May 1, 2017    9 minute read

Why Formalisation Has Failed In Developing Countries

Lost Potential    May 1, 2017    9 minute read

Why Formalisation Has Failed In Developing Countries

Formal capital markets are inaccessible to the populations of most developing countries, resulting in capital misallocation and unrealised growth potential for small businesses. One possibility that could explain this phenomenon is proposed by well-known Peruvian economist Hernando de Soto, who believes that the main reason for the failure of formal capital markets in developing countries is that the majority of micro-entrepreneurs do not formally own their properties, which means that they cannot claim their assets as collateral in order to secure loans within the framework of the formal banking system.

In ‘The Mystery of Capital’, De Soto argues that this results in missed investment and trade opportunities, despite the significant returns to capital that small business entrepreneurs can, and often do, achieve. Indeed, establishing formal property systems is vital to encouraging the populations of developing countries to participate in transactions that occur with “strangers”. While such transactions occur daily in developed economies on the basis of bank accounts and credit scores and fines that protect the creditor from the debtor’s default, in developing countries with large parts of the population outside of the formal sector, lending and borrowing is often restricted to neighborhoods and kin groups due to geographical and trust constraints among parties.

Thus, facilitating trade through increasing formalisation benefits business owners due to increased access to credit, and results in positive externalities to the growing network of formalised business owners, due to the positive correlation between the network’s size and efficiency.

Easier Said than Done

However, formal property systems are no free lunch – they are extremely difficult to develop from the standpoint of the policy-makers. De Soto argues that government action is required in determining the owners of “informal” properties and creating a registration network in order to formalise the existing arrangements. This is easier said than done, given the government’s initial limited (or often inexistent) information on the rightful owners of properties and the state’s difficulty in foreseeing or controlling the conflicts of ownership that are likely to occur during the formalisation process.

While in his book, De Soto discusses the experience of the American West, whereby the rights of the “squatters” were recognised by politicians in order to secure voter support, this experience is virtually unrealisable elsewhere. This is because developing countries often suffer from flawed and corrupt political systems and fund embezzlement, as well as large poor populations that would make formalization a cost-prohibitive process, since granting amnesty to squatters could lead to the creation of incentives for future informal settlements.

The Fortunes of the Poor

In his critical review of De Soto’s workChristopher Woodruff – a professor of development economics at Oxford University – highlights the shortcomings of De Soto’s formal titling solution, which calls for the government to recognise and incorporate the informal rules of ownership in order to establish formal property systems.  

Woodruff believes that formal titling and property rights alone will not magically unlock capital, because of the losses that occur during the property – collateral – credit – income transformations, specifically the overcollateralization that drains the developing country credit markets. For example, in Mexico, the banking system requires a loan to be supported by three times its value in collateral – a colossal request caused by the difficulties of foreclosure in Mexico.

Thus, Woodruff argues that, in addition to recognition of property rights, governments need to simultaneously implement banking and bankruptcy laws and regulations that will ease the process of foreclosure and diminish the problem of overcollateralisation. This would make markets more efficient, allowing the previously misallocated capital to generate returns on investment to the small business owners.

Furthermore, Woodruff presents valuable commentary on De Soto’s grandiose yet inflated estimates of the real estate ownership of the poor in developing countries. According to De Soto, the world’s poor hold $9.34trn in real estate. This number is a far-fetched extrapolation of the real estate ownership of 5 developing countries (Mexico, Peru, Philippines, Haiti, and Egypt, which, incidentally, are among the world’s least formalised economies) to the rest of the world, combined with exaggerated percentages of informal activity.

Woodruff’s conservative and evidence-based re-calculation of De Soto’s claim yields a substantially smaller, yet still impressive number of $3.5trn of real estate holdings among the world’s poor. Given the earlier stated losses of the transformation of assets into credit, the capital unlocked from the real estate could be a significantly smaller percentage of this number. Thus, in Woodruff’s view, formal titling alone would be insufficient to help the poor access formal capital markets. Th problem could only be solved through a simultaneous launch of reforms which could both protect the creditors from non-payment while helping debtors to acquire credit on realistic terms.

Rethinking Formalisation

Woodruff’s conclusion on the difficulties of orchestrating an efficient system of formalisation is exemplified in detail in the paper co-authored by Miriam Bruhn and David McKenzie: “On entry regulations and formalisation of enterprises in developing countries”.  Their work summarises the effects of reforms and policy actions on promoting and diminishing the costs of formalisation, based on existing evidence from 6 developing countries: Mexico, Brazil, Colombia, Peru, Brazil, Sri Lanka, and Bangladesh.

The evidence brought forth in these studies suggests that easing the process of formalisation alone will not induce formalisation, which contradicts De Soto’s assumption that micro-entrepreneurs stand to gain from formalisation in terms of land value or access to credit. This is particularly true of businesses that employ fewer than 10 people – a significant proportion of small businesses in developing countries, which typically consist of 2-3 people.

An important assumption that is often made about small business owners is that they do not choose whether to be formal. Based on these assumptions, McKinsey Global Institute data finds that informality accounts for 50% of the overall productivity gap between developing and developed countries. This assumption is not entirely accurate, as firms make their decision to formalise based on a cost-benefit analysis, and individuals who see large benefits to becoming formal would formalise, whereas those who would not derive similar benefits would choose to stay informal. This highlights the difficulty of establishing causality between productivity levels and formalisation, and a side-by-side comparison of formal and informal enterprises is likely to overstate the effects of formalisation.

Further In-depth

Bruhn and McKinesey highlight the importance of randomised experimental studies and econometric models that allow for the elimination of the selection bias from assessing the effects of formalisation. The results are rather surprising and are categorised in three compartments: the effects of easing formalisation on the number of firm registrations; the effects of easing formalisation on formalising previously informal firms; and the effects of information, waived costs and enforcement on the formalisation of informal firms.

Concerning the first category, two out of three studies have shown that easing formalisation by setting up one-stop-shops in urban areas increased business registration by approximately 5% in Mexico and Colombia, while a similar experiment in Brazil yielded a reduction in the number of firm registrations with no subsequent increase.

It is important to note that most studies cannot ascertain whether faster formalisation is due to the registration of previously informal firms or to the registration of new firms. The second category regarding the formalisation of previously informal firms yielded no substantial or permanent results: the effects of one-stop-shops in Mexico increased the number of business registration insignificantly, while the effect of issuing provisional licenses to businesses in Peru was short-term, as many firms did not renew their licenses later.

The third category of the effects of information and enforcement found that information and waived costs had no effect on formalisation rates in Brazil and Sri Lanka. Information alone had no effect on formalisation rates in Bangladesh, while subsidising the cost of obtaining a license increased the number of firms with a municipal license by 10-12%, even after the time of obtaining a municipal license was reduced from 160 to 1.6 days.

It is noteworthy that, while surveys of micro-enterprises show that informal firm owners are not well-informed about the process or costs of formalisation – with only 20% being aware of the costs of registration and the majority drastically exaggerating the amount of time it would take to register (more than a month vs. 2-5 days in reality) – information alone does not motivate firm owners to register. Most importantly, even after information, sanitary and inspection taxes and costs waived and free mandatory accounting services provided for the first year of formalisation, only one of  255 informal firms took the decision to formalise.

Long-lasting Effects

According to the studies presented in the Bruhn and McKenzie’s paper, the only factor that has a significant and long-lasting effect on increasing the rates of micro-enterprise formalisation is a higher rate of enforcement of regulations. Data shows that between 22-27% of enterprises that were visited by an inspector registered with the municipality – good news for policymakers who are looking for an efficient way to begin formalising micro-businesses.

While it is clear that information, one-stop-shops, and subsidies, are necessary steps to create a more efficient network, it is also clear that such steps are insufficient and unlikely to create lasting effects. The key issue for policymakers is in finding the correct combination of incentives and credit and labour market policies that would prompt small-scale firms to formalise.

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