Informally, yours: The prospects of the unorganised sector

We look closely at the constituent companies of the FTSE index, which by design, belong to the ‘formal sector’. (Representative image)

By Pranjul Bhandari & Aayushi Chaudhary

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The lack of high-frequency real-time economic indicators make it hard to track India’s large informal sector, which employs c80% of the labour force and produces c50% of the GDP. Proxying informal sector GDP by formal sector GDP works fine on normal days, but not when the two sectors are diverging. Recent shocks such as demonetisation and the pandemic have delivered a big blow to informal sector firms.

Around 80% of India’s labour force is employed in the informal sector, and the remaining c20% in the formal sector. Of the c80% informal sector workforce, half work in agriculture (c40% of total workforce), and the remaining in non-agricultural sectors (c40% of total workforce). Of the c40% non-agricultural informal sector workers, about half live in rural India and the remaining in urban India. Meanwhile, almost all of the c40% agricultural informal sector workers live in rural India. Of the c20% formal labour force, c8% is employed in the industrial sector, and c12% in services (of which about half is public services).

About two-thirds of rural workforce are in agriculture, and almost all are informally employed. The second wave hit rural India hard. Rural sentiment fell sharply, but has begun to recover since. To understand the economic health of agricultural workers, we divide them up into marginal farmers, who we broadly refer to as the ‘landless’ (~70% of households, owning less than 1 hectare of land) and the ‘landed’ (~30%, owning >1 hectare).

Wages, the main source of income for the landless, have been resilient over 2020-21, led by good monsoons and elevated reservoir levels. It helped that agricultural production and distribution were exempt from the various lockdowns, and being an ‘essential’, the demand for food remained robust. Recently, domestic demand has been accompanied by strong foreign demand. Agricultural exports have been on the rise. Alongside, the government has raised social welfare spending in rural India over the last year, which has propped up incomes.

Cultivation is the main source of income for the landed. Strong monsoon and robust production are likely to have aided the incomes of the landed over 2020-21, just as they did for the landless. This class is also more indebted than the landless, and here, there is some data to support that real indebtedness has moderated in recent years.

Will agricultural labourers contribute to the “pent-up demand” in 2021? Perhaps, but only selectively. As rural Indians emerge from the second wave, they may want to consume goods that make them feel more secure, funded by the relatively resilient agricultural incomes of 2020-21. These goods could include discretionary items such as two-wheelers, as well as home repair/renovations services.

Having said that, for at least three reasons, this is likely to be a selective wave of demand, rather than a large and broad-based one. One, while reservoir levels, an important driver of rural fortunes, are trending higher than the long-term average (31% of storage capacity on July 8, versus 25% long-term average), it is lower than last year (33%). We find that reservoir levels by the end of July matter most, and the catch up in July rains will be critical. Current rainfall deficit is 6% as of July 13 (but it is forecast by the weather department to catch up in subsequent weeks). Two, with core inflation rising recently, the terms of trade may tip against rural India. Three, even as agricultural wages are strong, non-agricultural wages have not been as resilient.

What are their long-term prospects? Pent-up demand is a one-off. Will agricultural workers have the income to support higher longer-term consumption demand? Given the irrigation infrastructure is patchy, rural incomes depend much on the vagaries on monsoon rains. Two things may be needed to snap out of this. One, more diversification of income sources. Too many people work on the farm. And two, higher agricultural productivity. Both of these need agricultural reforms—improving rural infrastructure, food distribution networks, crop insurance spread, etc.

Those employed in the non-agricultural informal sector, making up 40% of India’s labour are half rural, half urban. We worry that this group has borne the brunt of the economic disruption that the pandemic has unleashed. To explain our point, we first need to understand what these 40% do. On an all-India level, about half of these 40% are employed in industry (manufacturing and construction in equal parts), and half in services (like trade, hotels and restaurants).

The informal sector labour force of rural India, who are not in farming, are not doing as well. These labourers, making up 20% of labour force are mostly involved in construction, followed by trade and transport and manufacturing. Alas, non-agricultural wages have not been as buoyant as agricultural wages. The sharp rise in the demand for NREGA works may also be an indicator of this. The lack of convergence in rural wages. But this seems rather odd. Why are rural agriculture and non-agriculture wages diverging? Shouldn’t there be scope for arbitrage which makes the two converge? To understand what’s going on, we use a Granger Causality econometric set up. Using data from 2015 to 2021, we find that indeed, agriculture and non-agricultural wages are correlated with an optimal lag of 5 months. In econometric parlance, agricultural wages granger-cause non-agricultural wages, and vice versa.

We test this again, this time taking a more recent timeframe, i.e. 2018 to 2021, we find that while the two do correlate, the period over which this happens is 10 months, double the time compared to our first regression.

And finally, taking a more historical timeframe, i.e. 2015-2018, the optimal lag falls sharply to just 3 months. What’s going on? Why is arbitrage between agriculture and non-agriculture wages taking much longer now than in the past?

The dependence of rural workforce on agriculture has fallen over time, as the importance of activities like construction has risen. And some of the key drivers of the two differ. For instance, good monsoons are a key driver of agricultural wages, while urban demand and health of the banking sector can be a driver of non-agricultural wages. And since these drivers are unrelated, it is possible for them to diverge, elongating the timeframe over which agricultural and non-agricultural wages converge. But eventually they will converge, and whether they converge to the higher wage or the lower one, will determine the sustainability of rural demand.

The informal sector labour force of urban India, making up 20% of labour force, are employed across trade, hotels, transport, manufacturing, construction and others. They are at the receiving end of ‘forced formalisation’. Shocks such as the pandemic and demonetisation are likely to have hurt the informal sector, which does not have adequate buffers to withstand large shocks, more acutely.

We look closely at the constituent companies of the FTSE index, which 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 demonetisation, and also the pandemic period, formal corporate sales overshot nominal GDP growth.

This means some demand, which was previously catered to by the informal sector, began to be catered by the formal sector. Another database shows how demand moved from small firms to the bigger ones. It is no surprise that employees of large firms have done much better than small firms. And extending that, those involved with the small informal firms are likely to have done even worse.

The April-June 2020 PLFS survey showed a rise in self-employment in urban areas. Another recently conducted survey showed that this category suffered the highest earnings loss (in Sep-Oct 2020 vs same time a year ago).

Large and listed firms have benefitted through the pandemic and the resultant “formalisation” has showed up clearly in corporate results. Given the large efficiency gains associated with the formal sector, it is no surprise that equity markets have cheered hard.

But “formalisation” can be a double edged sword. If it happens at the cost of putting small informal firms out of business, then the disruption in the informal sector can weigh on demand in subsequent periods.

In previous research (and also discussed earlier in the report), we found that when urban informal workers without social security lose jobs, many move back to their rural homes. But rural wages are 2.5x lower than urban wages, leading to lower demand and growth over time.

It is also possible that formalisation wears off over time. If the ecosystem that promotes formality does not change very much, the informal sector makes a comeback. And in that case, the efficiency gains associated with formalisation wears off.

The constructive way to think about this is perhaps to differentiate between ‘forced’ and ‘organic’ formalisation. The formalisation that comes only on the back of external pressure or leads to deep distress in the informal sector, may not be sustainable. In contrast, the formalisation that happens on the back of policy changes which help small and informal firms grow over time into medium or larger formal sector firms, is more sustainable. What is perhaps needed now is to protect the 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 of remaining generous with programmes such as the rural NREGA scheme for longer. India doesn’t have an equivalent urban social welfare scheme. Government capex doubles up as an urban welfare scheme, providing short term jobs. But government capex can be unreliable. The government has also focussed on credit guarantee schemes this time around. But the success of those depends much on the health of the intermediaries—India’s banking sector. We believe there is a good case for setting up a more permanent direct urban social welfare structure. And in the meantime, steps to promote reforms that are necessary to help small businesses grow is critical—for example, lowering the regulatory burden associated with growing firms.

India can’t wish away the informal sector. And neither can it be assumed that the fortunes of the formal and informal sector move together. Investing in real-time informal sector data, and bringing the informal sector to the forefront of policy decisions can have large multi-year economic growth payback.

The authors are Respectively, chief economist (India) and economist, HSBC Securities and Capital Markets (India) Pvt Ltd

Edited excerpts from HSBC Global Research’s India Economics report dated July 15