Undoubtedly, we are faced with a unique crisis. Even though the country’s economic crisis has sources other than the global economic crisis, mere synchronization of the two makes this crisis unique. Also, this time, we do have a national debate over various policy options.

From this raging debate, however, an essential element is missing, which is a discussion about the unique features of our economy. Such a discussion is of crucial importance given that many of the participants in this debate, like this author, are trained in the West.

The ‘toy universes’ and the prototypes of the West may not be applicable to Pakistan.

There are two unique features in our economy, the first pertains to the banking sector and the second pertains to the role of intermediaries or middle-men in our economy. Our banking sector is a very interesting area of study since it essentially is a marriage of formal and informal money channels.

Our banking system (a formal system) relies on ‘hawala’ (an informal system) to control for the moral hazard of borrowers. Let me explain this point through a simple example. Suppose you are a businessman who is seeking a loan from a bank. Why should the bank lend money to you? Why should the bank lend money to any businessman in a country where the regulatory system is non-functional?

In such an environment, if a borrower defaults, the bank has no practical way of recovering its money or take-over any collateral that was pledged for the loan. In practice, the only real collateral is ‘cash collateral’. Everything else is simply an eye-wash.

What will a smart banker do? Well, a smart banker will know that as a successful businessman, you must have significant undeclared wealth.

Why not transfer this undeclared wealth abroad through ‘hawala’ and use the transferred currency as collateral for the loan given in Pakistan?

That way, the banker is happy that he is getting ‘cash collateral’ and the businessman is happy that his undeclared wealth remains undeclared since ‘hawala’ is an informal transfer channel.

A majority of Pakistani banks maintain two sets of books precisely for this reason (a fake one for the State Bank and an actual one for internal top management)

In essence, this mechanism allows a bank to separate borrowers who are genuinely interested in repaying their loans from borrowers who intend to misbehave.

A borrower who intends to behave will be happy with this arrangement since he gets the loan and his undeclared wealth remains undeclared (tax-free). Equivalently, one can think of this arrangement as converting undeclared equity into declared debt. Hence, businesses in Pakistan are essentially children of a marriage between the formal banking network and the informal ‘hawala’ system.

If one sees the above link between the formal and informal money channels, then it’s not difficult to grasp the implications of such a link. First, one can easily see that ‘hawala’ cannot go away irrespective of how fiercely the government swings its baton. So even suggesting that such a thing may happen in the near future is a blasphemy in pragmatism.

Second, in this marriage, businesses which do not offer ‘hawala based cash-collateral’ are step-children. Such businesses bear the brunt of monetary tightening.

That is, when the State Bank raises interest rates, such rates are passed on to them (for example auto-loans market) but the ones that offer ‘hawala based cash-collateral’ are typically spared since they are already providing equivalent cash collaterals.

For lack of better terminology, let’s call businesses that do not offer hawala-based-cash collateral ‘white businesses’ and the ones that offer such collateral ‘grey businesses’.

The discount rate set by the State Bank is the benchmark rate only for ‘white businesses’. The benchmark rate for ‘grey businesses’ is set in the private sector and is only weakly correlated with the State Bank’s discount rate. That means, State Bank’s ability to control inflation by hiking interest rates is severely hampered.

Consequently, the penalty imposed on ‘white businesses’ in a monetary tightening is now much larger. A thorough empirical analysis can pick up the difference in the two regimes. In one regime, such as the auto-loans, credit card market, or housing loans, the benchmark rate is set by the State Bank, and for the second regime, the benchmark is established through ‘hawala-based-cash collaterals’ in the private sector. Of course, such data is never reported; however, banking sector insiders are privy to this information.

The second unique feature of our economy is the presence of substantial micro-structure rents in the intermediation process. In simple terms, it means that the middle-men enjoy substantial bargaining advantages over producers.

This fact severely hampers the price discovery process. Prices, especially of agricultural commodities are often manipulated in Pakistan.

As just one example, middle-men buying crops from farmers typically have monopoly over items such as bags that are used to lift the crop from the field. It is not difficult to see that such asymmetry in bargaining power transfers most of the surplus to middle-men. Plus, these large intermediaries have access to credit due to the transfer of undeclared wealth through hawala and subsequent collateralization.

It is crucial that above features are kept in mind, while framing economic policies. The ‘unique features’ are severely damaging to our economy in the long-run as they give rise to serious efficiency losses.

It is the hope of this author to spark a national debate over these issues. Strong actions require political will, and mass awareness is a pre-requisite for political will. It is only through continued national debate that the required awareness can be generated.

The writer is a faculty member in the department of economics at Lahore University of Management Sciences.