What India’s informal sector needs right now

It is critical to provide protection to workers via social welfare schemes.

The lack of frequent and up-to-date economic indicators makes it hard to track India’s large informal sector, which employs around 80 per cent of the labour force and produces about 50 per cent of GDP.

A lot is at stake here. Ignoring problems in the informal sector can be costly as it can lead to job and wage losses, higher inflation and even risk the livelihood of migrant workers. For instance, following demonetisation, a disproportionately higher number of jobs were created in rural India which isn’t the positive it might seem as wages are 2.5 times lower than in urban India. As a result, overall wage levels and GDP declined over the next few years.

Informal sector workers suffered far more from the national lockdown in 2020 than their formal sector counterparts. With an inadequate safety net, there were painful accounts of displaced informal workers trying to get back to their rural homes.

Such disruptions can be inflationary too. India was one of the few countries with high inflation throughout pandemic-stricken 2020. Some of this is likely to be associated with the disruption in informal firms, who in normal times are very active in the production of essential goods like food and textiles.

Of the 384 million employed in the informal sector, half work in agriculture, living mostly in rural India, and the other half are in non-agricultural sectors. Of those, about half live in rural India and the remaining in urban areas. Each of these groups have fared differently through the pandemic.

The fortunes of those in the formal sector, who make up 20 per cent of the workforce, have been relatively good. Through the pandemic, large and listed firms have done better than smaller firms. A combination of cost-cutting, a lower interest rate environment, access to buoyant capital markets, and ongoing formalisation are likely to have helped keep profitability high.

The salaries of individuals working at these larger listed firms have also held up relatively better, though they are lower than the pre-pandemic trend. These individuals may also have benefitted from buoyant 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 post the first Covid-19 wave in 2020 by buying consumer durables 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 switch from spending on goods to services.

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

The prospects for the 40 per cent in the informal agricultural sector have been surprisingly resilient too. Rural wages have held up well over the pandemic, led by good monsoons, an exemption to the food trade from the various lockdowns, and more recently, higher agricultural exports. Higher government spending in various social welfare schemes has also helped.

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

The 40 per cent in the informal non-agricultural sector is the most worrying. These workers are most vulnerable as they have borne the brunt of the economic disruption that the pandemic has unleashed.

One half of this group lives in rural India. They have not done as well as their farming counterparts. Most of them involved in construction, trade and manufacturing have seen wage growth fall. The sharp rise in demand for rural unemployment benefits is an indicator of the disruption faced.

The other half lives in urban India and is employed across the trade, hotels, transport, manufacturing and construction sectors. This group has been at the receiving end of formalisation. We look closely at the constituent companies of the FTSE index, who by design, belong to the formal sector.

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

We believe this means that some demand, which was previously supplied by the informal sector, began to be supplied by the formal sector. Other data shows how spending has moved from small firms to bigger ones. It is no surprise that employees of large firms have done much better than small and informal firms.

Several surveys over this time also show a rise in urban unemployment and self-employment, with the latter category seeing the highest earnings loss.

What does all of this mean for economic growth? Formalisation can be a double-edged sword. While traditionally associated with
efficiency gains, if it comes at the cost of putting small informal firms out of business, and the disruption in the informal sector, it can weigh on demand in subsequent periods.

The constructive way to think about this is to differentiate between “forced” and “organic” formalisation. Formalisation that comes only on the back of external pressure or leads to deep distress in the informal sector, may not be sustainable. By contrast, formalisation that happens on the back of policy changes that help small and informal firms grow over time into medium or larger formal sector firms is more sustainable.

What is, perhaps, needed now is protection for informal sector workers via social welfare schemes so that the disruption they are facing does not lead to a permanent fall in demand. There is a case for remaining generous with programmes such as the rural MGNREGA scheme for
longer.

India doesn’t have an equivalent urban social welfare scheme. Government capex doubles up as one, providing short-term jobs. But this source of expenditure can be unreliable. We believe there is a good case for setting up a more permanent direct urban social welfare structure.

In the meantime, steps to promote reforms that are needed to help small businesses grow are critical. For example, lowering the regulatory burden associated with growing firms.

On a broader level, one big learning from the pandemic has been that India can’t wish away the informal sector. And neither can it be assumed that the fortunes of the formal and informal sectors move together.
Bringing the informal sector to the forefront of policy decisions can lead to a significant payoff for the entire economy for years to come.

The writer is chief India economist, HSBC Securities and Capital Markets (India) Pvt Ltd

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