Informal Sector and Economic Growth: The Supply of Credit Channel

A standard view holds that removing barriers to entry and improving judicial\ud enforcement would reduce informality and boost investment and growth. We show,\ud however, that this conclusion may not hold in countries with a concentrated bank-\ud ing sector or with low financial openness. When the formal sector becomes larger\ud in those countries, more entrepreneurs become creditworthy and the higher pres-\ud sure in the credit market increases the interest rate. This reduces future capital\ud accumulation. We show some empirical evidence consistent with these predictions