Formal and informal finance: Firm growth in Ghana

One of the key drivers of sustainable growth in developing countries is firm growth and productivity (Beck et al., 2006, Triki et al.,2011). Therefore understanding firm growth has become a major concern for researchers and policy makers. Over the years, research studies have documented many constraints faced by firms especially in developing countries including infrastructure, energy, access to markets and macroeconomic instability. However, a fast growing literature has revealed financial constraints to firms as the most binding of these constraints (Carpenter et al ., 2002, Foley et al., 2008, Guariglia 2008, Beck et al., 2006, Beck et al., 2013, Ayyagari et al., 2006, Quartey, 2008). These arguments have been driven by theoretical results showing the impact of informational asymmetry in contracting especially when it comes to financing (Tirole, 2006, Amissah et al. 2011). An interesting but controversial aspect of this area of research is the issue of formal versus informal forms of financing available to firms. Informal finance may require less information to get funds from lenders due to less rigorous information requirement but would normally come at a higher interest rate and limited availability of funds. On the other hand, formal finance offers greater pool of funds, which can help firms overcome financial constraints but may be difficult for informal firms to take advantage of, given the strenuous requirement processes. Therefore, if we can identify which of these channels promote firm growth in Ghana, it will provide the basis to influence policy direction to create the environment and the required initiatives to help informal firms access this form of finance. Also, it will help create the right platform for such financing firms to grow given the right government initiatives and institutions to support them. This research on how informal and formal finance directly impact informal firms’ growth in Ghana can help the Ghanaian government enhance the growth of small -medium scale enterprises. This project is also in direct response to the current need expressed by stakeholders at the National Economic Forum recently held by the Ghana government. The national consensus from the forum, presented in the Senchi Report (2014), highlighted the strong need for the state to encourage and promote indigenous entrepreneurship as well as providing further steps to support Small and Medium scale Enterprises.

We intend to use the enterprise survey dataset on informal firms in Ghana conducted in 2013 by the World Bank. The survey collects data on most SME’s in Ghana covering the major urban areas in Ghana (namely Accra, Tema, Takoradi, Kumasi and Tamale). The survey provides information on 729 firms out of which 365 are manufacturing firms and 364 are firms in the service industry providing a wide range of information about firm characteristics.

The key contribution from this research is to identify exactly which of these forms of financing promotes firm growth and hence provide a research led policy initiative. Also, given that these two types of financing provide unique benefits, identifying which channel operates in Ghana for informal firms would lead to policy recommendations to promote the use of the other channel. The outcome will help to identify whether there is a substitution or complementary relationship between formal and informal forms of financing in Ghana.