What India’s informal sector needs right now

The lack of frequent and up-to-date economic indicators makes it difficult to monitor India’s large informal sector, which employs around 80 percent of the workforce and produces around 50 percent of GDP.

A lot is at stake here. Ignoring the problems of the informal sector can be costly as it can lead to loss of jobs and wages, higher inflation and even endanger the livelihoods of migrant workers. For example, as a result of demonetization, a disproportionately higher number of jobs have been created in rural India, which is not as positive as it might sound as wages are 2.5 times lower than in the ‘Urban India. As a result, overall wage levels and GDP declined over the next few years.

Workers in the informal sector suffered much more from national lockdown in 2020 than their counterparts in the formal sector. With an inadequate safety net, there have been painful accounts of displaced informal workers trying to return to their rural homes.

Such disturbances can also be inflationary. India was one of the few countries to experience high inflation throughout the 2020 pandemic. Part of this is probably associated with the disruption of informal businesses, which under normal circumstances are very active in production. essentials such as food and textiles.

Of the 384 million informal sector workers, half work in agriculture, living mainly in rural India, and the other half in non-agricultural sectors. Of these, about half live in rural India and the rest in urban areas. Each of these groups fared differently during the pandemic.

The fortunes of people in the formal sector, who make up 20 percent of the workforce, have been relatively good. During the pandemic, large publicly traded companies did better than small businesses. The combination of lower costs, a lower interest rate environment, access to growth capital markets and ongoing formalization have likely helped to maintain high profitability.

The salaries of people working in these large publicly traded companies have also held up relatively better, although they are lower than the pre-pandemic trend. These people may also have benefited from vibrant stock markets.

Will they continue to lead the recovery? Most likely yes, but differently. Recall that the urban affluent class led the rise in demand after the first wave of Covid-19 in 2020 by purchasing durable consumer goods like furniture, electronics, cars and even houses. These items are generally not purchased year after year. As vaccinations are rolled out, these consumers may instead shift from spending on goods to services.

Over the longer term, the outlook for this group will depend on progress in policy reforms and economic growth, which are the main drivers of real wages.

The outlook for the 40 percent of the informal agricultural sector has also been surprisingly resilient. Rural wages have weathered the pandemic well, thanks to good monsoons, an exemption of the food trade from various lockdowns and, more recently, higher agricultural exports. The increase in public spending in various social protection schemes has also helped.

As this group emerges from the second wave of Covid-19, they may want to consume goods that make them feel safer, such as two-wheelers and home repair services. Longer-term consumption will depend on agricultural reforms that will help diversify sources of income and increase agricultural productivity.

The 40 percent in the informal non-agricultural sector is the most worrying. These workers are the most vulnerable because they have been hit hard by the economic disruption that the pandemic has unleashed.

Half of this group lives in rural India. They did not do as well as their agricultural counterparts. Most of them involved in construction, trade and manufacturing have seen wage growth plummet. The sharp increase in demand for rural unemployment benefits is an indicator of the disturbances encountered.

The other half live in urban India and are employed in commerce, hospitality, transportation, manufacturing and construction. This group was the recipient of the formalization. We take a close look at the constituent companies of the FTSE Index, which by design are in the formal sector.

We find that historically nominal GDP growth has been a good indicator of the sales of formal sector firms. But during the pandemic and also during events like demonetization, formal corporate sales exceeded nominal GDP growth.

We believe this means that part of the demand, which was previously supplied by the informal sector, has started to be supplied by the formal sector. Other data shows how spending has shifted from small businesses to larger ones. It is not surprising that employees of large companies have done much better than small informal companies.

Several surveys carried out during this period also show an increase in urban unemployment and self-employment, with the latter category recording the highest loss of income.

What does all this mean for economic growth? Formalization can be a double-edged sword. Although traditionally associated with efficiency gains, if it comes at the cost of closing small informal businesses and disrupting the informal sector, it can weigh on demand in later periods.

The constructive way to think about this is to differentiate between “forced” and “organic” formalization. Formalization that only comes under external pressure or that leads to deep distress in the informal sector, may not be sustainable. In contrast, the formalization that occurs as a result of policy changes that help small and informal enterprises transform over time into medium or larger formal sector enterprises is more sustainable.

What may be needed now is the protection of informal sector workers through social protection schemes so that the disruptions they face do not result in a permanent decline in demand. There is reason to remain generous with programs such as the MGNREGA rural program to
longer.

India does not have an equivalent urban social protection scheme. Government investment spending becomes one, providing jobs in the short term. But this source of expense can be unreliable. We believe that there are good reasons to put in place a more permanent direct urban social protection structure.

In the meantime, measures to promote the reforms needed to help small businesses grow are essential. For example, reducing the regulatory burden associated with growing businesses.

At a broader level, one of the great lessons of the pandemic has been that India cannot wish the informal sector to end. Nor can we assume that the fortunes of the formal and informal sectors go hand in hand.
Placing the informal sector at the forefront of policy decisions can have important benefits for the entire economy for years to come.

This column first appeared in the paper edition on August 20, 2021 under the title “The informal sector in the foreground”. The author is the Chief Indian Economist of HSBC Securities and Capital Markets (India) Pvt Ltd.

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