number of procedures, official time, and official cost that a start-up must bear before it can operate legally. The official costs of entry are extremely high in most countries. Countries with heavier regulation of entry have higher corruption and larger unofficial economies, but not better quality of public or private goods. Countries with more democratic and limited governments have fewer entry regulations. The evidence is inconsistent with Pigouvian (helping hand) theories of benevolent regulation, but support the (grabbing hand) view that entry regulation benefits politicians and bureaucrats.

What Moves the Discount on Country Equity Funds?

The paper characterizes several empirical regularities of closed- end fund prices and examines the extent to which a 'sentiment' model of asset prices is consistent with the empirical regularities. We find that after controlling for the effect of cross-border investment restrictions, country funds trade at an average discount. Discounts vary substantially and contribute to a variance in country fund weekly returns which is generally three times greater than the returns on the net asset value (NAV). Regression analysis suggests that discounts have predictive power for fund returns but not for NAV returns, suggesting that investor 'sentiment' is a component of the price of a fund and not its NAV. Estimation of an unobserved components model on the discounts of the funds reveals a significant and strongly persistent common component across fund discounts. Regressions of fund and NAV returns on financial variables reveal that fund prices are 'sticky' with respect to movements in the host country's stock market and overly sensitive to variation in the U.S. and world stock markets. This relation is unaffected when we consider separately funds whose host countries restrict cross-border investment and funds which invest in emerging stock markets.

The Unofficial Economy in Africa

We examine the productivity of informal firms (those that are not registered with the government) in 24 African countries using field work and World Bank firm level data. We find that productivity jumps sharply if we compare small formal firms to informal firms, and rises rapidly with the size of formal firms. Critically, informal firms appear to be qualitatively different than formal firms: they are smaller in size, produce to order, are run by managers with low human capital, do not have access to external finance, do not advertise their products, and sell to largely informal clients for cash. Informal firms thus occupy a very different market niche than formal firms do, and rarely become formal because there is very little demand for their products from the formal sector.

The Unofficial Economy and Economic Development

In developing countries, informal firms (those that are not registered with the government) account for about half of all economic activity. We consider three broad views of the role of such firms in economic development. According to the romantic view, these firms would become the engine of economic growth if not stopped by government regulation. According to the parasite view, informal firms, by avoiding taxes and regulations, unfairly compete with the more efficient formal firms and, by taking away their market share, undermine economic progress. According to the dual view, informal firms are highly inefficient, do not pose much threat to the formal firms, but also do not contribute to economic growth, which is driven by the efficient formal firms. Using data from World Bank firm level surveys, we find that informal firms are small and extremely unproductive, compared even to the small formal firms, and especially relative to the larger formal firms. Compared to the informal firms, formal ones are run by much better educated managers. As a consequence, they use more capital, have different customers, market their products, and use more external finance. Hardly any formal firms had ever operated informally. This evidence is inconsistent with the romantic and parasite views, but supports the dual view. In this "Walmart" theory of economic development, growth comes from the creation of the highly productive formal firms. Informal firms keep millions of people alive, but disappear over time.

Investor Protection: Origins, Consequences, and Reform

Recent research has documented large differences between countries in ownership concentration in publicly traded firms, in the breadth and depth of capital markets, in dividend policies, and in the access of firms to external finance. We suggest that there is a common element to the explanations of these differences, namely how well investors, both shareholders and creditors, are protected by law from expropriation by the managers and controlling shareholders of firms. We describe the differences in laws and the effectiveness of their enforcement across countries, discuss the possible origins of these differences, summarize their consequences, and assess potential strategies of corporate governance reform. We argue that the legal approach is a more fruitful way to understand corporate governance and its reform than the conventional distinction between bank-centered and market-centered financial systems.

Courts: The Lex Mundi Project

In cooperation with Lex Mundi member law firms in 109 countries, we measure and describe the exact procedures used by litigants and courts to evict a tenant for non-payment of rent and to collect a bounced check. We use these data to construct an index of procedural formalism of dispute resolution for each country. We find that such formalism is systematically greater in civil than in common law countries. Moreover, procedural formalism is associated with higher expected duration of judicial proceedings, more corruption, less consistency, less honesty, less fairness in judicial decisions, and inferior access to justice. These results suggest that legal transplantation may have led to an inefficiently high level of procedural formalism, particularly in developing countries.

Courts: the Lex Mundi Project

In cooperation with Lex Mundi member law firms in 109 countries, we measure and describe the exact procedures used by litigants and courts to evict a tenant for non-payment of rent and to collect a bounced check. We use these data to construct an index of procedural formalism of dispute resolution for each country. We find that such formalism is systematically greater in civil than in common law countries. Moreover, procedural formalism is associated with higher expected duration of judicial proceedings, more corruption, less consistency, less honesty, less fairness in judicial decisions, and inferior access to justice. These results suggest that legal transplantation may have led to an inefficiently high level of procedural formalism, particularly in developing countries.