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Does Informality Depress Investments and Job Recovery? Firm-Level Evidence from the COVID-19 Crisis in South Asia

Source: Policy Research Working Paper No. 10580
Authors: Arti Grover & Mariana Pereira-López
Date: October 2023

1. Introduction and Objective

The COVID-19 crisis disproportionately impacted informal firms in South Asia, exacerbated by their higher exposure to financial constraints and uncertainty. Using three rounds of Business Pulse Surveys (BPS) data (May 2020-August 2022), the study analyzes the link between informality and investment/employment decisions post-crisis. The objective is to quantify how informal firms' acute credit constraints and heightened uncertainty hindered recovery.

2. Key Findings

• Financial Constraints and Uncertainty:
  • Informal firms faced tighter liquidity constraints and were less likely to fall into arrears, possibly due to lower liabilities but also reduced access to formal finance. The extensive margin of informality (lack of registration) strongly correlated with financial constraints.
• Impact on Investment:
  • Fully informal firms had a 25 percentage-point lower probability of investing in digital technologies and fixed assets compared to formal firms. This was driven by financial constraints and high uncertainty, with necessity firms being most affected.
• Employment Adjustments:
  • Informal firms exhibited lower elasticity in employment adjustment and job recovery compared to formal firms. Parasite-type firms (highest formality) responded more to sales recovery, while necessity and De Soto firms showed minimal responsiveness.
• Crisis-Induced Barriers:
  • Credit crunch and uncertainty delayed investment decisions. Informal firms' limited managerial capacity and difficulty in forecasting sales further constrained their ability to invest and adjust employment.

3. Policy Implications

1. Financial Inclusion:
   • Strengthen microfinance and develop financial markets to improve access for informal firms.
2. Uncertainty Reduction:
   • Clear communication of support programs by policymakers to mitigate uncertainty's impact on delayed decisions.
3. Formalization Incentives:
   • Balanced policies reducing formalization costs and increasing benefits to encourage transition to formal finance and drive economic growth.

4. Limitations

• Data collection gaps in Afghanistan and Sri Lanka restricted recovery phase analysis.
• Low sample response rates in certain countries for digital readiness sections.

This study underscores the need for targeted policy interventions to address the unique challenges of informality during economic crises, especially in developing regions like South Asia. End.