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Emerging Economies Can Turbocharge GDP

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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International Monetary Fund Managing Director Christine Lagarde warned Wednesday that the world economy would show disappointing growth for 2015, mainly because emerging markets will experience a fifth consecutive year of slowing expansion. These economies, however,  have the ability to boost growth by bringing bits of their huge shadow sectors into the light.

In a recent paper, Europe's foremost expert on shadow economies, Friedrich Schneider, along with two collaborators, said that Romania, the European Union's most "shadowy" country, has an informal sector equal to 28  percent of its official gross domestic product.  Law-abiding Switzerland's shadow economy amounts to less than 7 percent of its GDP. Global Financial Integrity's September report on illicit financial flows has this graph of the Russian underground economy:

Global Financial Integrity

This indicates that Russia's shadow economy is close to 40 percent of GDP -- toward the high end of the estimates in academic literature -- but the report also shows that it has shrunk by more than a third since 2001, the year Russia introduced a 13 percent flat income tax. Not coincidentally, in the first years after that change, Russia recorded its most impressive growth since the break-up of the Soviet Union. The strength didn't reflect only higher oil prices, which didn't provide much of an economic boost until 2005, but showed the effects of  moving part of the economy from the shadow sector to the official one by removing the incentive to hide salaries from the tax authorities.

Anyone who traveled to Georgia before, during and after its libertarian economic reforms of the 2000s would be skeptical that the economy tripled in size in dollar terms between 2004 and 2008: People's lives improved, but not that drastically. The fairy-tale growth was the result of what was probably the most effective post-Communist anti-corruption campaign, which included an overhaul of the tiny country's police force and legal system, stripped bureaucrats of most of their regulatory powers and forced corrupt officials to return illegally amassed wealth. Between 2005 and 2008, Georgia rocketed from the 130th to 67th place in Transparency International's Corruption Perceptions Index

Countries can use the shadow economy as a resource for quick growth through sheer political will. It doesn't require legalizing drugs or prostitution: Most of the money in the shadows comes from tax-evading legitimate businesses. According to Global Financial Integrity, in 2012, India lost 5 percent of GDP to "trade misinvoicing," the practice of fraudulent declarations of the customs value of exported goods. The use of the same practice in the reverse direction led India to have an illicit inflow equal to 3.3 percent of GDP. It's far from the worst country in terms of illegal flows, too:

Misinvoicing accounts for most of Global Financial Integrity's numbers, probably because it's relatively easy to catch. It's enough to compare a country's import and export statistics with those of its trading partners. A similar method can be applied to other kinds of illegal flows and to "shadow" capital that remains within a country.

Dev Kar, Global Financial Integrity's chief economist and a former IMF analyst, doesn't net out illicit inflows versus outflows. He argues that the money that comes in this way is no more beneficial to a government than the money going out. That only makes sense from a government's point of view, however. In emerging economies, huge swathes of the population live outside of government control. They participate in  corrupt networks, businesses only partially visible to the government and informal markets in perfectly legal goods. Their standard of living is much higher than reported by the official statistics, but their situation is more precarious than that of their peers in developed nations: The law of the jungle is subject to unexpected change, and underground economies have no shock absorbers.

Most people would probably prefer the clarity and ease of living in the legal economy, but they don't have that choice. 

It's useful to keep in mind that emerging economies are not really comparable to developed nations, and nor is their growth data. Every emerging market with a third of its economy in the shadow could at any moment show a spike in growth. But that wouldn't be immediately meaningful for that country's people, who would just see part of their wealth suddenly "legalized," and the growth would even out once the effect of a particular measure is fully accounted for. That's what happened in Russia in the 2010s, when the government lost the political will to lure the shadow economy into the open.

Growth is probably the wrong term for such a statistical aberration. "Transparency improvement" might work better. Yes, smaller shadow economies mean better government services and increased trust among citizens and toward their country, but in the short term, the switch pays off with better governance, not true economic expansion.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor responsible for this story:
Max Berley at mberley@bloomberg.net