Pakistan’s informal economy is vast, estimated at around $457 billion, contributing between 40 percent to 70 percent of the country’s GDP. Despite its significance, this sector remains largely undocumented, with minimal regulation or oversight. The informal sector’s contribution to the national economy is significant, estimated at $661 billion, making it a crucial but underleveraged part of Pakistan’s economic framework. The informal economy also significantly impacts the country’s financial systems, including the Pakistan Stock Exchange (PSX). The disconnect between the informal and formal sectors creates unique challenges for the stock market, influencing market performance, participation, and stability. One of the primary consequences of a large informal economy is its limited contribution to formal financial markets. With 75 per cent of Pakistan’s labour force (according to the Labor Force Survey 2020-21) engaged in informal employment and businesses operating outside regulatory frameworks, significant amounts of wealth remain untapped. This restricts the inflow of capital into the stock market This includes street vendors, domestic workers, small businesses, and a significant portion of the real estate sector, all of which operate without formal registration. In comparison, countries like India and Bangladesh also face similar challenges, with informal economies contributing over 50 percent of their GDP, although these nations have made strides in digitizing and formalizing smaller businesses. For instance, Pakistan has a population of over 250 million, yet only 272,000 individuals are registered investors in the stock market, with fewer than 50,000 trading daily. In contrast, countries like India, with stronger integration between formal and informal economies, boast over 10 million active retail investors. The inability to channel informal savings into productive financial avenues like the PSX exacerbates low participation and leaves the market reliant on institutional investors and large corporations. The informal economy’s dominance in Pakistan poses both challenges and opportunities for the stock market. The informal economy also indirectly influences stock market fluctuations by perpetuating disparities in tax contributions and business practices. Only 38 percent of collected taxes reach the government treasury, with the rest lost to corruption among taxpayers, collectors, and intermediaries. For example, informal businesses, often avoiding taxes and regulatory compliance, place greater fiscal pressure on formal enterprises. The complex tax structure, heavily reliant on indirect taxes, discourages formalization. This phenomenon is not unique to Pakistan. For instance, Mexico’s tax reforms in the last decade have focused on simplifying procedures and incentivizing informal businesses to register, with positive outcomes. These additional burdens, such as higher corporate taxes and operational costs, impact profitability and the stock valuations of formal companies. The KSE-100 Index, comprising the top 100 companies in the PSX, is disproportionately influenced by a handful of sectors like banking, oil and gas, and fertilizers, which collectively dominate market capitalization. These sectors benefit from corporate advantages unavailable to informal enterprises but are also vulnerable to macroeconomic shocks exacerbated by the informal economy’s inefficiencies. For instance, fluctuating energy prices due to smuggled Iranian diesel, which accounts for 40 percent of domestic diesel consumption, create volatility in oil sector stocks. Smuggling, a major byproduct of the informal economy, directly affects the stock performance of legitimate businesses. For example, 74 percent of mobile phones and 53 percent of diesel sold in Pakistan are smuggled, undercutting the market for registered companies. This erodes revenue streams for formal businesses, adversely impacting their profitability and share prices. Pharmaceutical companies listed on the PSX also face challenges due to the PKR 3658 billion smuggling market in medicines. While legitimate firms struggle with regulatory hurdles and taxation, smuggled goods flood the market at lower prices, depressing the growth potential of listed pharmaceutical companies such as GlaxoSmithKline. Countries such as Indonesia and Malaysia have tackled smuggling by introducing tighter border controls, enhancing enforcement through technology, and imposing severe penalties. Pakistan, in comparison, struggles due to its porous borders with Iran and Afghanistan. For example, Iranian diesel smuggling alone results in a revenue loss of PKR 10 billion monthly, accounting for 40 percent of Pakistan’s domestic diesel consumption. A significant portion of Pakistan’s population, tied to the informal economy, lacks access to or knowledge of stock market investment. This contrasts with countries like China, which have successfully integrated retail investors from rural and informal sectors through financial literacy programs and mobile-based trading platforms. In Pakistan, such measures are minimal, leaving informal workers unable to participate in the stock market. Despite recent gains in the PSX, such as the KSE-100 Index growth, these benefits remain concentrated. Sectors like banking saw a 97 percent increase in profits, while oil and gas exploration companies recorded a 55 percent rise. However, these gains reflect the performance of a select few companies rather than broad-based economic growth. The informal economy’s dominance limits the trickle-down effect, as the benefits of market growth fail to reach the general population. For example, the Rs 10,000 billion market capitalization is driven largely by institutional and high-net-worth investors, with little input from small-scale investors or informal savings. As a result, market gains often exacerbate wealth inequality rather than reduce it. To mitigate the negative impact of the informal economy on the stock market, the government should prioritize formalization through: 1. Integration of Informal Businesses: Offering tax incentives and simplified registration processes for informal businesses could bring them into the formal fold, increasing their potential contributions to capital markets. 2. Encouraging Retail Participation: Initiatives similar to India’s UPI system could link informal savings to digital financial systems, channelling funds into the stock market. 3. Leveraging Technology: Digital payment systems and blockchain solutions, as implemented in Estonia, can improve transparency in tax collection and business operations. 4. Combatting Smuggling: Advanced surveillance systems and regional cooperation with Iran and Afghanistan are essential to curb smuggling. This means enhanced border controls and stricter penalties, as implemented in Malaysia, could reduce the economic distortions caused by smuggling, allowing legitimate businesses to flourish. 5. Encouraging Stock Market Participation: Launching public awareness campaigns about the benefits of investments and reducing transaction fees can attract a broader demographic to the PSX. The informal economy’s dominance in Pakistan poses both challenges and opportunities for the stock market. While it restricts capital flows and distorts market dynamics, it also represents a vast untapped potential. Bridging the gap between the informal and formal sectors could create a more inclusive stock market, stabilizing fluctuations and fostering economic growth. The writer is Foreign Research Associate, Centre of Excellence, China Pakistan Economic Corridor, Islamabad.