Access to Credit and the Size of the Formal Sector in Brazil

Abstract: This paper studies the link between credit conditions and formalization in Brazil.  During the last decade, Brazil has experienced a large increase in level of credit and the rate of formalization. A reduction in the cost of credit and policy reforms oriented towards improving the efficiency of the financial sector are linked to these changes. A model with endogenous formal and informal sectors is developed to evaluate how much of the change in corporate credit and the size of the formal sector can be attributed to a reduction in financial intermediation costs. The model predicts that the reduction in intermediation costs generate an increase in the credit to output ratio and the fraction of formal workers in line with the data. By affecting the allocation of capital and the entry and exit rates, the change in credit conditions have important implications for the firm size distribution and aggregate productivity.