Formal versus Informal Finance - Essay Example

?Formal versus Informal Finance Introduction Over the past two years, experts in matters of finance as well as economists have always identified China as a counterexample to the results found in research in the growth and finance literature. This has been the trend in spite of the fact that its banking system is full of weaknesses. Everybody agrees that it is among the fastest growing economies in the world. Scholars mention the growth rate of the private sector in China as evidence that it provides an alternative support to the country’s economic growth through financing and governance mechanisms (Chan, 2007, P. 18). This discourse delves into the firm financing patterns and growth in China. In the end, the paper finds that very few firms as well as companies rely on formal banks to finance their business, leaving most of them to depend on informal sources to drive up capital for their businesses. Furthermore, the author of this paper discovers that although, few businesses rely on formal sources of finance, such sources are responsible for faster growth of a business company compared to informal sources of finance. Some of the vices identified are corruption. However, there was no evidence to prove that such a vice affected the allocation of credit to firms from the financing institutions. It also did not affect the performance of the business both in the market and in terms of profit making. This paper presents a counter argument on the positive relationship between finance and growth using China’s economy as a case study. Analysis of the Relationship between Finance and growth Economists concur on the fact that China has the fastest growing economy in the world. The Chinese economy has gained significance that no other economy can ignore its rate of growth. Pundits believe that the Chinese economy will surpass the size of the US economy by the time we get to the third decade of the current century (Yao & Yueh, 2009, p. 40). Professionally though, its per capita income level will remain very low compared to that of the United States. In some other quarters experts dismiss this predictions as misleading citing various facts. The strength of the China’s economy for instance, appears in its manufacturing sector that is so far challenging manufacturing sectors in advanced economies around the world. This is profound especially in economies that are labor intensive (Angelina, 2008, P. 76). China is also undertaking a top-down approach while entering the high technology industry. This means that the rate at which such an economy accelerates is high and will hit its peak very soon. The growth of technology receives maximum support form high-level research by a large of scientists as well as engineers finishing their undergraduate and postgraduate courses. China is an essential counterexample to findings in various fields among them institutions, law, growth of literature, and finance (Pagano, 1993, p. 619). This is despite the fact that it has very poor financial systems and legal structures. Its economy defies all these to become the fastest growing economy in the world (Patnaik, 2011, p. 33). A lot of information from scholarly articles in the field of law and finance demonstrates that the growth of formal financial institutions relates closely to a faster growth of business organizations in addition to enhancing better allocation of resources (Yu, 1998, p. 79). Literature from these articles also considers the value and input by informal financial systems in the development of economies from developing economies. Informal financing as defined in the scholarly literature entails small, shorter, and unsecured loans. These sources of finance are restricted to the rural areas, households, agricultural financing and contracts, small entrepreneurial engagements, and individuals. The loans target the lower cadre of the market within the developing economies (Hsieh & Klenow, 2009, p. 21). The same appears in the developed economies but takes a different approach. In the US for instance, angel investors comprising of high net-worth investors play a crucial role in financing upcoming businesses that require modest capital until they attain the new status of receiving formal venture capital financing. Experts posit that the informal financing sources cannot replace the formal sources because of their poor enforcement and monitoring abilities (Shah, 2008, p. 19). The informal system is ill equipped to handle the follow-up mechanisms and cannot sustain the financial requirements on the higher cadre on the market in both developed and developing economies (Knight & Ding, 2010, p. 109). A number of researches hold that financial development is associated with the general growth of the economy positively. These literatures consider the size of the financial systems by evaluating total measures (Levine, 2005, p. 34). However, studies indicate that when the capital-market financing influences growth, it necessitates this through expansion of their investments that is increasing the profits investment rates and this only affects few business firms. China is a good example that defies this principal concerning the role of informal sources of financing to support the high-end market segment in an economy. China’s branch of literature says otherwise (Cabral, 2003, P. 34). Although it has weak financial and banking system, China has one of the fastest growing economies in the world. Data from this literature is important in investing two views in finding out the best alternative with operations of informal sector in China. There is growing evidence that private firms in China use formal financing sources such as banks in a similar way other private firms in other developing countries do. However, the difference in China comes in the use of informal sources of financing where greater distinctions appear. On comparison, business companies in China depend more on big informal financing options as well alternative financiers of businesses (Allen, 2005, P. 23). There is a high probability that the alternative financing sources take a larger portion when it comes to underground lending in China. However, researches also proof that growth and reinvestment of business firms arise more form the formal sources of financing. Various literature contradict the initial information that informal financing associates with faster growth and development of firms. The findings showed that on the contrary, it does not and this is a characteristic of the formal sources of financing (Eichengreen & Luengnaruemitchai, 2006, p. 65). Measurable benefits of informal financing are felt when retained earnings are classified as informal financing among earlier scholarly articles (Beck & Kneer, 2013, P. 29). Although there is evidence of business organizations growing quickly after receiving financing from banks, there is also evidence that some other organizations do not. This is major in business companies that admit to receive instrumental support from the government. Their rate of growth is low, they have poor productivity, and their ability to reinvest is minimal. This happens when compared to the growth of businesses that receive any financial support from the government. However, these reasons are not unique to China that it is a common occurrence to all businesses run by states or governments (Neftci & Menager-Xu, 2007, p. 51). Most of these businesses face many disadvantages because governments have poor management structures across the world. Counter Argument The general results are that the formal fin acing sources in China play a smaller portion in financing private firms. This is partly because of poor systems of both legal and financial institutions. However, it remains evident that even in fast growing economies, the role of formal financing sources are associated with faster growth of firms and increase the ability for them to reinvest (Yueh, 2013, R4). There is no evidence both from research and from scholarly articles showing the association between informal financing of businesses and higher rates of growth and increased profit reinvestment rates. There no possibilities that informal sources financing to firms cannot replace the formal financing sources because of their inability to monitor and enforce the policy (Allen & Chakrabarti, 2012, P. 56). The relationship and reputation between governance alternatives and informal financing in boosting the growth of the private sector is limited. It also limits the growth rate of such businesses organizations. From these findings, people need to understand the role of financing the growth and development processes as well as the importance of reforming the financial institutions and sectors. This is the reason that China has benefited largely from the capital market expansion (Didier & Schmukler, 2013, p. 41). Over the last twenty years, the country has grown to become an economic powerhouse. Based on nominal GDP China was the second largest economy in the world by close of two thousand and twelve. 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