Formal Credit and Informal jobs: Micro evidence from

Brazil

Luis Catão Carmen Pagés M. Fernanda Rosales

Feb 2009

Road Map

• Introduction• Prima facie evidence• Econometric results• Links with Productivity (very preliminary)• Conclusion

Introduction

• Formality is an optimizing decision of firms based on benefits and costs of being formal.

• However informality may have important costs for aggregate welfare and productivity.

• Increased supply of credit increases opportunity cost of being informal– If given only to formal firms.

Introduction II

• Brazil is an interesting case to look at because improved macroeconomic conditions have led to a substantial increase in the aggregate supply of credit.

• Plus has a rich household survey dataset that has not been used to look at links between formal credit and job informality.

• Key question we ask: to what extent increased supply of credit has led to higher formality, controlling for other factors.

Introduction III

• Increase formality may be driven by:

– Informal firms go formal (“within”)

– Formal firms that hire informal workers stop doing so and/or formalize existing ones (“within”)

– Formal firms expand faster and crowd out informal firms (“between”)

• Macro: Rapid Credit Expansion

Lower Interest Rates Huge REER Appreciation

• Labor Market: Significant Rise in Formalization Rates

(2 definitions) Weak (Labor) Productivity Growth

Stylized Facts

Credit (as % of GDP) has increased substantially since 2004…

Figure 3. Brazil: Bank Credit(as share of GDP)

15%

20%

25%

30%

35%

40%

2002Q1 2002Q3 2003Q1 2003Q3 2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3 2008Q1

Credit to Private Sector

Credit to Private Firms

And interest rates have gone down…

Figure 4. Brazil: Interest Rate Indicators(% a year)

0

10

20

30

40

50

60

2002Q1 2002Q3 2003Q1 2003Q3 2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3

Money Market Interest Rates

Intermediation Spreads

Since 2004 formality rates have increasedCarteira-salaried workers

Figure 1. Brazil: Share of Urban Workers with Formal Employment Contrato ("carteira")in Economically Active Urban Population

34%

36%

38%

40%

42%

44%

46%

2002.03 2002.08 2003.01 2003.06 2003.11 2004.04 2004.09 2005.02 2005.07 2005.12 2006.05 2006.1 2007.03 2007.08 2008.01

Since 2004 formality rates have increasedShare with social security-all workers

Figure 2. Share of Workers that Contribute to Social Security in Total Active Labor Force

40%

41%

42%

43%

44%

45%

46%

47%

48%

49%

1995 1996 1997 1998 1999 2001 2002 2003 2004 2005 2006 2007

Figure 5. Brazil: Real Effective Exchange Rate(2000=100)

60

70

80

90

100

110

120

130

2002Q1 2002Q3 2003Q1 2003Q3 2004Q1 2004Q3 2005Q1 2005Q3 2006Q1 2006Q3 2007Q1 2007Q3 2008Q1

And this took place amidst strong currency appreciation which shifts resources to non-tradables where informality is deemed higher…

Formality rates can be decomposed in:

E

F

E

F

E

F SL

S

SSS

S

S

L

LLL

L

L

E

F

E

E

E

E

E

F

E

F

E

E

E

E

E

F

E

F

Yielding:

Within L Between L Within S Between S

Where: “L” = >11 employees

“M” = between 2 and 11 employees

“S” = self-employed

Table 1. Decomposition of Aggregate Labor Formalization between Self-Employed, Smaller and Larger Firms(percent)

Labor Contract Definition ("carteira assinada")

(F/E) == (F/E)s (Es/E) (Es/E) (F/E)s (F/E)L (EL/E) (EL/E) (L/E)L

2002-2007 100.00 41.63 -22.02 40.06 40.33

2004-2007 100.00 44.66 -14.14 43.82 25.66

Social Security Definition:("contribuicao a previdencia)

(F/E) == (F/E)se(Ese/E) (Ese/E) (F/E)se (F/E)s (Es/E) (Es/E) (L/E)s (F/E)L (EL/E) (EL/E) (L/E)L

2002-2007 100.00 5.38 -8.16 30.45 -7.20 26.86 52.66

2004-2007 100.00 6.74 -5.69 35.08 -3.84 33.10 34.61

Note: "se" denotes self-employment, "s" denotes firms of 2-10 employees, and "L" denote firms with 11 or moreemployees. For the formality measure "cartera assinada", employment is divided into workers employed in small (2-10) and larger firms (>11) only, since the category self-employment is not included because "carteira assinada" onlyrefers to employees.

Can the increase in credit explain increasing formality rates?

Methodology

• Examine whether sectors “structurally” more dependent of external financing formalize more when credit becomes more abundant.

• Following Rajan and Zingales (1998), we measure external dependency of financing as:

FDj=(K invj-cash flowsj)/K invj

Methodology

• Where c=size categories: (1); (2-10); (10+)

Cjtjt

CCj

Ct

C

jt

c

FDGDPCreditE

E

*)/(0

Table 2. Formal Employment and Financial Dependence: Panel Regressions Using the "Carteira" Definition of Formality

Dependent variable: Formal employment/total employmentFormal employment defined as carteira

Credit to private sector/GDP Credit to firms/GDP Observations Sectors

Firms with 2-10 employees 0.2067*** 0.4218*** 156 26(0.0446) (0.1146)

Firms with more than 0.1111*** 0.2168*** 240 4011 employees (0.0192) (0.0575)

Robust Standard errors in parenthesis. * Significant at 10%; ** significant at 5%; significnat at 1%

Coefficients on FDj*Credit/GDP

Each entry corresponds to the coefficient of the measure of dependence on external finance per sector based on Rajan and Zingales (1998) methodology interacted to a measure of financial depth (Credit/GDP). In addition, the

Table 3. Formal Employment and Financial Dependence: Panel Regressions Using the Social Security Definition of Formality

Dependent variable: Formal employment/total employment

Credit to private sector/GDP Credit to firms/GDP Observations SectorsISIC

Self- employment 0.1309 0.3684 150 25(0.1166) (0.2545)

Firms with 2-10 employees 0.1748*** 0.3438*** 156 26(0.0520) (0.1294)

Firms with more than 0.1054*** 0.1996** 240 4011 employees (0.0285) (0.0780)

Robust Standard errors in parenthesis. * Significant at 10%; **significant at 5%; significant at 1%

Coefficients on FDj*Credit/GDP

Each entry corresponds to the coefficient of the measure of dependence on external finance per sector based on Rajan and Zingales (1998) methodology interacted with the measure of financial depth (credit/GDP) In addition,

Table 4. Formal Employment and Financial Dependence: Panel Regressions Using a Semi-log specification

Dependent variable: Ln(Formal employment/ total employment)All the sample without breaking by size

Formal employment Credit to private sector/GDP Credit to firms/GDP Observations Sectorsdefinition:

0.1846*** 0.3581** 240 40Social security (0.0600) (0.1630)

0.1392*** 0.2941*** 240 40Carteira (0.0420) (0.0977)

Robust Standard errors in parenthesis. * Significant at 10%; ** significant at 5%; ***significant at 1%

Coefficients on FDj*Credit/GDP

Each entry corresponds to the coefficient of the measure of dependence on external finance per sector based on Rajan and Zingales (1998) methodology interacted to a measure of financial development. In addition, the

Bottom-line of “within” regressions:

• Expansion of aggregate formal credit significantly fosters formalization within each size category.

• The results are robust to the alternative definitions of formalization.

• Effects are much stronger for “middle-sized” and “larger” firms [consistent with the unconditional decomposition exercise of Table 1].

• Results also robust without breaking by size (log spec.): is higher the lower F/E, so stronger for smaller caps.

Table 5. Formal Employment and Financial Dependence: Panel Regressions of Employment Growth ("between") Effects(2002-2007)

Dependent variable: Employment by firm size/total employment

Credit to private sector/GDP Credit to firms/GDP Observations Sectors

Sel- employment -0.0848* -0.1470 150 25(0.0475) (0.1120)

Firms with 2-10 employees 0.0353 0.0941 150 25(0.0346) (0.0754)

Firms with more than 0.0448 0.0526 150 2511 employees (0.0592) (0.1337)

Robust Standard errors in parenthesis. * Significant at 10%; ** significant at 5%; ***significant at 1%

Dependence on external finance as index

Each entry corresponds to the coefficient of the measure of dependence on external finance per sector based on Rajan and Zingales (1998) methodology interacted to a measure of financial development. In addition, the

Table 6. Formal Employment and Financial Dependence: Panel Regressions of Employment Growth ("between") Effects (2004-2007)

Dependent variable: Employment by firm size/total employment

Credit to private sector/GDP Credit to firms/GDP Observations Sectors

Self- employment -0.0818** -0.1685** 100 25(0.0357) (0.07)

Firms with 2-10 employees 0.0259 0.0532 100 25(0.0217) (0.0423)

Firms with more than 0.0786** 0.1561** 100 2511 employees (0.0343) (0.0678)

Robust Standard errors in parenthesis. * Significant at 10%; 88 significant at 5%; significnat at 1%Each entry corresponds to the coefficient of the measure of dependence on external finance per sector based on Rajan and Zingales (1998) methodology interacted to a measure of financial development. In addition to the variable listed, the

Coefficients on FDj * Credit/GDP

Bottom-Line of Between Regressions

• Greater credit availability tends to shrink the self-employment in the size distribution

Since much of the self-employment business is informal, this helps lower aggregate informality.

• Conversely, the shares of upper sizes are boosted.

• In particular, effect more significant among larger firms.

• This may mean that credit allows firms to expand into higher size segments but we can’t test that with this dataset with no information on gross flows.

Link with Productivity [very preliminary]

• Greater availability of formal credit facilitates entry and growth of smaller firms.

• To the extent that these firms have a lower ratio of capital to labor, aggregate labor productivity is dragged down.

• All the analysis here is from PIA which only covers industry and excludes informal firms.

• And eliminates most firms with <30 employees

Brazil: Number of Firms in Industry

0

5000

10000

15000

20000

25000

30000

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

New Firms

Old Firms

Linear (New Firms)

2004 break-point

trend

Firms Alive throughout

Brazil: Average No. of Workers per Firm

200

250

300

350

400

450

500

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

All

Larger Firms

Brazil: Average Labor Productivity in Industry(Deflated Value Added per Worker, 1996=100)

60

70

80

90

100

110

120

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

All Firms

Larger Firms

Brazil: Inter-Period Comparisons of Output, Employment and Labor Productivity Growth(% a year)

1999-2002 2002-2004 2004-20061. All Firms

Growth of Value Added -0.1% 6.6% 5.0%

Growth of Employment 3.8% 6.3% 5.6%

Growth of Investment 0.8% 0.2% 9.9%

Growth of Value Added/Worker -3.8% 0.2% -0.5%

2. Larger/Traditional Firm Segment

Growth of Value Added -0.6% 7.3% 3.9%

Growth of Employment 2.2% 4.8% 2.3%

Growth of Investment 3.1% 3.4% 9.1%

Growth of Value Added/Worker -2.8% 2.5% 1.5%

Conclusions

• Highly imperfect credit markets seem to be a factor behind high informality rates.

• The evidence suggests that improved access to credit has led to higher formalization.

• Much of reduction of informality takes place via “within” effects: holding relative sector size constant, firms within each sector have an incentive to formalize their employees as credit becomes more abundant.

• But also some evidence of a significant between effect – i.e. crowding out of self-owned firms by larger formal firms and faster expansion of the largest size segment during the credit boom period 2004-2007.

• This is consistent with self-owned firms dying out and/or simply becoming bigger and moving to the larger size segment.

• The same applies to the middle segment, which does not expand relatively much.

• This is not necessarily with inconsistent with a literature on credit constraints and firm size (Bernanke et al, 1995), since our larger size category (>11) still encompasses a number of small firms.

• And what is typically meant “large” in a LA context is small on a world scale (Herrera and Lora, 2003).

• Alas, the PNAD does not allow a less coarse size breakdown, nor to look at gross entry/exit.

• So, using alternative data sources to gauge the size composition effects of financial deepening is left for future research.

• In any event, to the extent that wider credit access and formalization boost long-run productivity, our findings suggest that financial deepening can have far-reaching effects on long-term economic growth.

• Our findings also highlight the importance of sound macro policies:

• As you reduce macro volatility and keep inflation stable, this boosts credit supply, lower risk and hence interest spreads, thus fostering formality.

• So, there is clear a link between informality, productivity and macroeconomic policy that is typically overlooked in the macro literature and policy debate.

• Yet, such a positive association between credit and (labor) productivity may be tempered in the short-run.

• This is because, abundant credit seems to favor the entry of smaller and lower cap firms which typically have lower labor productivity to begin with.

• What happens to TFP needs to be documented.

• At any rate, to the extent that credit is allocated efficiently, this (-) effect on labor productivity should be gradually overcome in the longer-run.

• But this again is a matter for further research.