VoxEU Column Development Financial Markets

Informal or formal financing: First evidence on co-funding of Chinese firms

Non-bank financing originating in the shadow banking system has increasingly become an issue for policymakers. This column argues that informal financing has, in fact, been an essential element of corporate performance in China. Through reviewing the interaction between informal and formal financing, evidence suggests that informal financing simultaneously granted with formal financing (co-funding) is helpful for growth, especially for small firms.

The credit squeeze in June 2013 has triggered policymakers’ concern worldwide about a potential debt crisis in China, while at the same time the Chinese government has moved to crack down on undisciplined lending in order to alleviate the debt-bubble fears emanating from the shadow banking system.1 

Shadow banks in China consist of trust companies, insurance firms, leasing companies, pawnbrokers, and other informal lenders which are subject to only limited financial regulation. While the formal (bank) financing is often claimed to be the main engine for economic growth (Ayyagari, Demirgüç-Kunt and Maksimovic 2010), researchers find that the informal financial market may be better than formal banking market in supporting firm growth in China (Allen and Qian 2010).

The informal financiers emerge as alternative financing sources for firms when bank financing is difficult to obtain. However, the informal financiers (family members, friends, moneylenders, and loan sharks) may not only compete with the banks for borrowers, but also complement the banks in financing the Chinese firms.

Ever since the global financial crisis, the reform in the financial market has increasingly become a strategy to sustain the high economic growth in China. As a result, the financial liberalisation has been under intensive debate recently by researchers and policymakers, for example with respect to the interest-rate liberalisation.2 Generally speaking, the pros and cons of informal financing are as follows:

  • Small and private firms often refer to informal financing to alleviate liquidity constraints, which may help them grow faster.
  • The government often blames the substantial burdens placed on the borrowers due to the high interest rate of informal financing.

Instead of running a horse race between informal and formal financing, in a recent discussion paper we show that firm growth may be larger when firms are co-funded, i.e. enjoy both informal and formal financing (Degryse, Lu and Ongena 2013). We therefore contribute to this debate by investigating how informal financing interacts with formal financing, which may enhance the growth of firms. Specifically, using a survey dataset of Chinese private firms, we find that informal financing can complement the use of formal financing and help small firms grow faster, while we find no such effect for large firms.

The size of the informal financial market in China

Informal financing accounts for about 28% of the total firm borrowing in China (Li and Hsu 2009), while the self-financing and other sources provide about 80% of the total fixed investment in the country (Figure 1).3 Informal financing is especially important for the small and private firms which face major obstacles in accessing bank financing. In certain regions of China, the informal financial market has become so large that it endangers the stability of the local banking system.4 With the recent credit crunch of banks in China, the informal financial market has become increasingly important for the financing of small and private firms. While the government often represses the informal financial market due to the concern on the soundness of the financial market, the enhancing effect of informal financing is often undervalued by policymakers.

Figure 1. Proportion of financing sources for fixed asset investment in China

Note: 1990–2010, in percentage points. Source: National Bureau of Statistics of China.

Informal versus formal financing

Recent debate often revolves around the relative importance of informal versus formal financing (Ayyagari, Demirgüç-Kunt and Maksimovic 2010). Our analysis is motivated by two competing views as follows:

  • Informal financing enhances the high economic growth of China.

Informal financing is claimed to be an essential source for the Chinese firms due to substantial obstacles in obtaining bank financing. Informal financiers often have better information than banks due to relationship with the borrowers, while they may also have better enforcement tools than banks, e.g. through reputation and coercion. Thus, informal financing may enhance firm growth through providing better screening and monitoring. 

  • Formal financing supports the high economic growth in China.

Formal finance is claimed to be the most important financing source for firm growth. Banks are efficient financial intermediations in the standard literature, providing proper screening and monitoring for borrowers while keeping the interest rate at a low level. As a result, banks can alleviate the credit constraints of firms and help grow faster.

Instead of comparing the importance of informal versus formal financing, we investigate whether informal financing can co-exist with formal financing for the same firm. As informal financiers have an informational advantage over banks, they can help screen the borrowers and complement the use of bank financing. In contrast, formal financing has a lower interest rate than informal financing, which lowers the interest rate of co-funding. As a result, co-funding, especially with a majority proportion of formal financing, may be the best choice for the growth of small firms.

Financing profiles and firm growth

Using a survey dataset of Chinese private firms in 2006, we examine the effect of financing profiles (i.e. no borrowing, borrowing only from informal financing, only from formal financing, and from both types of financing) on the sales growth rate of firms. We obtain the following three main findings:

  • Co-funding is associated with a higher sales growth rate than other financing profiles for small firms.
  • Co-funding with a majority proportion of bank financing (i.e. more than 50%) is associated with a higher sales growth rate for small firms.
  • Informal financing is associated with a higher sales growth rate for small firms.

The above relationship does not exist for large firms, however. Information asymmetries about small firms (e.g. no audited financial reports) makes it more difficult for formal financiers to provide loans, while the informal financiers can employ their information advantage to screen these opaque borrowers. As a result, informal financiers can complement formal financiers in selecting borrowers. Nevertheless, banks have an advantage in the interest rate, which makes co-funding an optimal compromise between the informational and cost advantages. As the informal financing often has a higher interest rate, a majority proportion of bank financing can keep the interest rate at a low level for co-funding firms, which turns out be an optimal financial profile for firm growth.


Our results suggest that informal financing may complement the use of formal financing, so that co-funding can better enhance firm growth. We conclude that the informal credit market should not be simply repressed as it may co-exist with the formal banking system and supports firm growth in a proper way. As the risks in the shadow banking system has not been regulated properly in China, it is high time that the Chinese regulators curtail the risks and channel the non-bank lending into a proper track in order to avoid a debt crisis. Informal financiers could then still continue to be a vital player in the Chinese credit market and sustain the high economic growth.


Allen, Franklin, and Jun Qian (2010), “Comparing Legal and Alternative Institutions in Finance and Commerce” in Heckman, J, Nelson, R (eds.), Global Perspectives of Rule of Law, Routledge, New York, 118-144.

Allen, Franklin, Qian, Jun, and Meijun Qian (2005), “Law, Finance and Economic Growth in China”, Journal of Financial Economics 77, 57-116.

Ayyagari, Meghana, Demirgüç-Kunt, Asli, and Vojislav Maksimovic (2010), “Formal versus Informal Finance: Evidence from China”, The Review of Financial Studies 23(8), 3048-3097.

Degryse, Hans, Lu, Liping, and Steven Ongena (2013), “Informal or Formal Financing? Or Both? First Evidence on the Co-funding of Chinese Firms”, CEPR Discussion Paper 9519.

Li, Jianjun, and Sara Hsu (2009), Informal Finance in China: American and Chinese Perspectives, Oxford University Press, New York.

1 See the Wall Street Journal for the recent credit crunch in the inter-bank market in China: http://online.wsj.com/article/SB10001424127887324021104578552891506605904.html and also for a survey of the shadow banking system in China: http://online.wsj.com/article/SB10001424127887324637504578563570021019506.html.

2 See the Wall Street Journal for the lift of interest-rate floor by the central bank: http://online.wsj.com/article/SB10001424127887324448104578615430573714510.html.

3 The shadow banking system has been growing at 34% per year for the last couple of years, and the total assets has reached 34% of outstanding bank loans and 44% of GDP at the end of 2012, see the Wall Street Journal for more:

4 See The Economist for a survey of the financial market of the city of Wenzhou which is famous for its highly developed informal credit market: http://www.economist.com/node/21533412.

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