Tuesday, May 27, 2014

Pakistan Has World's 4th Highest Number of Shadow Entrepreneurs

Pakistan has 109 informal entrepreneurs for every formally documented entrepreneur, ranking the country 4th in the world for the size of its shadow economy, according to a study published by Professor Erkko Autio and Dr. Kun Fu of the Business School of London's Imperial College.

Pakistan's 109 shadow entrepreneurs for every officially registered one rank it 4th behind Indonesia's 131, India's 127 and the Philippines' 126. Egypt ranks 5th with 103 shadow entrepreneurs.

The U.S. appears at number 32 on the list with 2.37 unregistered businesses for each registered one, while the UK exhibits the lowest rate of shadow entrepreneurship among the 68 countries surveyed, with a ratio of only one shadow economy entrepreneur to nearly 30 legally registered businesses.

Shadow entrepreneurs are individuals who manage a business that sells legitimate goods and services but they do not register it. This means that they do not pay taxes, operating in a shadow economy where business activities are performed outside the reach of government authorities.

The shadow economy results in loss of tax revenue, unfair competition to registered businesses and also poor productivity - factors which hinder economic development. As these businesses are not registered it takes them beyond the reach of the law and makes shadow economy entrepreneurs vulnerable to corrupt government officials.

In a study of 68 countries, Professor Erkko Autio and Dr Kun Fu from Imperial College Business School estimated that business activities conducted by informal entrepreneurs can make up more than 80 per cent of the total economic activity in developing countries. Types of businesses include unlicensed taxicab services, roadside food stalls and small landscaping operations.

 A 2011 World Bank report titled "More and Better Jobs in South Asia" showed that 63% of Pakistan's workforce is self-employed, including 13% high-end self-employed. Salaried and daily wage earners make up only 37% of the workforce.

M. Ali Kemal and Ahmed Waqar Qasim, economists at Pakistan Institute of Development Economics (PIDE), have published their research on their estimates of the size of Pakistan's shadow economy.

They have explored several published different approaches for sizing Pakistan's underground economy and settled on a combination of  PSLM (Pakistan Social and Living Standards Measurement) consumption data  and mis-invoicing of exports and imports to conclude that the country's "informal economy was 91% of the formal economy in 2007-08".

While Pakistan's public finances remain shaky, it appears that the country's economy is in fact healthier than what the official figures show. It also seems that the national debt is less of a problem given the debt-to-GDP ratio of just 30% when informal economy is fully comprehended. Even a small but serious effort to collect more taxes can make a big dent in budget deficits. My hope is that increasing share of the informal economy will become documented with the rising use of technology. Bringing a small slice of it in the tax net will make a significant positive difference for public finances in the coming years.

Related Links:

Haq's Musings

Pakistan's Underground Economy

Job Creation in Pakistan

IBA Report on Entrepreneurship in Pakistan

Pakistan's Economy Ranks Among World's 25 Largest

Tax Evasion in Pakistan Fosters Foreign Aid Dependence

4 comments:

Riaz Haq said...

Small is beautiful - unless you are a business that wants to grow. In which case, small is not so appealing. In Pakistan, where 90 percent of businesses are small or medium, challenges to scaling-up businesses have kept the private sector from realizing their full potential and contributing as much as they could to the economy. To help address a major constraint to the growth of small and medium enterprises (SMEs) in Pakistan, the U.S. Agency for International Development (USAID) is partnering with local banks to boost lending to SMEs. The new $60 million "U.S.-Pakistan Partnership for Access to Credit" was launched at last week's U.S.-Pakistan Business Opportunities Conference, as part of a larger bilateral government effort to boost trade and investment in Pakistan.

Finance is an important enabler of economic growth anywhere in the world. For Pakistan, which needs annual economic growth of at least 7 percent just to keep up with the number of youth expected to enter the labor market each year, this financing is important not only for the economy but for stability. Yet the private sector credit to gross domestic product (GDP) and financial depth ratios in Pakistan trail behind leading emerging economies.

In the SME segment, the volume of lending and types of financing tailored to SME needs have been very limited. A World Bank study found that only 16 percent of total credit in Pakistan went to SMEs. Moreover, about 70 percent of SME borrowing was used for working capital while only about 12 percent went toward long-term investment. Another survey shows only 11 percent of micro, small, and medium enterprises (MSMEs) in Pakistan report having access to finance, below the 15 percent international average and well below percentages reported in higher performing middle-income countries like Brazil and Turkey (30 and 48 percent respectively).

Despite these limitations, SMEs make an out-sized contribution to Pakistan's economy. The same World Bank study found that SMEs in Pakistan employ nearly 70 percent of workers in the manufacturing, services, and trade sectors and generate an estimated 35 percent of manufacturing's value addition. They also contribute over 30 percent of GDP and more than 25 percent of export earnings. Thus, alleviating a key constraint to their growth could lead to substantial increases in the number of jobs for Pakistan's large number of youth and greater income generation.

The new Partnership reflects a shared commitment to promote broad-based economic growth in Pakistan. Private sector investment was identified as an essential ingredient for growth in the Government of Pakistan's Vision 2025 strategy. The Partnership is part of a larger umbrella of U.S. support to SMEs in Pakistan to help them grow and expand into new markets. It will provide partner banks- Bank Alfalah, JS Bank, Khushhali Bank and First Microfinance Bank- with a loan portfolio guarantee through USAID's Development Credit Authority (DCA). The guarantee will lower the risk to the banks for lending in sectors they would otherwise perceive as being too risky. It will also encourage partner banks to extend longer-term loans and introduce credit products that address the needs of SMEs.

With more access to finance, small and medium businesses are poised to make even larger contributions to the Pakistan economy than they do now. The new U.S.-Pakistan Partnership for Access to Credit will make it possible for dynamic SMEs to be more than small and beautiful. After all, beauty is in the eye of the beholder and for businesses eyeing scale-up, there are few things more attractive than being able to grow.

http://www.huffingtonpost.com/borany-penh/eyeing-business-growth-in_b_6865186.html

Riaz Haq said...

Informal Savings in Pakistan


https://www.dawn.com/news/1725956


According to research by Oraan, around 41pc Pakistanis saved via committees (or Rosca), whereas Karandaaz puts that figure at 34pc. Assuming the informal economy accounts for roughly 30pc, as suggested by research from the Pakistan Institute of Developing Economics, it translates into annual committees of Rs4 trillion at base prices, using conservative inputs.

While this back-of-the-envelope calculation is far from scientific, it helps contextualise how big the informal savings market really is. Everyone from a widow looking to save up for her children’s education to young adults trying to save up for their marriage, committees are what they turn to.

This phenomenon is not exclusive to Pakistan. According to a note by Middle East Venture Partners (one of the investors in Bykea), “the global market is largely untapped and ripe for disruption with 2.4 billion people using money circles through traditional channels.”

They recently participated in the Egyptian digital committees’ startup MoneyFellows’ $31m Series B.

Apart from the traditional financial institutions’ general apathy towards the customer, committees appeal to an average Pakistani for several reasons: they are a community-based instrument with some level of flexibility and there is no interest involved.

Most importantly, it helps them manage cash flow better due to habitual change. For women, the product enjoys particular popularity since the former financial services are largely inaccessible.

However, since committees are primarily cash-based with virtually no money trail involved, it poses massive risks, as we saw recently when a girl, Sidra Humaid, who ran a network of committees through social media, defaulted on Rs420m of payments.

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Even beyond this, committees have flaws by design, only amplified by Pakistan’s macros. For instance, the person receiving the first lump sum amount will always be at an advantage since their instalments in the subsequent months would be worth less due to both inflation and rupee depreciation. The recipient of the last payment would see the amount’s purchasing power eroded substantially by the time they get it.

Moreover, due to the community-based nature of the product, the risk of network defaulting is higher as people of usually similar risk profiles would be pooling in their money.

For example, if employees from an organisation have running office committees, delayed salaries or layoffs within the organisation would lead to a bad equilibrium, creating losses for the rest of the group, often resulting in default.

However, there are ways to address some of those challenges. First of all, to (partially) protect your lump sum from depreciation or devaluation, you can enter a committee with a duration of up to 10 months. Given Pakistan’s macros of late, you’d still lose money in real terms but to be fair, that’d most likely be the case in any other instrument as well, including the risk-free government papers.

In fact, contrary to popular perception, there are certain ways to further alleviate the inflation problem. Digital committees have an option of gamifying the experience by rewarding good payment behaviour through loyalty programs and/or brand partnerships to provide discounts on utilities-based services and products.

Secondly, digital committees help create a trail of money which, coupled with a centralised authority (the platform itself), brings in accountability and recourse in the event of a default. The receipt and/or ledger helps with basic accounting in committees creating transparency for people within the group.

The third benefit of digital committees is the security factor. The participant has to go through a know-your-customer and credit check process to make sure there is no fraudulent behaviour that could negatively impact the group, along with the participant’s ability and willingness to pay to create an overall environment for responsible finance.

Riaz Haq said...

Plotistan: The mystery of low savings rate

https://profit.pakistantoday.com.pk/2022/02/27/plotistan-the-mystery-of-low-savings-rate/

Economic agents are not rational, and neither are government policies often driving the interplay of savings and investments

There is a lot of noise regarding the savings rate, and how a transition towards the formal economy would enhance the savings rate. This is indeed a novel idea, and recent digitization measures would certainly boost savings rate as an increasing number of transactions flow through the system, while the size of the informal economy contracts. Over the last ten years, Pakistan has had a savings rate of 14.5 percent, stooping to a low of 12.5 percent only a few years back. Savings rate in Pakistan has gradually dropped in this century, after hitting a peak of 23 percent in 2004.

A traditional national income identity, where cumulative GDP for a country is a function of consumption, investment, government expenditure, and net exports (negative if imports are higher), suggests that as savings in an economy increases, overall investment also increases. The underlying assumption is that rational agents in an economy would save for a certain rate of return, which they would get by investing in the economy. As the overall stock of savings increases, the overall investment also increases. The overall increase in investment enhances the overall national income, with a spillover effect on increasing consumption (higher employment, and higher disposable income), as well as higher exports – if investments are routed towards export-oriented activities.

However, the real world is slightly different. Economic agents are not rational, and neither are government policies often driving the interplay of savings and investments. National accounts often consider what can be measured, or what is formal, and disregard the informal, or the shadow economy. Savings that either result in an increase in bank deposits, stock of national savings, or flow into the capital markets, among other avenues can be counted as savings in national accounts, eventually being routed as investments – with banks lending into the real economy (or back to the government), while various businesses raise capital in the primary and secondary markets, and so on. However, if the same capital is simply redeployed in a multitude of real estate schemes, which are not developed and simply operate secondary market of ‘plot files’, then that truly is savings – but isn’t really an investment that would be recognized in national accounts.

The last ten years have resulted in emergence of plotistan. An economy which encourages investment in plots (whether legal, or illegal) for accumulation of wealth, rather than allocating that capital towards more productive areas of the economy. The capital markets have barely seen a sliver of fresh retail capital flowing into it, depressing valuations, and discouraging businesses from fresh listings given unattractive valuations. Meanwhile, the value of plots in cities across the country have grown multifold.

A marginal, and negligible taxation regime, massive distortion in reported value and transaction value of real estate, and amnesty schemes to further accelerate scarce capital to move towards real estate rather than actual productive enterprise has ensured that plots remain a safe haven for preservation of grey capital. A largely cash based market also ensures that fire sales are far and few in between, as investors (or plot-ists) as they like to call themselves are fine with staying underwater as that still remains a more tax efficient structure than investing in the formal economy. A drop in savings rate during the last ten years has been accompanied by an increase in cash in circulation as a % of GDP, signifying how an increasing number of economic activity is being conducted in cash, rather than through formal financial institutions.

Riaz Haq said...

How Informal Sector Affects the Formal Economy in Pakistan? A Lesson for Developing Countries

https://journals.sagepub.com/doi/full/10.1177/2277978719898975

There have been multiple estimates for the informal sector of Pakistan (Ahmed & Ahmed, 1995; Ahmed & Hussain, 2008; Arby et al., 2010; Aslam, 1998; Gulzar, Junaid, & Haider, 2010; Iqbal, Qureshi, & Mahmood, 1998; Kemal, 2003; Kemal, 2007; Kemal & Qasim, 2012; Kiani, Ahmed, & Zaman, 2015; Mughal, Schneider, & Hayat, 2018; Shabsigh, 1995; Yasmin & Rauf, 2003), yet most of the studies are limited to measuring the informal sector only. However, Shabsigh (1995) explored the relationship between fiscal deficit and informal sector, while Yasmin and Rauf (2003) and Kemal (2007) attempted to explore the nexus between informal and formal sectors. The estimates of the first author were based on simple ordinary least squares (OLS) without accounting for cointegration among variables. On the other hand, Kemal (2007) used vector autoregression (VAR), and his results showed unidirectional causality from informal sector to nominal GDP. Further, they used Johansen Cointegration test and Error correction model to conclude that shadow economy has a positive effect on the formal sector in short- as well as long run. We, however, argue that the effect of the informal sector on official economy may be of asymmetric in nature in the long and short run, emanating from two contrasting propositions:
1.
First, the informal sector, being more dynamic and extensive, is considered a safe haven for informal employment and production activities stemming from its capacity to avoid the bureaucracy and legalities. This may be supporting the economic activity in the long run when the income and savings from the informal sector are spent on consumption goods being produced by the formal economy. Furthermore, countries with relatively high incidence of poverty and weak social welfare institutions may use the informal sector as a substitute for social security.
2.
On the contrary, informality is a burden on exchequer, particularly when it comes to revenue collection in the short run; hence, it restrains the formal economic activity by raising the cost of being formal; that is, taxpayers have to bear the cost of tax evaders. Lower tax collection implies less expenditure on public utilities and lower productivity and economic growth.
The above contrasting propositions also seek strength from Khan, Khwaja, and Olken (2015) who used an experimental study on performance-based incentives to tax officials in Pakistan. Although they showed that the tax revenue increased, however, bribe requests also increased by 30 per cent, which depicts a clear burden on economic growth in the short run. Therefore, we hypothesize that the informal sector may affect the formal economy positively in the long run and negatively in the short run.