The role of formal and informal finance in the informal sector in Ghana

Abstract

Within the developing world, especially Sub-Saharan Africa (SSA), informal (small and medium) enterprises’ (SMEs) access to financing has been extremely limited mainly because of the reluctance of banks and other formal financial institutions to lend to such firms. The impact of this challenge on their growth trajectory has remained relatively indeterminate. This study examines the differential impact of sources of finance on the growth of informal firms in Ghana. We employ the Heckman Selection Technique (HST) to model the selection process of firm financing choices and reverse causality problem. By making use of the World Bank’s enterprise survey data on 720 informal firms in Ghana from 2007 – 2010, we find that formal sources of finance, compared to informal sources, are superior in their impact on firms in Ghana. Formal finance institutions, with their ability to provide more than just finance, positively affect firm growth. This result has an important policy implication for the current focus of Government of Ghana in promoting indigenous entrepreneurship through initiatives that will enhance access to financial support of local enterprises in Ghana. In view of this, this study proposes that Government policy towards formal financing institutions and their lending to informal sector need adjustments to provide incentives that will encourage increased lending to informal firms.

RÉSUMÉ

Dans le monde en développement, en particulier en Afrique subsaharienne, l’accès des petites et moyennes entreprises (PME) informelles au financement a été extrêmement limité, principalement en raison de la réticence des banques et des autres institutions financières formelles à prêter à ces entreprises. L’impact de cette difficulté sur la trajectoire de croissance de ces PME est resté relativement indéterminé. Cette étude examine l’impact différentiel des sources de financement sur la croissance des entreprises informelles au Ghana. Les institutions financières formelles, avec leur capacité à fournir plus qu’un simple financement, ont un effet positif sur la croissance des entreprises. Ce résultat a une implication politique importante pour la priorité actuelle du gouvernement dans la promotion de l’entrepreneuriat indigène par des initiatives qui amélioreront l’accès au soutien financier des entreprises locales au Ghana. En outre, la politique gouvernementale vis-à-vis des institutions formelles de financement et de leurs prêts au secteur informel devra faire l’objet d’ajustements pour fournir les incitations nécessaires à l’augmentation des prêts aux entreprises informelles.

Keywords:

• Ghana
• firm growth
• formal finance
• informal finance
• informal firms

Mots-clés:

• Ghana
• croissance des entreprises
• financement formel
• financement informel
• entreprises informelles

Acknowledgment

We will like to acknowledge funding from International Growth Centre funded by DFID.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 According to the GSS (2008), 31 percent of Ghanaians who are 15 years and above have never attended school, 55.7 percent have basic education while only 13.6 percent have secondary education or higher.

2 Levine 2005 provides a survey of the different theoretical and empirical evidence provided to examine the relationship between financial development and growth.

3 Informal firms cover firms that are not legal or partly legal. Such firms have not registered their business or have registration for some parts of the business (Arias et al. 2007)

4 The manufacturing sector includes food products, beverage, wearing apparel, leather products, furniture and metal products, household (consumer) products, and other manufacturing. The service sector includes communication services, professional services, household services and food and beverage services, selling of wearing apparel services, selling of other goods.

5 The 8 factors identified by the firms were limited access to finance, limited access to land, corruption, crime, problems with electricity supply, problems with water supply, limited access to technology, inadequately educated workforce. Out these 8, limited access to finance, problems with electricity supply and limited access to land were the 3 highest factors indicated by the firms.

6 Out of 729 firms, 314 firms (53%) indicated finance as a constraint and 278 (49%) indicated finance was not a constraint. The other 137 firms had no response for these questions.

7 Informal finance captures financing from family and friends. Bank finance covers financing from commercial banks. Internal finance is finance through retained earnings from the business; operational finance is finance from suppliers and customer trade credit, money lenders is finance from business and individuals predominantly of the Money Lenders Association, Ghana, micro financing is finance from small size institutions.

8 Following Zingales and Kaplan (2000) Firm size is determined by using the average cost of labour.

9 We did similar analysis of firm financing across Ownership, firm age and educational level of the largest owner.

10 We follow a similar approach by Allen, Qian, and Qian 2005, Ayyagari, Demirgüç-Kunt, and Maksimovic 2010.

11 Because the survey covers only informal firms, the data are dominated by sole proprietor and partnerships.

12 Primarily, the largest owner has the greatest influence on decision making in the business.

13 See Asamoah and Doe (2014) for a study on power fluctuations on SME’s profitability.

14 All columns of the results table were significant at 1% except column 3 which was significant at 10%. We attribute this to the loss of sample due to missing data for the average sales variable.

15 In a paper by Beck, Demirgüç-Kunt, and Maksimovic (2006), they showed how the impact of legal and financial constraints on firm growth depended heavily on firm size. Small firms were greatly constrained by such problems.

16 We estimated this for the other two bank financing variables (Bank Dummy and Investment Finance Dummy) and the results were similar to those of tables 5 and 6. However, in the case of the Investment Finance Dummy, the instrument did not pass the test of weak instrument. First stage results can be found in the Appendix.

17 Collateral is represented by a variable that measures collateral requirement for loan. It captures both personal and physical guarantees required to qualify for a loan.

18 Almost all the control variables had the right signs and are significant.

19 See Li and Prabhala (2007) for a summary and examples of other studies that apply the selection model to control for the impact of selection bias on the coefficient estimates.

20 We estimate the selection model using the bank dummy and investment finance dummy variable and results were still consistent.

21 See Cheng and Degryse (2010), Fan and Wang (2005) for similar results on bank financing and firm growth.

Additional information

Notes on contributors

Festus Ebo Turkson

Festus Ebo Turkson holds a PhD in Economics and researcher with particular focus on International Trade and Development, International Macroeconomics, Financial and Industrial Economics, Applied Microeconometrics, and Policy Analysis. He is currently a senior lecturer in the department of Economics at the University of Ghana. He has several publications in different journals and reviewer for several journals. He is a principal researcher of The Employment Effects of Different Development Policy Instruments: The Case of Ghana- Swiss Programme for Research on Global Issues for Development –A collaboration with the World Trade Institute, University of Genève, Switzerland; WITS University, South Africa etc. (funding from Swiss Science Foundation and Swiss Agency for Development and Cooperation). He is also a co-investigator of “Financing the Growth and Transformation of SMEs in Africa: What are the Constraints to SME Financing within ECOWAS?” An AERC Financial Sector Project, African Economic Research Consortium (AERC) based in Nairobi- Kenya.

Emmanuel Amissah

Emmanuel Amissah holds a PhD in Economics from the University of Nottingham and currently a senior lecturer at the Nottingham Trent University. He is also currently a peer review member of the ESRC’s Global Challenges Research Fund (GCRF) administering £1.5 billion funding stream for different project for the duration of five-year. He was a principal investigator of two International Growth Center -DFID projects worth £12,000. He is a member of the Leverhulme Centre for Research on Globalisation and Economic Policy (GEP) based in the University of Nottingham. He has a publications in the World Economy Journal, and Modern Economy journal and working papers in highly placed centers such as Center for Economic Studies (CES) in Europe. He is current an associate editor of the Economic Issues journal. He is also a reviewer for the World Economy Journal, Modern Economy Journal, Economic Issues Journal and Journal of Small Business and Entrepreneurship. His research interest is the area of development finance.

Agyapomaa Gyeke-Dako

Agyapomaa Gyeke-Dako has a PhD in Financial and Development Economics from the University of Nottingham (U.K). She is currently a lecturer at the University of Ghana Business School. Prior to her joining the University of Ghana Business School, she worked with Durham Business School (UK) as a Teaching Fellow for three years, lecturing in various courses. She has published in the University of Peking Press. She is also now a co-researcher on a collaborative research with the World Trade Institute, University of Geneva and WITS University South Africa (Funding from Swizz Science Foundation and Swizz Agency for Development and Co-operation). She is in addition working on a project funded by the International Growth Centre. She has been affiliated with the Leverhulme Centre for Research on Globalisation and Economic Policy (GEP) and the Chinese Economic Association (CEA) and is also a reviewer in Thunderbird International Business Review. Her research interest is in the area of Financial and Development Economics.