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Income risk, coping strategies and safety nets

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  • Stefan Dercon
Abstract
Rural and urban households in developing countries face substantial idiosyncratic and common risk, resulting in high income variability. Households in risky environments have developed sophisticated (ex-ante) risk-management and (ex-post) risk-coping strategies, including self-insurance via savings and informal insurance mechanisms to do so while formal credit and insurance markets appear to contribute only little to reducing income risk and its consequences. Informal credit and insurance, however incomplete, helps to cope with risky incomes. Despite these strategies, vulnerability remains high, and is reflected in fluctuations in consumption. It is clear therefore, that further development of safety nets will be necessary. In this paper, we focus on the opportunities available to households to use risk-management and risk-coping strategies, and on the constraints on their effectiveness. Fluctuations in consumption usually imply relatively high levels of transient poverty. High income risk may also be a cause of persistent poverty. The failure to cope with income risk is not only reflected in household consumption fluctuations but affect nutrition, health and education and contribute to inefficient and unequal intrahousehold allocations. Deaton’s model provides a useful description of the advantages of self-insurance. Policy conclusions may be limited however. In practice, assets are risky, not safe. The covariance of asset values and income due to common shocks makes self-insurance a far less useful strategy than it seems. We quantify the consequences of holding risky assets that are covariate with incomes, using simulations. Access to relatively safe and profitable assets, which might be useful for consumption smoothing, may also be limited. Lumpiness in assets may be a reason why the poor cannot protect themselves easily via assets. Policies that influence asset market risks could be beneficial to households attempting to deal with shocks. Policies could include providing more attractive and diversified savings instruments. Microfinance initiatives should put savings for self-insurance on the agenda. Macroeconomic stability during income downturns would also allow self-insurance to function better. Income smoothing can be achieved by income portfolio adjustments. In practice relatively little income smoothing (even via income portfolio adjustments) is achieved by poorer households. Income diversification for effective risk-reduction appears limited. Observed diversification patterns are often not aimed at reducing risk. Households face entry constraints to enter into profitable activities. Income risk reduction often comes at a cost. Income skewing is likely if less protection is offered by investing in assets. The long-term consequences for the asset-poor are lower average incomes and a higher income gap relative to asset-rich households. Observing specialisation does not necessarily imply that the household follows a high-risk strategy. Also, entry constraints may limit the diversification that can be achieved, leaving only low-return activities free to the poor. Income portfolios must be seen in relation to the asset portfolio and other options available: a risky, specialised portfolio may mean lower consumption risk than a diversified portfolio, depending on the asset position. Finally, several income-based strategies are only be invoked when a crisis looms. These (income)‘coping’ or ‘survival’ strategies are especially important when the shock is economy-wide. There has been increasing interest in the empirical analysis of informal risk-sharing and theoretical modelling on the sustainability and consequences of these arrangements. Risk-sharing can be viewed as the cross-sectional equivalent of consumption smoothing over time. In the absence of enforcement problems, the existence of better savings opportunities and a public safety net providing transfers when common shocks occur, could improve welfare without crowding out the informal insurance arrangement. A transfer-based safety net is, however, likely to crowd out private (precautionary) savings. Informal insurance arrangements are likely to have to be self-enforcing, imposing sustainability constraints. Circumstances in which risk-sharing arrangements may be sustained are, inter alia: a low discount rate of the future, high frequency of interactions, situations in which idiosyncratic shocks are more frequent relative to other shocks. Evaluating the effects of alternative coping mechanisms such as savings, or of policy interventions such as providing better savings instruments or public safety nets, needs to take into account their effect on incentives to sustain the agreement rather than to go it alone. It is possible that opportunities for precautionary savings or a public safety net would actually be welfare reducing and displace the informal insurance arrangement by more than one to one. Any policy intervention that improves an individual’s position outside a private group-based informal risk-sharing arrangement may provide incentives to break down the informal arrangement. Targeted interventions that target only some members of communities or groups could be particularly counterproductive. Group-based savings schemes could provide a useful alternative or complement if one is concerned about crowding-out. The possibly negative welfare effects can be avoided. Whether the crowding-out and potential negative welfare effects of interventions on informal insurance mechanisms are significant is an empirical question. If common shocks are dominant and if groups and communities rather than just individuals are targeted, these negative effects are likely to be less significant. Standard quantitative poverty analysis assumes that consumption is smooth. If smoothing is not possible, especially when large negative shocks occur, then alternative measures of poverty and vulnerability need to be explored. If interiii temporal data are available, broader definitions can be used to describe vulnerability. Aggregate measures of ‘vulnerability’ can be obtained. Targeting assistance to the vulnerable population requires specific kinds of information. Analysing the characteristics of households experiencing chronic or transient poverty, or in general, their consumption fluctuations, can provide this information. Panel data are required for this analysis. If policies are exogenous to the risk management and coping strategies, then information on how households handle income risk is irrelevant. However, policies may affect household opportunities to cope with risk (e.g. by changing exit options from informal insurance). In that case, how households cope with risk is relevant for the design of policies, in turn increasing data requirements. If effective safety nets and other consumption risk-reducing policies require detailed knowledge of existing risk-reducing actions by households, then surveys need information on physical, human and social capital, on shocks, as well as on opportunities in labour, product and asset markets. Panel and cross-section surveys could be used to collect relevant information. The complexity of consumption-risk reducing strategies implies that a simple indicator is unlikely to be available. Measures of vulnerability would typically require detailed data, including from panels. Some indicators that aim to describe vulnerability are typically flawed. The emphasis on the ability to cope with risk via assets, human capital and informal insurance and on the opportunities available, marks a convergence of different disciplines, bridging gaps with more qualitative approaches.

Suggested Citation

  • Stefan Dercon, 2000. "Income risk, coping strategies and safety nets," CSAE Working Paper Series 2000-26, Centre for the Study of African Economies, University of Oxford.
    • Handle: RePEc:csa:wpaper:2000-26
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