Can the informal economy bolster economic resilience in emerging markets?

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  • The informal sector accounts for around one-third of economic activity in emerging markets
  • Informal enterprises play an important role in economic resilience and employment
  • Fintech solutions are helping support formal and informal MSMEs in underbanked areas

Long viewed as a barrier to market development and fiscal sustainability, a dynamic informal economy is increasingly being recognised as an important source of resilience and a target for financial technology (fintech) services.

The informal economy accounts for approximately one-third of economic activity in emerging markets, compared to 15% in more mature markets, underscoring its outsized impact.

Also known as the “shadow” or “grey” economy, the informal sector comprises legal activities that contribute to the economy but are not taxed or regulated by the government or covered by formal agreements.

According to the International Labour Organisation, at least 2bn workers over the age of 15 – or some 60% of the global workforce – spend at least some time in the informal sector.

Informality and economic resilience

Although a large informal sector can constrain growth, limit government tax revenue and weaken the financial sector, informal micro-, small and medium-sized enterprises (MSMEs) contribute to the formal economy in a variety of ways, either through value-added taxes on purchases or the incidental costs of operating a business.

Indeed, the widespread transfer of funds from the informal to the formal sector suggests that emerging markets may be more resilient to shocks than official metrics suggest.

Nonetheless, access to credit remains an obstacle to growth and formalisation for many small firms.

Approximately 40% of MSMEs around the world – or some 65m firms – face a cumulative annual credit gap of $5.2trn, according to the International Finance Corporation, underscoring a sizeable opportunity for microlending in emerging markets.

While informal workers typically are paid less than their formally employed peers, the informal sector in emerging markets tends to be more dynamic and competitive, nurturing the development of human resources when more traditional opportunities are absent or inaccessible.

Similarly, the MSMEs that make up the bulk of the informal economy represent a highly flexible form of employment capable of providing jobs to large portions of a country’s population, even when official unemployment figures remain high. This may have contributed to the relatively swift post-Covid-19 pandemic recovery of countries like Pakistan, where the informal sector represents 70% of total employment.

New technologies for informal activities

The uptake of new technologies can help encourage formalisation through increased financial inclusion. Fintech, including technologies based on blockchain, has helped improve access to finance in emerging markets.

As OBG has noted, the sharp rise in remittances witnessed during the pandemic attests to the wide scale of informal remittances conducted globally, often in cash and outside of traditional or digital banking channels.

Remittances to Africa grew by $80bn in 2020, with intermediary platforms such as East Africa’s Pangea supporting the flow of these funds into local entrepreneurial activity.

One fintech initiative that has seen robust adoption in emerging markets is mobile money.

M-Pesa, a money-transfer service that allows users to make payments and store and receive funds via their mobile phones, is a notable example. Launched in 2007 by Vodaphone and Safaricon, Kenya’s largest mobile operator, the service is used by 51m people across seven African countries and is set to expand to Ethiopia following an October 2022 licence approval.

Digital currencies are another route that governments are using to increase financial inclusion. Around 90% of the world’s central banks are set to deploy digital currencies, especially as many consumers in emerging markets shift to virtual currencies to protect against inflation.

In 2021 Nigeria rolled out the eNaira, Africa’s first digital currency. Uptake remains low, however: roughly one in 200 people used the currency as of October of this year, a performance attributed to hesitancy related to the depreciation of the naira and confusion after a government crackdown on cryptocurrencies.

Consumers in emerging markets generally exhibit more support for digital currencies than those in mature markets, with a recent report by Morning Consult noting that 36% or respondents in India strongly supported the adoption of a central bank digital currency, compared to 3% in Japan.

Digital payments are already widespread in India, which has seen its digital payment volume grow by an average of 50% over each of the last five years, thanks in large part to its mobile-enabled system, the Unified Payments Interface (UPI).

In March the Reserve Bank of India announced a UPI for feature phones, an expansion that could bring financial services to 400m potential users in rural areas where levels of informality are high.

The “buy now, pay later” model also serves to boost financial inclusion, helping MSMEs to secure the funds needed for formalisation via interest-free peer-to-peer lending.

Credit: OBG

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