Reducing the gap between formal and informal economies

By Charles Dhewa

Narrowing the gap between formal and informal economies remains a big challenge for many African countries. Instead of increasing interdependence between the two economies, in countries like Zimbabwe, the gap between the two economies seems to be widening.

As if that is not enough, academia, politics and financial institutions remain detached from society and the informal economy.  For instance, while more than 70 percent of active economic actors are now in the informal economy, this economy lacks finance and enabling policies. The shrinking formal economy continues to be controlled by colonial systems and constraints yet it still gets most of the resources from government and financial institutions.

Dominant characteristics of the formal and informal economies
The two economies can be defined by the type of actors who dominate in each of them as shown below:

The above classification clearly defines two economies. While the informal sector constitutes the bigger part of the economy, there are proper pathways for supporting it. Whoever is trying to assist the informal economy faces the same challenges faced by informal actors.

Challenges emanating from colonial systems
As long as developing countries continue to hold onto colonial systems and forms of business, closing the gap between the formal and informal economy towards a hybrid economy will take many years. The following are some of the colonial systems that have to be revisited and contextualized:

1. Formality continues to be defined by registration with government institutions such as the registrar of companies or with an appropriate department if one wants to operate a Private Voluntary Organization, a Micro Finance Institution or a bank. In a dynamic world economy, formality should not be defined by prohibitive and tedious registration processes. If registration was everything, shelf companies would be doing productive work.

2. Emphasis on referrals should be re-examined – For instance, asking a loan applicant to get a letter from a previous client or employer is a very old fashioned requirement in a dynamic and fluid economy. It does not make sense to ask someone to get a letter from a former employer because where the employee was doing very well, the employer will certainly not be keen to endorse loss of talent to competitors in the form of knowledge and expertise.

3. Collateral – It is now evident that although they lack colonial forms of collateral, actors in the informal economy continue to drive the new economy. The knowledge economy demands new forms of collateral. Insisting on traditional forms of collateral is meant to favor actors in the formal economy who have run out of ideas but continue to receive financial support.

4. Long application and approval processes – There is often no guarantee that loan applicants who go through time-consuming loan application and approval processes will get the funds. The application form is used as the only tool with no consideration for building relationships and trust as part of laying the business foundation upon which funding can then be extended. Everyone is given the same application tools irrespective of different business cycles, knowledge, ambition levels and vision for the future.

5. Selective quality and standards – Everyone now knows that quality is important in a competitive world. However, where you get a high quality product there are definitely second and third grades. Unfortunately, formal contractors tend to ignore the other grades in preference for first  grade as if it is possible for a farmer or SME to produce first grade only. When formal buyers do not provide alternative markets for lower grades, smallholder farmers end up refusing to work with formal buyers but creating their own market (informal) where all grades have a market.

6. Prohibitive measurements – By stating that they start buying from 30 tons of groundnuts upwards, formal buyers create barriers to entry for smallholder farmers who cannot manage to supply such volumes individually. This requirement creates barriers to internal trade to the advantage of big formal actors who can easily get money from the bank to the disadvantage of small actors who remain marginalized.

7. Payment modes – Sellers to formal companies are not given choices like payment in part cash. In what is tantamount to a take it or leave it scenario, formal companies insist on bank transfer as part of their policy.

8. Payment terms – The payment terms are determined by formal buyers whose policy can stipulate that payment is done after 14 days. Even if your commodity is bought by consumers before you leave the supermarket or processing company, you will receive your payment after 14 days.

From business proposals to business cases
In the formal economy, there is still emphasis on proposals, business plans and financial projections irrespective of the fluid and dynamic nature of the modern economy. Unfortunately, by the time you present financials for funding the situation will have completely changed and that means financials for the previous two years may be meaningless is such an environment. It makes more sense to focus on business cases and adapt as things unfold than try to present a proposal complete with cash projections when what’s written on paper changes before the ink has dried.  Creating new legislation and laws which do not exist at the moment will go a long way in increasing overlaps between formal and informal economies.
Easy of doing business
Before considering creating an easy of doing business environment for external investors, it is critical for policy makers in developing countries to enable easy of doing business for internal actors. Bureaucratic systems that are part of the formal colonial economy will not be able catch up with fast and fluid economic fundamentals. That is why formal economic actors are having to rely on prohibitive government policy in order to compete with the informal actors.