Governments worldwide are investing in financial-literacy programs, in part to help small merchants gain access to bank financing. But this may not address the core issue that impedes credit access in some less-formal economies, according to Chicago Booth’s Rimmy E. Tomy and University of Southern California’s Regina Wittenberg-Moerman. In a study of traders at the Iewduh market in northeastern India, a regional center of trade, they find that trust is central: wholesalers who make credit decisions want to know about retailers’ sales and profits, but they are concerned about the reliability of the data.

Retailers, meanwhile, worry that wholesalers might misuse their financial information.

“Our results highlight that such [financial-literacy] interventions are unlikely to substantially increase the use of financial information in credit allocation in informal markets,” the researchers write. “Instead, mechanisms to improve reporting reliability might be more fruitful.”

The informal sector accounts for 30 percent of global GDP and 70 percent of employment, according to work by Brown University’s Rafael La Porta and Harvard’s Andrei Shleifer and a 2019 report from the Organisation for Economic Co-operation and Development, respectively. Tomy and Wittenberg-Moerman frame Iewduh as a microcosm of the informal sector, as bazaars such as this exist in many developing countries. At the market, 5,000 merchants trade in groceries, tobacco, textiles, household appliances, and other products. Rather than use bank financing, these merchants tend to rely on wholesalers and suppliers for credit, which means their growth is limited by the amount of trade credit they can wrangle.

What works in an informal sector

In a related project, the researchers link membership in one of the market’s many distinct communities to access to credit. (Read more in “In Some Places, Community Is Key to Who Gets Commercial Credit.”) They find that informal mechanisms dominate access to credit. But in this study, they find that wholesalers might use financial information more if they had access to reliable data. Instead, a lack of trust on both sides restrains credit growth.

Between January and March 2022, the researchers interviewed about 140 wholesalers to determine their inclination to use retailers’ financial information in their credit assessment decisions. They presented each with 24 hypothetical scenarios reflecting two retailer profiles per scenario. A wholesaler was told the retailers’ ethnic community, their sales and profits relative to other retailers, the length of time they had worked with the wholesaler, and the amounts of trade credit potentially on offer.

The values of the attributes were randomly varied across the scenarios. The wholesalers were told to assume that the retailers were identical in all other respects and that the information was accurate and reliable. For each pair of retailers, the wholesalers were asked which retailer they would provide with a given amount of trade credit. For example, when presented with Retailers A and B, from different ethnic communities and with differing sizes and relationship histories, would the wholesaler rather offer 30 percent trade credit (equal to 30 percent of the goods purchased) to Retailer A or 50 percent to Retailer B?

Wholesalers were willing to provide 11 percent more trade credit as a percentage of sales to retailers with sales higher than their peers, the research finds. The wholesalers would also provide 2 percent more trade credit to a retailer with sales equal to that of a typical retailer than to one with no sales data, suggesting that financial information has an economically meaningful effect on wholesalers’ willingness to provide trade credit. These results also held for less financially sophisticated wholesalers.

Informal information matters, such as a retailer’s community membership and the length of the relationship between the retailer and wholesaler. Wholesalers reported a willingness to provide more trade credit to same-community retailers relative to those from outside their community, and they were also inclined to provide more credit to retailers with whom they had a longer relationship. Utilizing more formal financial information in credit-allocation decisions does not imply that wholesalers would stop relying on informal information, write Tomy and Wittenberg-Moerman.

However, they note that even wholesalers who tend to rely on such signifiers said they find financial information worthwhile in credit decisions. This was as true for women as it was for men, even if women put more value on informal information. Wholesalers who expected to find the financial information of little use still valued it in decision-making, although they were less willing to pay for the data.

In a survey of almost 375 merchant-borrowers, most respondents agreed that providing financial information to wholesalers could improve their access to credit, but said confidentiality and other concerns made them reluctant to share such information. This caution held regardless of the retailers’ own financial sophistication.

Designing a verification mechanism that constrains both retailers’ ability to lie and wholesalers’ ability to misuse information may lead to more significant uptake of financial information in credit allocation, Tomy and Wittenberg-Moerman conclude. By enhancing the efficiency of lending decisions, such a mechanism could increase access to credit in informal markets.

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