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Understanding formalisation and its benefits – for all Egyptians

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Office of Peruvian economist Hernando de Soto responds to Egyptian op-ed, defends benefits of formalisation in developing economies like Egypt

Hernando de Soto

Hernando de Soto

In an article published in El Shorouk on 3 June, 2014, Mr. Galal Ameen argues that the formalisation programs for Egypt championed by Hernando de Soto and the think tank he leads, the Institute for Liberty and Democracy (ILD), will not benefit the poor. According to Ameen, “the poor can never benefit from a credit system that sides with the major capitalists and proprietary classes no matter what deeds and documents proving their entitlements are registered. The rich will continue to harvest most of the credit and the entitled poor will not find any benefit of the registered documents except for selling their small properties to the proprietors who will only become richer.”  Ameen concludes that “giving the poor deeds of entitlement would be (…) like tapping signs on their backs that say: ‘Kick me!,’ because all this would end up with kicking the poor out of their properties instead of enhancing their livelihoods.”

Unfortunately, Ameen’s criticisms are based on common misconceptions about formalisation and are short on the facts about the impact of formalisation around the developing world, particularly in De Soto’s native Peru, where ILD reforms initiated three decades ago have had impressive economic effects on helping the poor enter the middle class and growing the economy.  In his effort to portray De Soto as just another “neoliberal” apologist, spreading capitalism and its “cruelty” rather than really helping the poor, Ameen also displays a shaky grasp on De Soto’s ideas and the actual ILD Reform Program, first proposed to the Egyptian Government in 2004.

As readers of De Soto’s book “The Mystery of Capital” or the many articles he has written in recent years about Egypt’s economic problems and the root causes of the Arab Spring know, he has never claimed that formalising property is some kind of “silver bullet” that will solve every problem that developing nations face. In fact, De Soto has argued clearly and often that formalisation is more than just handing out property titles.  He has also explained that property rights involve a lot more than defending the self-interest and real estate of the very rich. Economic growth, he reminds us, is primarily driven by entrepreneurship and investment.  Entrepreneurs make “combinations” out of assets and the talents of people, joining them into more complex and valuable wholes. The higher the value of these aggregations, the more economic growth there will be.  Humanity’s most innovative achievements – from the 120 parts that make up your clock to the countless financial deals and developments that produced the Internet and flight navigation systems – all result from joining people and things to each other.

Today, most Egyptian entrepreneurs are struggling outside the law in the informal economy without the ability to make those combinations – like most entrepreneurs throughout the developing world, as De Soto was the first to point out in his writings decades ago.  He has noted that Egypt’s informals are, in fact, part of a global social movement in the developing world that for the past three to five decades have been fleeing small-scale, economically exhausted societies (tribal, communal, feudal) toward their countries’ large-scale globalised economies. Blocked from entering the legal and global markets by burdensome, discriminatory and just plain bad laws, they are trapped in the informal economy without the protections or benefits of the legal system. Instead, they cobble together hundreds of anarchic and discrete informal arrangements for holding and protecting their property and doing business outside the law.

 

After working for six years with 120 Arab researchers, ILD identified a series of obstacles that Egypt’s informals faced every day, grouping them into 13 categories – with easily implemented solutions.

  1. Too many laws to get into business: 215 separate laws. ILD has consolidated incorporation rules into one law.
  2. Too many organisations to deal with: 29 different agencies. ILD’s redesign includes a “New Business Public Registry” (NBPR), eliminating $200 million in constraint-related costs.
  3. Too much time to register: 189 days, 86 steps and EGP 8,362 for a single-person business. ILD redesign decreases the time to 19 days.
  4. Redundant documentation: Registering a business requires 57 documents for six agencies —containing the same information. ILD’s redesign requires only ID and four documents to be presented to the NBPR.
  5. Too difficult to shut down a business: Exit procedures are not clearly established or regulated. ILD’s redesign consolidates regulations for voluntarily leaving the market into a single law under the NBPR.
  6. No mechanisms for protecting the property of the vast majority of companies:  90% of all businesses are unable to protect their assets or to attribute them any economic functions. The ILD has drafted legislation to enable property to be used for other purposes, such as: – Limited liability to reduce exposure with respect to third parties – Protection of personal, family or communal assets by limiting liability – Issuing shares to raise capital – Bills and notes proving ownership to raise finance – The concept of branding and entitlement for representing reputation, good will, and identity – Property registration used as information for collateral – the creation titles and records to increase value of property and provide information to allow risk to be properly measured, etc.
  7. No Accounting Standards: ILD’s solution is an Accounting Council dedicated to the regulation of accounting standards.
  8. Arbitrary procedures: Lack of standardised forms and payment schedules for tax and social security payments undermines compliance and encourages arbitrary inspections, unpredictability and redundancy. ILD’s solution is a Simplification System to coordinate rules, payment brackets and schedules for Tax Administration, and Social Security.
  9. Inadequate information: Because most businesses are informal, creditors are unable to obtain up-to-date information on a business’ financial status, making it difficult to obtain credit. ILD’s redesign includes a new Business Information System with mechanisms for exchanging data between government agencies and utility companies.
  10. Too many risks: A foreclosure to recover even a debt of EGP 20,000 secured with real estate requires 162 processes, 411 days and EGP 7,286 (8 years, on appeal); secured credit is even more costly. ILD’s solution is a special system for resolving disputes reducing foreclosure period for mortgages by 55% —and pledges by 77%.
  11. Too hard to globalise: Importing and exporting goods is time-consuming and costly; e.g. importing spare parts for vehicles by air requires 46 steps, 116 days, and costs EGP 6,799. ILD’s solution is for the NBPR to also handle all import/export authorisations using simple and precise procedures.
  12. Property is not fungible: Because the rules for assigning, recognising and protecting property rights are dispersed across at least 132 laws applied by 44 entities, 92% of Egyptians hold property extra-legally: formalising a piece of state-owned land, for example, requires 174 steps, 460 days and costs EGP 17,911. ILD’s solution is a “New Real Estate Registry.”
  13. Too much non-legal access to property: Most property in Egypt cannot be protected from expropriation, used to its full value, combined to create more wealth, used as security to obtain credit, divided into shares to generate business capital. ILD’s New Real Estate Registry will make all this possible.

ILD presented a plan in 2004 for removing these constraints on wide-based growth.  If those reforms had been done, Egypt’s GDP would have increased after 2010 by more than $2.6bn per year; the equivalent of:

  • 54% of the loan from the International Monetary Fund ($4.8bn).
  • 58% of the value of Foreign Direct Investment in Egypt ($4.5bn).
  • 41% of the value of all World Bank loans to Egypt ($6.3bn).
  • 31% of the Market Value of companies on the Cairo Stock Exchange ($8.3bn).

The plan that ILD has now proposed to the Sisi government will update its findings and reform recommendations.

 

Formalisation, De Soto has argued, is ultimately about nation building —including all of the country’s people into a single constituency unified by a single rule of law.  He has also pointed out that in the 18th and 19th centuries, the US. and European countries were also the home of massive informal economies full of migrants, squatters and poor entrepreneurs suffering through social, political and economic disruptions of the Industrial Revolution.  And then, thanks to a series of legal reforms that gathered and organised the knowledge fragmented and dispersed through their own informal economies, they were able to formalise the assets of their poor majorities to that they cold do business not only on a local but national scale. Thus integrated into the legal system, people gained access to its tools and their benefits:  property rights that facilitate buying and selling for combinations, limited liability, and asset sharing to reduce the risk of expropriation; the ability to make commitments to contractual documents instead of speech acts; a hierarchic structure independent from family or political organisations to divide labour among specific sub-functions submitted to a single-control system; limited liability to reduce risk and separate what is personal from business; perpetual succession so as to transfer capital and reputation over time; asset partitioning to pull and distribute resources in the abstract without having to physically separate them; to issue shares representing property against investment; to create a moral personhood to establish a separate entity independent from its owners within which collaborative efforts can be objectively organised; asset collateralisation to generate mortgages, guarantee credit, and encourage compliance by attaching owners to assets, assets to addresses, and addresses to enforcement.

 

Providing easy, affordable access to all those essential legal tools to any and every Egyptian who wants them is the ultimate objective of ILD formalisation programme for Egypt.  Ameen is worried about the poor being “kicked out of their property.”  That will not happen if they have the same legal protections that Egypt’s elites have – another primary goal of the ILD’s plan.  Moreover, Ameen does no service to Egypt’s poor by ignoring the impact of ILD’s formalisation programme in other countries, particularly in Peru where it was first introduced more than 30 years ago – in the midst of that country’s worst economic crisis with 7,600% inflation, a GDP drop of 13.4% and the entire country terrorised by a radical communist terrorist group that called itself “The Shining Path.”  Today, Peru is Latin American’s fastest growing economy – with a middle class growing four times faster than its neighbors and the least amount of violence in the region.

 

The impact of the ILD’s reforms is no secret, having been documented across a number of areas by independent authorities.  For example:

 

  • After the implementation of the formalisation programmes designed by the ILD and executed by Peru’s national formalisation agency (COFOPRI), which was also designed by ILD, 1.7 million plots of land located in marginal urban areas in which 8.4 million people lived were titled and registered.

 

  • As a result of formalisation, the owners of the 1.7 million titled and registered land had the option to enter the legal market transactions protected by the legal framework, for example, transfer, rent, sell or use as collateral real estate assets.

 

  • Formalisation also encouraged titled landowners to invest in improvements thereto, its value increased by $ 12.8 billion.

 

  • Institutional reform meant a reduction of 85% (U.S. $195) in costs of titling and registration of extralegal property owned by a poor family. The time required for the procedure was reduced from 94 months (almost 8 years) devoted to completing the 165 instances in 14 offices, to no more than 2 months in 25 instances and only two public offices. The perceived benefit for the families involved, due to the reduction in costs, was U.S. $ 195.9 million between 1991 and 2007.

 

  • From 1995 to 2002, the owners of 198,000 new titled real estate properties used these lands as collateral and obtained $ 300 million in loans.

 

  • Due to the legal security provided by the titling and registration of land, families were able to increase the working hours outside home in about 45 additional hours per week. The additional income received by these families amounted to U.S. $ 5.1 billion in capital value, in the period 1991-2007.

 

  • Formalisation Programs resulted in a 28% reduction in the likelihood that children of families who inhabited the land registered titled had to stay in their homes as a precautionary measure to protect their tenure. As a result, children had more hours available per day to attend school and raise their chances of finding future best-paid jobs.

 

In addition, independent scholars (from such prestigious U.S. universities as Harvard, Maryland, Duke) have pointed out in articles in mainstream journals that titling increases pro-market beliefs in 20%, reduces the household fertility rate in 22%, raises  housing investment in 65%, elevates labor supply in 14%, increases educational achievement in 35% and  raises property values in 23%.  Further, it has been found that there is a positive relationship between formalisation and women empowerment and reduction of chronicle diseases.

 

Surely Ameen wants this kind of progress for Egypt?   ILD has offered an explanation for the continued unrest in Egypt – and the entire MENA region:  economic apartheid.  That most Egyptians are not benefitting from the system is surely something that Ameen and De Soto can agree on.  De Soto has offered his solution, arguing that the frustration resulting from the inefficiency of informal economic arrangements can be harnessed to remove constraints to entrepreneurship and investment; or it can be harnessed toward extremist ends to lead a country astray. He has noted that “everything is possible for those in the formal economy; for those in the informal economy, nothing works and eventually revolution of any sort doesn’t look so bad.”

Sure, [we] Egyptians have had enough of revolution. It is now time for us to work together to build a modern economy that serves all our people, poor as well as rich.  That is what De Soto and his ILD have offered to help Egypt do.  That Egypt’s new government is talking and listening to De Soto and  moving in the direction of major formalisation reforms is something that all Egyptians should be grateful for.

 

Hernando de Soto is a Peruvian economist known for his work on the informal economy and on the importance of business and property rights. He is the president of the Institute for Liberty and Democracy (ILD), located in Lima, Peru.


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