Precautionary wealth of rural households: Is it better to hold it at the barn or at the bank? Franz Gomez-Soto Claudio Gonzalez-Vega International Conference on Rural Finance Food and Agricultural Organization March 20 th, 2007

“Precious little is known on how the rural poor use money and other financial instruments. More work is needed so that adequate savings instrument can be provided.” Fafchamps, 2003 Motivation

How do rural households cope with risk? Ex-ante (Income smoothing) Diversification –Crops, plots –Farm and off-farm Production choices –Low return, low variability Strategic migration Ex-post (Consumption smoothing) Temporary changes in labor supply –Child labor Transfers –Extended family The use of Precautionary Wealth (PW) Shock t-1t+1t

Assets held as Precautionary Wealth (PW) Livestock Bullocks Stocks of grain Land Durable goods Jewelry Cash 1. What is the problem with them? High covariance with income! 2. Why not deposits? More liquid and presumably safer But… High transaction costs ! 3. Do deposits break the covariance problem? It depends… –Large, more diversified, regulated institutions –Small, local, less diversified, unregulated institutions

Research Questions 1. Does increased access to deposit facilities affect the level and composition of PW held by rural households? 2.Do changes in the level and/or composition of PW affect rural households’ capacity to smooth consumption against income shocks?

Effects of increased access to deposit facilities on PW 1. Composition (positive) PW Portfolio composition effect (positive) Level (ambiguous) Strategy substitution effect (positive) Melting effect (negative) 2. Protection is less costly → More protection

Method a.Dynamic Stochastic Model b.Insights from a Two Period Model. PW can be held as: –Case I: Only livestock (risky asset) –Case II: Livestock (risky asset), and Deposits (risk-free asset), with transaction costs attached

Main Results The model shows that rural households have a high willingness to pay to have access to deposits in a bank as a means for holding PW If transaction costs are not prohibitively high: –Households, in the model, always hold at least half of their PW in the form of deposits. –Household’s welfare is greater when PW is diversified by adding deposits.

Policy Implications Poor rural households do accumulate PW ! They are willing to incur in high transaction costs in order to hold deposits as major component of their PW. Reducing depositor transaction costs in the rural areas may be welfare improving. –Micro: Rural households are able to smooth their consumption better –Macro: More efficient use of resources

Questions for Policymakers and Practitioners What kinds of innovations are being successful in reducing the transaction costs of depositors? What kind of regulatory framework would be most appropriate for the expansion of deposit facilities in poor rural areas? How could the expansion of credit and insurance services complement the availability of deposit-taking instruments to facilitate household management of risk?