Formalizing the “informal” sector may intensify market fragmentation and trading inequalities (Senegal Edition)

This is from a fascinating paper by Abhit Bhandari, a PhD candidate at Columbia:

Economic growth requires confidence in the secure exchange of goods. But when states selectively enforce rule of law, political considerations can moderate the trust that buyers have in sellers. How do political connections moderate economic behavior in developing countries, and how do such connections operate alongside formal state institutions? I propose a theory of seller moral hazard in exchange, where buyers believe that politically connected sellers can break deals with relative impunity. In this context, state-backed formal contracts may only protect the claims of connected buyers who similarly receive preferential treatment from the state.

I test this theory in an environment with real economic stakes by creating and operating a legal business in Senegal, and hiring employees to conduct door-to-door sales. In a field experiment, I randomize whether my employees signal their political connections and/or offer formal contracts as part of the deal. Results show that sellers’ political connections decrease trust in exchange while formal contracts increase trust. Taking buyers’ connections into account, however, shows that asymmetric political connections impact willingness to trade, and that formal contracts boost trade only for politically connected buyers (emphasis added). These findings demonstrate the importance of unequal political connections in impeding trade, and the limits of piecemeal legal solutions. Exchange under such conditions can result in distinct trading networks that intensify inequalities.

Oh, and to get the study going Abhit registered a business in Senegal:

In preparation for the experiment, I undertook the process of creating and registering a formal business in Senegal. I completed the process in 2016 at APIX, Senegal’s primary agency for the promotion of investment and major works, which is also home to Senegal’s guichet unique (one-stop 20 shop) for formalizing a business. Despite the “one-stop” shop, the process took approximately one month from start to finish, as registering the business required the acquisition of certain documents that are not centrally controlled. This required visits to my local chef de quartier (neighborhood chief), police department, and the Ministry of Justice. The result of the process was the successful formalization of the business and the receipt of a unique business identification number called the NINEA (numero d’identification national des entreprises et des associations). NINEAs are commonly understood in Senegal as proof that a business is formal.

I highly recommend reading the paper. Abhit’s other ongoing projects are available here.

screenshot2019-01-31at9.02.58pmInspired by Yuen Yuen Ang’s take on the institutional structures that shepherded China’s takeoff, I have recently been thinking more seriously about what “optimal” institutions (as opposed to some notion of “strong” institutions) in specific developing country contexts would look like. With this in mind, Abhit’s paper offers an important insight into the potential pitfalls of lukewarm reforms — in this case the process of sectoral formalization. A common mistake made by most would-be reformers is the total disregard for forms of organization that make business transactions credible in the “informal” sector in the name of imposing a state-centric rule-based systems. As Abhit finds, the usefulness of formalization crucially depends on whether it also serves to level the playing field and expand the extent of firms’ markets. I for one think that the distinction between “formal” and “informal” sectors tell more about states’ fragmented regulatory capacity than about specific firms or sectors.

More broadly, I would argue that the world would be a better place if we knew more about firms in low-income states. What policy interventions can help accelerate firm growth? What management practices work in contexts where labor is insufficiently specialized (for insurance purposes)? Is firm-level productivity in Nigeria, Kenya, or Angola improving or not?

(If you know any works along these lines the comments section is open)