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How to build a staircase between formal and informal economies

Intermediaries not bureaucratic government approaches are what’s needed for the ground floor to meet the top floor

15 May 2022 - 17:58 By John Luiz
In Zimbabwe, a private, for-profit organisation backed a donor-funded project, acting as a bridge between the formal and informal economies connecting small-scale farmers to formal markets.
BRIDGING THE GAP In Zimbabwe, a private, for-profit organisation backed a donor-funded project, acting as a bridge between the formal and informal economies connecting small-scale farmers to formal markets.
Image: 123RF/Kostic Dusan

In 2003 Thabo Mbeki, then president of SA, described the country’s economy as being like a two-storey house. The top floor was quite plush, with all the fittings packed neatly together. He referred to this as the modern, diversified economy within SA. Below that level, however, was an informal economy, where the poor were trapped in poverty, with little or no skills.

Mbeki’s analogy went further: there was no interconnecting staircase between the two floors. In effect, SA had two economies and there was no bridge between them.

What Mbeki was describing is a common problem in developing countries, including Zimbabwe. My colleague Baldwin Guchu and I recently conducted research on an initiative in Zimbabwe that is trying to address the problem. In the paper we examined the role intermediaries are playing in connecting formal and informal economies in the country. SA can learn from this.

Since 1994 SA has built on the existing two-storey infrastructure without paying much attention to a stairway. At least not one wide or sturdy enough to encourage upward movement. This poses a serious developmental problem, one shared by many developing economies.

Academic research typically labels this as being a function of dualism and the lack of institutional connections between these dual economies: though institutions establish the “rules of the game” governing economic activity in each of these economies, the institutions do not bridge the two disparate economies and so they coexist, but in isolation.

How often do we hear the refrain that big business does not do business with small business?

The result of this missing link is that the two economies struggle to engage with each other, leading to inefficiencies and substantial lost opportunities. Worse still, it entrenches social and economic divisions, and deepens inequality. We see this manifest in various ways in SA.

The country has deep and liquid financial markets, with a highly functioning and well-regulated banking industry, which means our top-floor financial system measures well against any of the leading economies in the world. Access to capital should therefore be widely available.

But it’s not. Swathes of small businesses fail to meet the criteria set for top-floor financing. In developed economies small businesses have a range of alternatives for financing from banks or other capital markets, including secured and unsecured options.

How can this be fixed? Claiming “it’s the government’s job” ignores other players who have the ability to play a more innovative intermediary role.

Small-scale farmers need some level of financing to ensure access to machinery and a sustainable supply of input commodities necessary to plant, harvest and store their crops. This is impossible without collateral to guarantee a loan or without buying contracts from retailers. The result is that they are trapped in a vicious cycle -- they can’t borrow money to produce, nor are they able to produce to borrow money.

If SA’s two-storey economy is pronounced, Zimbabwe’s is severe. Its house is pyramid shaped. Yet there are attempts under way to connect the different levels. Our research looked at what these are.

The role of intermediaries

Zimbabwe has a reputation for weak and extractive political and economic institutions. The World Bank estimates that the informal economy makes up approximately 60% of the total economy; roughly 90% of those considered “employed” work in the informal economy.

This is especially true in the agricultural space, where the combined legacy of colonialism and, more recently, land grabs has carved a chasm between large-scale commercial farmers and small-scale, often subsistence farmers.

These smaller producers cooperate in their villages through a system of mutual trust, but this way of doing things does not extend beyond the villages. Tight legal contracts are needed to sell to the bigger retail industry players. In addition, small-scale farmers need some level of financing to ensure access to machinery and a sustainable supply of input commodities necessary to plant, harvest and store their crops.

This is impossible without collateral to guarantee a loan or without buying contracts from retailers. The result is that they are trapped in a vicious cycle — they can’t borrow money to produce, nor are they able to produce to borrow money.

That’s where an organisation such as the private, for-profit entity Palladium can step in. Its approach is collaborative. In this case it backed a donor-funded project, acting as a bridge between the formal and informal economies connecting small-scale farmers to formal markets. In other words, the staircase between the two floors.

Palladium functions as an intermediary in various ways. It facilitates contract farming by connecting input suppliers with small-scale farmers, who then agree to sell the produce back to them at a pre-agreed future price. This addresses input financing and provides a guaranteed market for the farmers’ output.

It also builds partnerships with the private sector to enable mobile buying systems. This frees farmers from having to find a market and ensures them a fair price; furthermore, it relieves them of the problem of storage and packaging.

What governments can do is enable policies that support these intermediaries to function effectively and to recognise that the traditional boundaries between the public and private sectors are increasingly blurred and hybrid partnerships provide the potential for innovative solutions.

As part of a consignment stock initiative, the intermediary also keeps an electronic transaction history farmers can use to access credit in the future by providing records and information that would otherwise be missing.

Solutions

All these interventions are better served by intermediaries rather than through bureaucratic government overreach. This is particularly true where government institutional capacity is weak and corruption is common.

Governments with little or no entrepreneurial mindset fail at this because they don’t see a gap they can fill in a sustainable way. What governments can do is enable policies that support these intermediaries to function effectively and to recognise that the traditional boundaries between the public and private sectors are increasingly blurred and hybrid partnerships provide the potential for innovative solutions.

For its part big business needs to realise that maintaining the status quo of dual economies delegitimises markets and results in lost opportunities.

The question for intermediaries is to imagine ways in which bridging support can extend beyond project initiatives. These projects are time-bound, with limited budgets. If not implemented with longevity in mind, such interventions can create dependencies rather than solve them. That’s why longer-term, more sustainable solutions must be imagined to bring the formal and informal economies closer together. And also to ensure permanent integration.

Without this type of lateral thinking countries like SA and Zimbabwe will continue to have two-storey houses with no stairway, leaving the majority of citizens stranded on the ground floor looking upwards. Such structural inequality is unsustainable.

John Luiz is a professor of international business strategy and emerging markets at the UK’s University of Sussex Business School and the Graduate School of Business, University of Cape Town.

Baldwin Guchu is a co-author of this article. He has a background in financial management, with his work focusing on the nexus between institutions and financial markets in developing regions.

This article was first published by The Conversation.

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