Small entrepreneurs key to India’s urban future, job creation, and growth revival

Our mindset lets large enterprises have a disproportionate influence in policy making, with no place for the informal sector at the table. But India’s urban future, job creation, and growth revival may be with the small entrepreneurs

Small entrepreneurs key to India’s urban future, job creation, and growth revival
India’s informal manufacturing sector is large, no matter which definition we use, enterprise or employment.

By Ejaz Ghani

For developing countries as a group, more than half of all jobs still remain in the informal sector. Early views of industrialisation leading to an inexorable pull of the rural population into urban areas saw urbanisation and formalisation as being the same thing. Later views of rural-urban migration, as leading to a translation of rural poverty into urban poverty, coincided with caution on urbanisation, and greater support for rural development.

We now find ourselves at a conjuncture where urbanisation is being promoted as an integral part of our growth strategy, but concerns about the informal sector have been folded with the black economy, congestion costs, and a threat to law and order and social cohesion. The “undermining of social cohesion and law and order” bears a familiar resemblance to concerns of colonial regulators about activities that were “on the other side” of the dual economy divide. These concerns run counter to our understanding that the informal sector remains an integral part of India’s structural transformation and young demographics (

The growth dynamics of the formal and informal sectors are very different. These differences can be seen in their spatial location, the pace at which they create jobs, their contribution to traded and non-tradable activities, and their impact on networking and gender equality. These differences are enormous. But informal and formal sectors remain friends, not foes.

India’s urban transformation is taking place at a 100-times faster pace than what developed countries have experienced. India is also the youngest country in the world, riding a wave of youth bulge that will continue to add 10 million additional workers to the labor force every year for decades to come. Urbanisation and informal sectors have the potential to complement each other, and absorb this youth bulge and promote shared prosperity. Policy makers should not worry about slow pace of formalisation.

Trends in urbanisation and formalisation
India’s informal manufacturing sector is large, no matter which definition we use, enterprise or employment. While India’s overall manufacturing sector has become more urbanised, the differences in the spatial development of the formal and informal sectors are striking. The formal sector is de-urbanising rapidly and moving from urban to rural locations to remain cost competitive. India is one of the most densely populated countries in the world, and the high population density of a city makes large-scale manufacturing less competitive, and forces them to move to a rural setting. On the other hand, the informal sector is urbanising rapidly to benefit from a better physical infrastructure.

The urbanisation of the informal sector and the de-urbanisation of the formal sector can’t be explained by changing definition of urbanisation, as the definition of an urban setting in India has been mostly stable since the 1961 census. India uses a more demanding set of criteria than most countries to define what is ‘urban’. For example, substantial parts of the US metropolitan areas like Atlanta or Phoenix would be classified as rural in Indian statistical analyses because their population densities fall below 1,000 persons per square mile.

India’s employment growth in the manufacturing sector during the last two decades has occurred largely in the urban areas. Job growth has been concentrated in the informal sector. Informal sector jobs have expanded in the traded sector and contracted in the non-tradable sector. So, growth in traded industries is not due to plants achieving larger economies of scale, as was expected from reforms implemented in the early 1990s. The rapid urbanisation of the informal sector appears to be the most important factor.

Informal sectors conform much more closely to the overall contours of India’s economic geography than formal sectors. Not all jobs in the informal economy yield paltry incomes. Many self-employed earn more than unskilled or low-skilled workers in the formal economy. A diverse and large number of entrepreneurs in garment industry in New York have made it much more competitive compared to Pittsburgh with one large and vertically integrated steel factory, which has now become a ghost town.

It is unlikely that rapid urbanisation and technological changes will lead to the demise of the informal sector. Remaining small is a rational response to high urban density. Technological changes have enabled entrepreneurs to operate at a smaller scale, and benefit much more from networking and agglomeration economies associated with urbanisation. The growth benefits of urbanisation come from agglomeration economies, which are much stronger in India compared to the US. It is even stronger in the informal sectors.

Tax reforms, demonetisation and financial stress
While the goal of Goods and Service Tax reform is commendable, its hasty implementation has adversely impacted small entrepreneurs in the informal sector. It has broken the link between formal and informal sectors. Large enterprises that outsource a lot of tasks to small enterprises are now less inclined to outsource it to the informal sector that barely come under the GST net. The informal sector has been badly affected by the economic slowdown and much of this may not be captured in official statistics.

Insolvency and bankruptcy reforms are important and needed for more efficient resource allocation. But it is not of a great consequence to the informal sector. There is mounting evidence that economic shocks that worsen infrastructure affect informal sectors by reducing their access to markets and basic services.

There is rising concern that demonetisation has also adversely impacted the informal sector more than the formal sector. Hundreds of millions of small enterprises that operate in the informal sector, and which are cash dependent, have suffered losses and lost their jobs. India may have experienced a potential reversal in structural transformation, as more than 2 million people have migrated back to villages from cities. But the backbone of the informal sector is not broken, as India’s urbanisation will continue to expand the informal sector.

Policy agenda
India’s favorable structural trends and young demographics will revive growth, with urbanisation and informal sector playing a key role in job creation. First, the FM could explicitly recognise the role of informal sector as an important driver of growth and job creation in the next Budget. Second, while the agenda on smart cities has caught the attention of policy makers, it needs to be made more inclusionary by integrating the informal sector into city planning, budgeting and financing. Third, technological revolution has made the informal sector as partners in development. Smartphones have become the key tool for women entrepreneurs, putting instant information about safety alerts, traffic, tourism, health services, and community news into millions of hands. India’s urban future is in the informal sector.

Lead economist, World Bank.
Views are personal

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