Theme 4: Precautionary Wealth of Rural Households: Is it Better to Hold it at the Barn or at the Bank?

Poor rural households are vulnerable to income shocks due to output and price variability and other adverse events. The use of precautionary wealth is a self-insurance strategy motivated by prudent behavior. Precautionary wealth can be held in various forms, such as livestock, grain inventories, jewelry, cash, and deposits in financial institutions. In the rural areas of developing countries, too costly access to deposit facilities for financial savings prevents households from using them as instruments to store precautionary wealth. Gaining greater access to deposit facilities is significant especially for households that face credit constraints. If they do not have access to loans or lack credit reserves, in the absence of liquid wealth risk management is very costly.

This research examines how greater access to deposit facilities affects the level and composition of the precautionary wealth of credit-constrained rural households. This is accomplished by solving a dynamic stochastic model on wealth portfolio decisions. In the model, households make three decisions: how much to consume, how much to save to deposit in a bank, and how much livestock to keep in the barn. These portfolio decisions depend on the rates of return for each type of asset, the correlation of these returns with systemic shocks, the volatility of income, the probability of bank bankruptcy, and transaction costs for depositors.

Simulation results based on estimated parameters should reveal how increased access to deposit facilities – via a reduction in transaction costs – improves the ability of credit-constrained households to insulate consumption from income variations. A simple exercise of portfolio choice, using credible magnitudes for the relevant parameters, shows that the influence of transaction costs on precautionary wealth decisions is substantial, and it suggests that potential depositors in the rural areas of developing countries are being discouraged from depositing by prohibitively high transaction costs.

These results should also show that effective financial regulation and supervision and robust financial institutions that are less vulnerable to local systemic shocks create an environment conducive to holding a greater share of precautionary wealth in the form of financial assets. These holdings reduce the costs of risk management for households while they increase the volume of financial intermediation. The growing financial intermediation leads to additional valuable services for the rural population. The research sheds light on policy debates about strategies for rural deposit mobilization.

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