Demonetisation push to labour reforms: molding the future of the markets

Demonetisation has the potential to facilitate an environment that will develop a formal culture in India’s labour markets

Among the loudest critics of the demonetisation policy are those who predict doom for India’s informal sector as a result of this exogenous shock. Numerous anecdotes are being forwarded to highlight the suffering of daily wage earners and informal labourers across the country. Let us use this opportunity to critically evaluate the factors that have contributed to keeping approximately 83% of India’s labour force informal, despite 25 years of modest growth in a seemingly liberalized economy.

The most authentic estimates of the size of informal labour market in India are from the National Sample Survey Office, which holds employment-unemployment rounds every few years. The data shows little has changed over the years in the nature of employment, as size the of the informal labour market remained significantly high and predominant in the economy overall. In 2004-05, the composition of organized vs unorganized was 13:87; while in 2011-12, this had changed to 17:83. The growth in organized employment was, however, overwhelmingly informal in nature. So, even within the organized sector of the Indian economy, formal employment declined significantly and informal employment rose with time. Within the unorganized sector, nearly all the increase was, expectedly, informal in nature.

If we dig deeper, we find some troubling truths about our growth story. While the share of agriculture in total employment has fallen from approximately 60% to less than 50% and the share of manufacturing remained largely unaffected at approximately 12%, it is the share of the non-manufacturing sector (construction) which has nearly doubled from 6% to 12%, while the share of the services sector rose from 23% to 27%. Informal employment in the non-agricultural sector increased by 27%. Most jobs created in the high growth period of the last decade have been informal in nature, even in the organized sector. This implies that the benefits of Indian economic growth are concentrated among a few, while a growing proportion of the population has been relegated to living as working poor.

The literature over the last one decade has identified lack of labour reforms as the main culprit that has kept employment in India low and informal. Poor labour laws have often been cited as the menacing shackle around Indian manufacturing. Lack of labour reforms has generally meant multiple labour legislation that deter hiring of labour. Over the last several years, some states have been proactive and have lowered the stringency of labour regulations and simplified compliance and procedural requirements. But the empirical evidence on this leads us to a fundamental puzzle: Even in those states of India that achieved a high labour reform index, like Gujarat and Andhra Pradesh, the jobs that were created were overwhelmingly informal in nature. The lesson, then, is that labour reforms are not enough. There is a need to make serious efforts at facilitating a widespread environment that will develop a formal culture in India’s labour markets. demonetisation has the potential to become one such serious policy intervention.

Despite high growth, most sectors chose to employ labour informally because it lowered their overall costs. Routing wages and salaries away from cash payments and towards formal channels such as bank accounts, electronic and mobile payments will create a formal culture of employment, but in the process obviously lead to higher costs for firms. But this must be viewed as a correction of a distortion in the labour markets in India. Much like the Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGS) which effectively enforced the minimum wages legislation in a labour-abundant economy like ours. India had minimum wage legislation long before the MGNREGS was conceived, yet its implementation was lacking for reasons of enforcement.

When the flagship rural jobs scheme was implemented across the country, rural wages saw a significant increase. There is sufficient robust empirical evidence to support this rise. And the wage increase was higher in states where MGNREGS was “better” implemented, such as in Andhra Pradesh. Everyone who employed rural labour would now have to compete with or match the minimum wages paid at the MGNREGS worksites. The private labour market was deeply affected, and this meant that the costs of production rose for most micro, small and medium enterprises in the rural economy. This was a new equilibrium being wrestled between a welfare state enforcing minimum wages in a labour-surplus economy, and a rapidly growing private sector that provided jobs and higher incomes to millions of Indians. After 10 years, there is evidence to support that the overall effects of MGNREGS were positive as it lowered poverty without impeding growth.

Demonetisation is forcing employers in the country to reconsider employment contracts. There needs to be a simultaneous push from the formal financial institutions such as banks, payment interfaces such as National Payments Corporation of India and other private firms to facilitate the adoption of new payment methods. Each firm will have to assess its internal fundamentals to evaluate what the short-term costs of going formal entail while achieving operational and dynamic efficiency to remain in business in the long run. This can only be great for their employees and the economy overall.

This article first appeared in Mint, on 15 December 2016. Like other products of the Brookings Institution India Center, this report is intended to contribute to discussion and stimulate debate on important issues.
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