Formal Versus Informal Finance: Evidence from China

The paper takes a close look at the fast growth of Chinas private sector firms and the financing mechanisms available to them. Despite its banking systems weaknesses, China is one of the fastest growing economies in the world. This suggests that alternate financing and governance systems are supporting this growth. This paper examines firm financing patterns and growth using a database of 2400 Chinese companies. Findings reveal that:

• Few firms use formal bank finance, while a larger number of firms rely on informal sources for funds;
• Formal sector financing is associated with faster growth, while that from the informal sector is not;
• Although firms report bank corruption, it does not appear to significantly affect allocation of credit or performance of firms that receive credit;
• Ability to post collateral is an important determinant of access to bank loans;
• Role of reputation and relationship based financing and governance mechanisms might be overestimated.

Finally, findings suggest that in poor institutional environments, firms have to rely on collateral rather than credit history or growth opportunity to access finance. This underscores the importance of institutions in facilitating firms access to bank finance.