How the shadow economy moves markets

Exchanges taking place under the official radar may seem harmless, but they can have big effects on the wider economy. Investors should pay attention, says Jonathan Compton.


The more widespread this kind of thing, the lower the multiple
(Image credit: Credit: Andriy Blokhin / Alamy Stock Photo)

A family lunch on the terrace at a mahogany table with fresh fish and excellent wine. In the distance a combine harvester gathers in the crop, while nearby the gardener, window cleaner and maid bustle about; the carers look after my old father and the nannies take care of my grandchildren. There is new tarmac on the drive, a new lick of paint on the outbuildings and our eggs and vegetables are selling well.

The feeling of well-being is greatly enhanced knowing that every activity, payment or sale is outside of the recorded economy, a huge financial saving. Sadly, this scenario is just a dream, but it demonstrates the ubiquity of the "shadow economy".

The shadow, grey, unofficial, or black market has many other names and more definitions, but a useful description is any economic activity that takes place outside government-sanctioned channels, usually to allow participants to avoid government regulations, price controls, tax and reporting. Economists bicker over what to include, but like an elephant it's usually easy to recognise even if you struggle to define it.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

All governments take the moral high ground when mobilising their forces against black markets, by emphasising the genuinely undesirable economic consequences (not to mention humanitarian costs). These consequences include the loss of revenue to fund public services children's healthcare is the standard emotive headline, along with education and the police.

Then there are the obvious dangers of the vast market in illegal car and aeroplane parts; the devastating effects of illegal logging; the risks of poorly-manufactured pharmaceuticals, be they of the medicinal variety or insanely toxic recreational drugs.These shadow markets also punish the honest. No business can compete against those that fail to pay their property, sales and other taxes or their staff so there is a genuine economic cost. Yet such campaigns evade three issues: we all like to make use of such markets (tips to the waiter, or paying cleaners or gardeners); governments themselves are often the cause of their existence; and often they can be a real public good.

The world's darkest markets

Who are the big players? Their very nature means that calculating the size of illegal or underground activities has to contain a lot of guesswork. Not that this has stopped bodies such as the IMF or EU producing data accurate to many dubious decimal points. Still, the models used to estimate black-market activity suggest that GDP in Latin America is between 30% and 50% larger than the official data would suggest (Chile isthe standout good guy with activity at around 12%).

In Africa it varies from 40% to more than 60% across the continent (in Nigeria, Tanzania and Zimbabwe it may even be close to the same size as the official economy). In Asia it's no surprise that Thailand and Myanmar are the "winners" (though the relatively low estimates given for India, Pakistan and China tell me, from my first-hand experience, that this is a fairy tale).

In the more advanced countries, again the guesses are mostly what you would expect. In Switzerland and Austria the shadow economies are about 8% and 9% of GDP respectively. Japan, Australia and the UK are pretty good at between 10% and 12%; the obviously crooked regimes in Turkey, Romania and Bulgaria are at more than 30%. The US is reckoned to be the squeakiest-clean country in the world at around 7%.

To market participants, such numbers matter. Every day investors and traders pore over official data such as economic growth or retail sales and react accordingly. But if the black market is as large as it seems to be in most countries and don't forget such numbers do not include a host of unrecorded but semi-lawful activities such as car-boot sales, farmers' markets, or booze runs to Calais the true numbers might prove quite the reverse, so at best they are flying partially sighted.

An interesting exception to expectations is Scandinavia, which ranks behind the less sanctimonious UK, France, or Germany. One major reason is alcohol, which demonstrates how governments often cause black markets to arise. Finland and Sweden have strict rules on purchasing alcohol and it is highly taxed. As a result, it is normal and socially acceptable to distil at home, or to smuggle. This is not the only way in which governments stimulate black markets.

Research provides consistent reasons for their emergence. Most important is the quality and incorruptibly of institutions, from legal systems to administration and tax collection. Greece is a great example: after the 2008 crash it emerged that every dentist was in the bottom tax band, yet relative to average income they are among the highest paid in Europe. Two-thirds of all Greek MPs had illegal offshore bank accounts. It's little surprise that theGreek population considers paying tax to be voluntary.

Countries with high inflation, weak currencies and large current-account deficits always have giant black markets think Venezuela, Zimbabwe, or Pakistan. Import or export controls, and thus shortages, cause a logical reaction among consumers: they buy the product on the black market. One of the main reasons for the collapse of the USSR was its basic failure to satisfy simple desires for bread, music and blue jeans so the entire population moved to the illegal economy.

A perhaps more arcane reason for the rise of black markets is a pegged currency. One whose exchange rate is fixed to, say, the dollar at an unrealistic rate will always fire up the unofficial economy. Long ago I visited Myanmar when the official exchange rate was a sixth of the real rate as reflected by the black market. The proceeds from selling 400 cigarettes and two bottles of Johnny Walker on the black market paid for the entire trip. Up to the 1990s, China's currency was widely mistrusted not least because it had disappeared four times in a century. Owning gold was illegal, yet gold trading was rampant.

Another stimulant to black markets is recession. When the regulated economy weakens, or even fails, the black market has a vital role to play in picking up the slack. Every cyclical downturn sees the shadow economy boom. If you believe the official data then youth unemployment across Europe remains stubbornly high a decade after the financial crash, at more than 40% in Greece, 30% in Spain and Italy, 20% in France and 16% across the euro area.

This is statistical hokum. I would not pretend that their employment markets are easy, but ask any young waiter, driver, or messenger if they are officially employed. No. Bad employment laws and bureaucracy mean they are on the payroll, but off the data. This is no bad thing as in this segment of the black market around 75% of all illegal earnings flows into the official, thus taxable, economy within weeks; otherwise, the GDP numbers would be much lower.

Where governments are particularly dim is in the use of price controls. Price controls force activity underground. Housing is a good example. Fixed rents and controls inevitably result in people gaming the system. This has long been the case in France, especially in Paris, in Sweden, and in many otherwise sensible countries. Berlin is about to introduce them as a knee-jerk reaction to the perceived problem of high rents. In Europe, including the UK, playing the fixed-rent social housing market is a popular sport, sub-letting the property at a higher price. Not surprisingly, governments tend to understate this problem.

A force for good

Controversially, perhaps, the black economy can also be a force for modernisation, development and growth. It improves efficiency. Mobile-phone companies in the developing world, for example, tended to be monopolies and would thus gouge their customers.

I recall hearing one emerging-market entrepreneur boasting that with his telephone monopoly he could charge $1,000 per analogue handset (more than a quarter of then average annual income) when far better digital versions could be bought overseas for $250. The black market filled demand and he lost. The black economy can be a highly efficient provider of goods, services and necessities at an affordable price when governments fumble.

In the UK it is a sign of success that on all measures we rank as very clean, but we also rank poorly in terms of knowing how many people live and work here, so this ranking may overstate the true position. Government data, for example, tells us the number of children by area, which determines how much schools get. Application numbers show a wildly different figure. We have blundered into obvious traps too. Since 2008, successive chancellors have clung to the "alcohol escalator", whereby duties rise at a higher rate than inflation.

Revenue take was far below projections while imports of alcohol from France for "personal use" doubled. So too for cigarettes. Gambling was another blunder. Higher taxes than punters thought fair made Gibraltar boom as they moved offshore (and again revenue take fell). Gambling taxes had to be cut. The message is that consumers everywhere will turn to black markets if prices or taxes are perceived as unreasonable; hence they act as a hidden check on government policy.

Does this matter for stockmarkets? Yes, but it's hard to prove. Thirty years ago I noticed that Thailand's market returns correlated well to CIA opium-crop estimates. Illegal money was being recycled. More mainstream, perhaps, is the observation that while small black markets can have a useful purpose, larger ones reflect serious problems. As a simple rule of thumb, the more widespread the shadow economy, the lower the market multiple. Cleaner countries attract proportionately more investment, meaning higher employment, capital expenditure, tax receipts and returns for investors.

Investors in countries with gargantuan black economies (say more than 20% of GDP) see their profits and dividends clipped by pay offs and kickbacks. Thus when you are told that "frontier" markets, such as those of Greece, eastern Europe or Thailand, are "cheap", take five minutes to consider the black market. They may be cheap because the rampant unofficial economy has reached a tipping point.

Jonathan Compton was MD at Bedlam Asset Management and has spent 30 years in fund management, stockbroking and corporate finance.