Informal trap

Published June 26, 2014
The writer is a business journalist based in Karachi.
The writer is a business journalist based in Karachi.

A GROWING proportion of economic activities in Pakistan are now taking place in what is called the informal sector. This has three major consequences that possibly present a threat to the future viability of the state.

The biggest consequence is how much of this activity is able to escape the state’s revenue machinery. With a declining ability to capture economic output in the revenue apparatus of the state, there is a diminishing pay-off for the state in the economy’s growth.

This is no minor issue. With amongst the lowest tax-to-GDP ratios in the world, the state in Pakistan is already critically dependent on subsidised foreign inflows in order to be able to pay its own bills. With all of the growth that the country has experienced since 1990, when its first opening up to the outside world began, the proportion of taxes collected has failed to keep pace. Simply extrapolating this trend into the future shows quite clearly that a point will arrive when subsidised foreign inflows could become larger than the total quantity of revenue collected from taxing domestic activities. Of course we are far from that point at this stage, but give it another decade or two more and we’ll see how the totals tally up.

Beyond revenue, we can see an increasing quantity of wealth now accumulating outside the formal economy. Consider some other important ratios where Pakistan lags tremendously: total cash in circulation to bank deposits, for instance, where out ratio is amongst the largest in the world. This shows that increasingly money prefers to remain outside the formal depository and payments system of the country. As capital accumulates in the grooves of the informal economy, it restricts the balance sheet of the formal economy and remains inaccessible for investment purposes, at least investment in fixed capital. Consider that total mortgage lending in Pakistan is somewhere around Rs70 billion, probably less than the value of the housing stock in one elite neighbourhood in Karachi, meaning much of our property market, even though it is the preferred asset for collateral when taking a bank loan, remains off the balance sheet of the formal economy.


It is vital that a pathway be developed to progressively incorporate the informal sector into the formal.


A point is approaching — and it’s not possible to say with what speed — where the state will be choked of revenue and the economy will be starved of investible capital, locking us permanently in a situation where the state is dependent on geopolitical rents to pay its own bills. The economy would dissolve in a sea of informal trading and services activities, which can blend easily into illicit and conflict economies functioning along our borders and the lawless hearts of our cities.

But informality has some strengths too. For one, the speed and flexibility with which informal players can deploy capital cannot be matched by their formal sector counterparts. Informality is also resilient to the sharp volatilities that our economic environment is subjected to, and can thrive in spaces where the power of the state cannot reach. Large-scale fixed capital, by contrast, has to be white, is dependent on the state for protection of property and contract, and depends on a network of other formal sector inputs like loans and energy. Its fate is critically conditioned by developments elsewhere in the economy.

To a large extent, the informal economy also partakes in the rhythms of the larger economy. Small-scale informal manufacturing, for instance, is hardest hit by the energy crisis because it cannot invest in captive power production. But informal trading, commodity financing and forex broking are able to operate largely unaffected by the energy crisis, but share in the ups and downs of the agrarian economy as well as currency movements.

Second, informal activities keep the economy stuck in a low-productivity equilibrium, primarily because they are not able to reach any economies of scale due to the lack of investible resources as well as a skewed incentive structure which discourages investment in up-gradation and maintenance.

For this reason, informal activity finds it very difficult to enter into export markets for anything beyond rudimentary raw materials, like cotton. Just look at how our mango growers are struggling to tap the export markets in the United States and the European Union as an example. But consider how transport and agrarian lending, which remain largely informal, also inhibit the formal sector with which they come into contact. Oil movement is a good example of how informality in the transport business maintains a chokehold on the formal operations of our oil-based power plants, or how the structure of rural money-lending markets inhibits the diversification of our agriculture away from traditional crops towards higher value added and lower water intensive cropping.

So long as the bulk of the activity in any given sector, such as transport or agriculture, remains in informal hands, will continued investments in infrastructure — roads or dams — really help raise productivity?

Third, since the state finds it difficult to control or regulate or even visualise informal economic activity, players in this field frequently reach out to local power wielders to help resolve their issues. As an example, water provisioning in SITE area was controlled by a group of interests with close ties to the Awami National Party. When the industrial concerns in the area felt they were being squeezed too hard by this racket, they elected a businessman with close ties to the MQM to be the chairman of their association, who promptly sorted out the water mafia. Informal rackets often become drivers of politics, and in many other cases, become drivers of conflict as well.

For the sake of ensuring the viability of our state, of releasing our economy from behind a low-productivity barrier, and of safeguarding the state’s role in governing the affairs of economy and society, it is vital that a pathway be developed to progressively incorporate the informal sector into the formal.

The writer is a business journalist based in Karachi.

khurram.husain@gmail.com

Twitter: @khurramhusain

Published in Dawn, June 26th, 2014

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