Thursday, April 14, 2011

Portfolios of the Poor: A Book Review

The World Bank introduced $1 poverty rates into our vernacular in 1990 with their World Development Report. However, little was known about how these people, classified as extremely poor, actually lived. Since then research such as that described in an earlier post titled "Economic Lives of the Poor" shed some light on this question. Carrying forward that research agenda is a 2009 publication from Princeton Press called Portfolios of the Poor. Four economists tell a fascinating story about the financial lives of the poor and how the world's poor live on such little money.

What is novel about Portfolios of the Poor is how it moves beyond the static story of year-to-year statistics and into a more dynamic realm. In other words, former studies were like pictures that represented snap-shots in time, this book is like the introduction of the motion picture. The authors are able to improve in this way because of their unique data. Throughout three countries Bangladesh, India, South Africa the authors employ financial diaries (which participants filled out fortnightly) as a vehicle to acquire information about how poor people make decision with their money.

What emerges from the diaries is a bounty of information about the daily grind. First, it was interesting to learn what kinds of occupations employed the poor. The occupations in their sample were varied from sheep intestine seller, rickshaw driver, construction labor, factory labor, small farmer, cab driver, cigarette roller, and many more. Secondly, it was a revelation to learn that their occupations and incomes were frequently irregular. Many of the households in their sample pieced work together from regular wages, casual work, and self employment (~65% in South Africa, nearly 70% in Bangladesh, and more than 85% in India. Moreover, the $1 or $2 per day measures used by the World Bank were averages over the course of the year. Put another way, they could earn $3 on Monday, $0 on Tuesday, $1 on Wednesday, $4.25 on Thursday and etc. The poor had to stitch together a livelihood from multiple sources.

At the most basic level the poor are in a particular bind because they suffer from what the authors call "The Triple Whammy": low incomes, irregularity, and a lack of financial instruments. These open the door to a myriad of questions: How do the poor handle negative and unpredictable shocks such as illness in the family?, How do the poor acquire enough savings with their low incomes to send their children to school, buy grains to store during the monsoon season, or host a special even such as weddings or funerals? The authors have distilled these kinds of questions into three categories of financial needs for the poor:

"1. Managing basics: cash-flow management to transform irregular income into a dependable resource to meet daily needs.
2. Coping with risk: dealing with the emergencies that can disrail families with little in reserve.
3. Raising lump sums: seizing opportunities and paying for big ticket expenses by accumulating large sums of money."

Currently the poor manage their money largely through informal channels. This is probably not surprising since there are a shortage of formal lending and borrowing institutions geared towards poor households. Moreover, microfinance institutions are often focused on helping the poor raise money for capital investments. There is nothing inherently wrong about that focus, but, the poor have immediate needs in addition to building up their long term prospects. In managing their money day-to-day the poor will rely on neighbors and/or family members who are marginally better off as lenders or "money guards". A money guard is simply a person who safely stores the money given to them by another person (sometimes for free but often for a fee). The rationale for this institution is simply a commitment to self-control. Seeking family for both lending and money guarding it is stressful for the poor for at least three reasons: unreliability, lack of privacy, and lack of transparency. For example, these informal loans are unreliable because the money guards might have spent the money (the money guards are still poor). A lack of privacy is important because people may not want to borrow because they feel ashamed and pay a big emotional toll. Moreover, if they borrow money they will later be expected to reciprocate. Finally, sometimes the transparency of the interest rate is questionable when lending through informal channels. All of this adds up to high risk in gathering substantial sums of money and a stressful situation for the poor.

Having access to some credit or savings is very important because the poor are rarely insured against a variety of events. For example, if a family member develops a sudden illness this acts as a large negative shock to their income. In rich countries we have various kinds of insurance to protect us against such risks; however, insurance is a difficult financial instrument to use amongst the poor. People have tried to provide so-called "micro insurance" with mixed results. In particular, in the authors' sample the results for insurance in Bangladesh and India were quite bad with poor management of funds that resulted in an inability to payoff the insured.

Alas, if the poor are uninsured they must have the ability to acquire a loan or dip into savings to absorb risk. Then, the question becomes, "How do the poor accumulate larger sums of money?". So far we've talked about informal loans which you can think of as "accelerators" but the poor will sometimes utilize different kinds of savings arrangements ---we'll call those "accumulators". The authors discuss a few accumulators such as savings clubs, rotating savings and credit associations (RoSCAs) and accumulating savings and credit associations (ASCAs). Savings clubs are simple commitment devices in which a large group of people save X dollars for Y months and then receive X*Y at the end. The purpose of joining a savings club is simply to encourage each other to stay committed. RoSCAs and ASCAs on the other hand are a little more complex because people take turns reaping the benefit of the savings. In RoSCAs each person puts in X dollars a month and every Y months it's your turn to receive all the money in the pot. Some RoSCAs are even more sophisticated where they auction the right to the money to people who haven't taken their turn (which essentially acts as an interest rate). Finally the ASCAs are like the RoSCAs but don't zero out the pot each time. Some money is left in the pot to act as loanable funds to increase the overall wealth of the membership.

Then, the authors discuss some of the most up-to-date innovations in microfinance and other commercial banks. With commercial banks the authors provide the example of "Kishan Credit Cards" which allow for small and marginal farmers to improve their cash flow. The farmers can use these credit cards anytime throughout the year and must pay them back by the end of the year to use the credit card in the subsequent year. This allows for farmers, whose incomes are seasonal, to smooth their consumption over the year. Another innovation that comes from microfinance is the concept of "top-up" for loans. Without top-up borrowers needed to pay the entire loan back before receiving more money; however, with top-up borrowers are able to refresh the loans to their original amount even when they haven't paid back the whole loan.    

These innovations are an excellent example of institutions. Institutions are the "rules of the game" and small changes in the rules of the game can have a significant impact on the ability for the poor to meet their daily needs. Finally, after discussing some of the innovations the authors are able to cull some additional insights from their research about the what characteristics of financial instruments are most important for the needs of the extremely poor. The authors identify four such characteristics: reliability, convenience, flexibility, and structure.

Reliability - The poor need a safe place to store their money with someone who is trustworthy and will not be tempted to spend their savings. Reliability is crucial in their financial instruments because so many other facets of their lives are irregular from earned income to schools and clinics to care for them.

Convenience - One of the primary reasons the poor in the authors' sample did not take advantage of microfinance institutions is that they were not convenient. The poor needed to travel long distances or attend regular meetings to obtain credit. The more accessible the financial instruments the more likely they are to be used. The authors provide the example of some microfinanciers who have begun daily visits to provide people with more opportunities to repay and take-up loans.

Flexibility -Because incomes are so irregular the poor need some flexibility in the payment schedules for the loans. The Kishan Credit Card is a good example of providing such flexibility. The main objective is for the loan to be paid in full, but, it allows the poor to supplement their less abundant months with credit while paying off the loan in the more abundant months.

Structure -Even with flexibility there needs to be some structure because it is difficult to maintain self-control when you're living on such a small income.

There were many other interesting facets of the book such as how interest is charged in the microfinance industry and how the interest rates are not as exorbitant as they may look at first blush because they are nominal rather than compounded. Also, the interest rates must be somewhat higher because of high default rates and because debts owed are cancelled upon death. To me the book comes down to this really central point from the authors:
"In the rich world, a household's portfolio of financial instruments is usually managed on the basis of risk and return. The portfolios of the poor households are instead managed to ensure money can be obtained in the desired amounts at the desired times."
The book was a joy to read and gave me a lot of insight into how the poor actually live and the struggles they face. Below is a video of well-known development economist Bill Easterly discussing the book.

1 comment:

Souhail M said...

1) Fantastic blog name (Matt 10 has been a favorite verse of mine ever since Gone Baby Gone came out)

2) I enjoyed your analysis of the book and actually learned a fair bit.

3) I'd love to see you review the book "Naked Economics"