Formalize the informal: market segmentation and integration in the formal and informal credit markets in Wenzhou

In 2012, the Chinese government designated Wenzhou city as a testbed for policy experimentation aimed at institutionalizing informal lending practices. This study investigates how interest rates in the formal and informal credit markets interacted before and after this policy experimentation. Hence, we use the vector autoregression models and ordinary multiple regression method, which is based on the financial repression theory. We document large yield spreads between the formal and informal credit markets in Wenzhou before (2003–2011) and after (2013–2018) the reforms. We find an increase in the responsiveness of the informal sector to the formal sector, after the reforms. We argue that the informal financial system serves as a one-way substitute for the formal financial sector in Wenzhou. An analysis of the transaction-level data suggests that maturity, availability of collateralization, loan purpose, and the amount of loans determine informal lending rates. Thus, this study provides important policy implications for reforming China’s financial system.