What is Different about Informal Finance?. Financing of Private Firms in China

In China?s bank-based financial system, in parallel with formal banking institutions, there is a flourishing informal financial market. Informal financial institutions contribute to meeting the ever increasing credit demand of China?s private enterprises that seem to be neglected by the largely state-owned formal banking sector. Private firms would prefer to borrow at lower cost from the formal sector, but in lack of credit history or credit rating they may be rejected. Smaller firms in non-manufacturing sectors and with lower profitability have less chance to obtain formal credit. Formal and informal financial institutions co-exist in China and have different approaches to lending decisions to the private sector. This paper investigates the determinants of the size of formal and informal financing and the conditions of access to formal bank loans across private firms. The result of the empirical analysis suggests that loan officers at formal and informal financial institutions take into account different factors when extending loans. While formal banks focus on past performance of the firm, such as credit rating, previous tax payments and credit history, as well as the size of the firm and manufacturing activities, informal institutions put a relatively higher weight on current operations. The amount of receivables is a very important determinant of the size of the loan extended. Further, informal institutions exploit the information on earlier borrowing from the formal banking sector, suggesting that they may economise on the monitoring costs and that there may be a certain merit of co-existence of formal and informal finance.