Hawala and Hundi are two of the most familiar terms in Pakistan’s economic landscape. Put simply, these are synonymous with informal channels through which money flows in or out of the country. It has been on the policymakers’ radar for a long time but there has not been any significant success in terms of curbing its workings. These days, there is a new urgency to tackle it as Pakistan finds itself on the Financial Action Task Force’s (FATF) Grey List.
It is a good time to peek into the nature, history and workings of this system in order to understand its continued sway and why it became popular in the first place. Hawala basically denotes a system made up of money lenders and businessmen around the globe. What distinguishes it from the formal exchange channels (like banking) is that it works largely on repute and trust rather than formal contracts. It comes with its advantages, anonymity being the primary one. The other primary advantage comes in the form of avoiding expensive formal channels of finance and exchange. Anonymity, however, comes with a heavy price tag for countries like Pakistan as this particular characteristic has been mercilessly exploited by smugglers, drug peddlers and terrorism financiers. No wonder Pakistan finds itself on the FATF radar.
Transfer of financial resources using a Hawala type system, based on trust, is a very old practice. Robert Sobel, in his magisterial The Pursuit of Wealth, has traced the system back to the dawn of commerce and trade (he does not explicitly mention Hawala, though). Babylonian and Sumerian merchants, for example, relied heavily on people of reputation (including priests) for acting as clearing houses and money transfer intermediaries/channels providing a valuable service to citizens. Instead of taking the substantial risk of carrying money and valuables themselves, they were deposited with these individuals who in return would give them an acknowledgment receipt (with their particular stamp or insignia). When merchants would reach their destination, they would redeem the amount by presenting the receipt to the Hawala dealers of that particular place. Thus, a transaction was settled with minimum of fee and administrative requirements. Moreover, the existence of such a valuable service oiled the wheels of commerce as it took away the many risks that merchants faced while carrying money themselves.
If looked at in modern parlance, Hawala is a decentralised system based on competition. There is little requirement for meeting statutory obligations and cumbersome procedures that exist under a modern, centralised banking system. Historically, money lenders under Hawala have charged just a fraction of what formal transfer channels charge from consumers. A question may arise as to the profitability of such a service when the charged fees are low. But that aspect has, historically, been taken care of by realising economies of scale: lower charges on transfers have attracted enough customers to ensure a healthy return.
Since the dawn of commerce and trade, this system has persisted despite challenges. It was quite common in the Middle Ages, as has been documented extensively by the economist Avner Grief’s research. For example, 8th century China under the Tang dynasty had a similar system called fei-ch’ien (flying money). The need for such a system arose due to the dangers encountered in physically transferring tax money and valuables to the empire’s capital. The operation of that particular system ameliorated that risk to a large extent. Formidable challenges to this informal, decentralised authority rose with the rise of nation states, powerful central governments and central banking authority. Yet, the system refuses to vanish.
What, then, are we to make of global efforts to clamp down and curb Hawala type transactions? Specifically, one has to look at the social and economic benefits of doing away with such a system. In hindsight, this may seem odd since the official version foisted upon our imaginations is one of a system that causes substantial damage to the economy. This version stands vindicated if we were to limit the system’s workings to facilitating money borne out of drug peddling, terrorism financing and other such harmful activities.
But one has to be careful in limiting their imagination to only these activities. The fact of the matter is that a Hawala like system offers many socially beneficial incentives that tend to get lost in the fog of official versions. It tends to discount the benefits accrued to consumers. I have already narrated its extremely beneficial role in facilitating trade and commerce in the earliest known civilizations. Aside from this facilitation, there are other advantages that such a system confers upon the society. Specifically, its presence ensures lower transaction costs to its subscribers.
Banks illustrate this point. They charge various types of fees from customers under the garb of different heads and make a healthy profit based on the deposits of customers. On net, the benefits accrued to customers are either cancelled or are inferior to what they are charged for the service. But when these kinds of institutions fail (largely based on their actions), they are usually bailed out using taxpayer money (the ‘too big to fail’ phenomenon). If you think about it, it is akin to a heist! And the only remedy available against such excesses are courts, which again exact a heavy cost from society due to the time, duration and financials involved. In a country like Pakistan, given the state of affairs of courts, it is advisable to stay away from them and save time plus money.
Consumers are usually saved that predicament in an informal, decentralised system like Hawala. Once a reputation of operator is tarred, its curtains for that business and no amount of running around can recoup the lost repute. More importantly, there is little possibility of ‘too big to fail’ phenomenon, to be bailed out using taxpayer money. Thus society not only benefits in terms of saving money (very low transaction fees), but also in terms of a decentralised system that weeds out inefficient, unproductive and corrupt operators without the need for a central authority or courts.
The lesson from all of this discussion, at least for policymakers, is that efforts to curb hawala type system needs an understanding of the nature and forces that propel it. If informal systems of financial transactions have endured for centuries, there are good reasons for that, some of them outlined above. A society and its inhabitants have the capacity to compare transaction costs of having a formal system against an informal system. If the former confers a lower cost, the latter would disappear without the need for state intervention (and vice versa). If this point can be grasped, then it is clear that Pakistan’s policymakers should first review the predatory nature of its functioning (specifically its taxation) plus that of its financial system, and what cost it inflicts upon the society. It also does not help that the government strongly incentivised use of such channels when it was in its interest (to finance Afghan Jihadi groups, for example), helped entrench it, and now wants to get rid of it when faced with external pressure.
Historical evidence, though, suggests that such administrative exercises are usually futile in the end since an alternative tends to rise. The rise of crypto-currencies, like Bitcoin, is an apt reflection of this fact. At its core, crypto currencies reflect the working of a decentralised exchange with meagre transaction costs, just like Hawala. How would the world curb this system? Ban computers? I don’t think so.
The writer is an economist
It is a good time to peek into the nature, history and workings of this system in order to understand its continued sway and why it became popular in the first place. Hawala basically denotes a system made up of money lenders and businessmen around the globe. What distinguishes it from the formal exchange channels (like banking) is that it works largely on repute and trust rather than formal contracts. It comes with its advantages, anonymity being the primary one. The other primary advantage comes in the form of avoiding expensive formal channels of finance and exchange. Anonymity, however, comes with a heavy price tag for countries like Pakistan as this particular characteristic has been mercilessly exploited by smugglers, drug peddlers and terrorism financiers. No wonder Pakistan finds itself on the FATF radar.
Transfer of financial resources using a Hawala type system, based on trust, is a very old practice. Robert Sobel, in his magisterial The Pursuit of Wealth, has traced the system back to the dawn of commerce and trade (he does not explicitly mention Hawala, though). Babylonian and Sumerian merchants, for example, relied heavily on people of reputation (including priests) for acting as clearing houses and money transfer intermediaries/channels providing a valuable service to citizens. Instead of taking the substantial risk of carrying money and valuables themselves, they were deposited with these individuals who in return would give them an acknowledgment receipt (with their particular stamp or insignia). When merchants would reach their destination, they would redeem the amount by presenting the receipt to the Hawala dealers of that particular place. Thus, a transaction was settled with minimum of fee and administrative requirements. Moreover, the existence of such a valuable service oiled the wheels of commerce as it took away the many risks that merchants faced while carrying money themselves.
If looked at in modern parlance, Hawala is a decentralised system based on competition. There is little requirement for meeting statutory obligations and cumbersome procedures that exist under a modern, centralised banking system. Historically, money lenders under Hawala have charged just a fraction of what formal transfer channels charge from consumers. A question may arise as to the profitability of such a service when the charged fees are low. But that aspect has, historically, been taken care of by realising economies of scale: lower charges on transfers have attracted enough customers to ensure a healthy return.
Since the dawn of commerce and trade, this system has persisted despite challenges. It was quite common in the Middle Ages, as has been documented extensively by the economist Avner Grief’s research. For example, 8th century China under the Tang dynasty had a similar system called fei-ch’ien (flying money). The need for such a system arose due to the dangers encountered in physically transferring tax money and valuables to the empire’s capital. The operation of that particular system ameliorated that risk to a large extent. Formidable challenges to this informal, decentralised authority rose with the rise of nation states, powerful central governments and central banking authority. Yet, the system refuses to vanish.
What, then, are we to make of global efforts to clamp down and curb Hawala type transactions? Specifically, one has to look at the social and economic benefits of doing away with such a system. In hindsight, this may seem odd since the official version foisted upon our imaginations is one of a system that causes substantial damage to the economy. This version stands vindicated if we were to limit the system’s workings to facilitating money borne out of drug peddling, terrorism financing and other such harmful activities.
But one has to be careful in limiting their imagination to only these activities. The fact of the matter is that a Hawala like system offers many socially beneficial incentives that tend to get lost in the fog of official versions. It tends to discount the benefits accrued to consumers. I have already narrated its extremely beneficial role in facilitating trade and commerce in the earliest known civilizations. Aside from this facilitation, there are other advantages that such a system confers upon the society. Specifically, its presence ensures lower transaction costs to its subscribers.
Banks illustrate this point. They charge various types of fees from customers under the garb of different heads and make a healthy profit based on the deposits of customers. On net, the benefits accrued to customers are either cancelled or are inferior to what they are charged for the service. But when these kinds of institutions fail (largely based on their actions), they are usually bailed out using taxpayer money (the ‘too big to fail’ phenomenon). If you think about it, it is akin to a heist! And the only remedy available against such excesses are courts, which again exact a heavy cost from society due to the time, duration and financials involved. In a country like Pakistan, given the state of affairs of courts, it is advisable to stay away from them and save time plus money.
Consumers are usually saved that predicament in an informal, decentralised system like Hawala. Once a reputation of operator is tarred, its curtains for that business and no amount of running around can recoup the lost repute. More importantly, there is little possibility of ‘too big to fail’ phenomenon, to be bailed out using taxpayer money. Thus society not only benefits in terms of saving money (very low transaction fees), but also in terms of a decentralised system that weeds out inefficient, unproductive and corrupt operators without the need for a central authority or courts.
The lesson from all of this discussion, at least for policymakers, is that efforts to curb hawala type system needs an understanding of the nature and forces that propel it. If informal systems of financial transactions have endured for centuries, there are good reasons for that, some of them outlined above. A society and its inhabitants have the capacity to compare transaction costs of having a formal system against an informal system. If the former confers a lower cost, the latter would disappear without the need for state intervention (and vice versa). If this point can be grasped, then it is clear that Pakistan’s policymakers should first review the predatory nature of its functioning (specifically its taxation) plus that of its financial system, and what cost it inflicts upon the society. It also does not help that the government strongly incentivised use of such channels when it was in its interest (to finance Afghan Jihadi groups, for example), helped entrench it, and now wants to get rid of it when faced with external pressure.
Historical evidence, though, suggests that such administrative exercises are usually futile in the end since an alternative tends to rise. The rise of crypto-currencies, like Bitcoin, is an apt reflection of this fact. At its core, crypto currencies reflect the working of a decentralised exchange with meagre transaction costs, just like Hawala. How would the world curb this system? Ban computers? I don’t think so.
The writer is an economist