November 11

Oscar Abello

Not a Formality: The Productivity of Capital

In a previous post, I described why the BoP can’t yet mobilize the $10 trillion of assets they already own. If they ever get the chance to do so, alongside other fresh and creative channels for mobilizing capital, the productivity of capital comes to mind as the next challenge for growing BoP businesses. Here’s a thought experiment to illustrate what I mean by productivity of capital.

Imagine a woman selling home-baked bread to support her family in any slum or rural village. Her business is not formally registered, which reinforces her business’s isolation, already limited to quite a small network of business acquaintances. In each transaction as a baker, she encounters a price. There’s a price paid for inputs – flour, yeast, eggs, and fuel for her oven – and there’s a price received for output – bread. Some she can sell on their own, right on her doorstep. Some she might take to market when she has the time. Much of it, she sells to a retailer who will take her bread to market along with bread from other nearby bakers.

It’s always a challenge to find the best inputs for a reasonable price, while finding the highest possible price for output. The challenge is greater as an informal business owner whose network of business acquaintances is typically limited to the surrounding neighborhood or village. It’s also no help that suppliers and buyers can’t guarantee that they’ll always have a good price at every transaction. This challenge is how to build a sustainable value chain from supplier to producer to hungry consumer. Given any amount of capital, the sustainability of a value chain determines just how far that capital will go toward creating further wealth and opportunity at the BoP. That’s the productivity of capital.

Building a sustainable value chain is incomparably easier when you are formally registered as a business. Businesses with legal status can formalize contracts between suppliers, retailers, transporters, franchises and other value chain components. When and where they are enforced in a timely fashion, formal contracts provide a solid foundation for value chains that go beyond local social circles, from upstream suppliers, to employees, to downstream retailers and consumers. Contracts increase the productivity of capital by providing an open and competitive environment to build value chains among broader networks of people.

BoP entrepreneurs understand the value of formal registration and contract enforcement. After ILD and CIPE helped to reduce registration costs in Lima during the ’80s and ’90s, over 380,000 existing informal business registered formally between ’91 and ’94. One of the most overlooked advantages of formal registration in a BoP market, is the power that contracts provide by bringing information into the formal legal system. When it comes to negotiating where to get better inputs at a better price, or where to sell outputs for a higher price, comparing contracts is more effective than comparing word-of-mouth recollections. Formal business relationships open up a world of sustainability, by documenting information and also by providing the reliability of setting prices for longer periods than one transaction.

Formalization also has impact beyond sustainability. Within a more open business environment, thanks to lower business registration costs, the ease with which an idea becomes commercially viable translates into more conducive environments for innovation. Wider-reaching value chains facilitate the faster spread of new goods and services, diminishing what growth economists call the ’stepping on toes’ effect, whereby competing innovators expend time and effort solving a problem for which a viable solution already exists. The faster entrepreneurs find out a problem has a commercially viable and accessible solution, the faster they collectively move on to solve other problems. When this can happen, the productivity of capital skyrockets.

If formal registration is so explosively beneficial, what’s the problem? The non-OECD average business registration time is 36 days and requires eight procedures, with official licensing and permit fees adding up to 39 percent of annual income per capita – to say nothing of taxes levied upon registered businesses. Due to such high costs of formal registration in developing economies, it’s not unusual to find that the informal sector still accounts for fifty percent or more of economic activity. In India, business registration costs two-thirds of annual income per capita. A recent ILO-WTO joint study stated that 93 percent of India’s workforce remains in the informal sector. (link to original study) Meanwhile, enforcing contracts outside the OECD takes, on average, 679 days, 40 procedures, and costs 34 percent of what is owed to the plaintiff.

In many places, these numbers have been improving; but they miss something that should be obvious to MFIs and other BoP supporters: gender inequality. Even in the too-few developing economies where women have the legal right to do any of the above, gender bias looms as a deciding factor against women, who often make up a vast majority of BoP entrepreneurs. Although teaching people how to fish can feed them for a lifetime, ’fishing’ won’t feed enough if the informal sector is the only place BoP entrepreneurs can ’fish.’ For capital to have real legs for development, the entrepreneurs it backs must not be locked out of the formal sector.