Does Microfinance Participation Improve Income-Smoothing by Poor Households?

In my last post (# 36), I outlined the five risk-management strategies described in the seminal March 2000 paper by Sebstad and Cohen. Two are precautionary strategies (Income-Smoothing and Asset-Building), and three are loss-management strategies (Consumption-Modifying Strategies, Income-Raising Strategies and Personal Financial Intermediation).

Here is the overarching question of Theme Four: How can or does microfinance support these strategies and shift the mix of risk-management strategies used by the household from those that damage long-term resilience to those that enhance resilience in the future?

Sebstad and Cohen identify three main pathways through which microfinance services can reduce vulnerability: income-smoothing, building assets (including financial, physical, human and social assets), and empowering women. I start with the first pathway, income-smoothing.

Theme Three of this blog examined evidence of the income-increasing effects of microfinance (through investment in IGAs) and found that significant, poverty-reducing increase of household income is relatively uncommon among microfinance clients. On the other hand, researchers have often perceived that client households are more successful in stabilizing household consumption during seasonal, business-related and personal setbacks (often a health problem).

Keep in mind that consumption-smoothing is not the same as income-smoothing. The first result is about expenditure of money available in the household (from current income but also access to loans and savings and selling of assets) to reduce the number and depth of major dips in expenditure during the year. The second result is about money coming into the household and reduction of the number and depth of major dips in income during the year. Income-smoothing, the topic of this post, is one way to smooth consumption. The following posts will focus on different ways to smooth consumption.

From their review of the literature up to the year 2000, Sebstad and Cohen suggest that microfinance (most research had been on microcredit) can smooth income by increasing the number and variety (diversity) of sources of income, including increased participation of household members (especially women) in income-generating activities (IGAs).

Loans are often used to diversify sources of income. Mostly this means that borrowers use their loans to offer a greater variety of goods and services within the same enterprise and/or start new enterprises that complement their existing IGAs by selling into different markets at different times of year (such as farm products sold after harvest, non-farm trade during the pre-harvest months, special craft-making for a brief tourist season, and special product offerings for holiday preparations). Both Sebstad and Cohen and Freedom from Hunger’s research (MkNelly and McCord) report a frequent pattern of serial loan use starting with investment of first and second loans in more inventory or inputs for existing IGAs, then investment of later loans in riskier expansion of IGAs into new markets and/or start-ups of new, complementary IGAs or occupations.

As observed in Poor Economics, the poor are much more likely to develop two or more tiny businesses than to grow one IGA into a highly profitable business. It seems this diversification strategy reflects both their poor prospects for growing IGAs into truly viable businesses (making it risky to invest all eggs in one basket) and the benefits of having a diverse portfolio of income sources to smooth income and therefore consumption through the year.

Loans are also used to increase participation in IGAs by more members of the household, especially loans to women, many of whom had not been much engaged in IGAs before having access to loans. Women are reported to spend more time on income-earning work than before, but in some other situations they spend less time at work but bring in the same amount of money because their loan-supported IGAs use their time more productively. Self-employment also often allows women to combine IGAs with child and home care, unlike labor away from home. On the other hand, there has been concern that family-run IGAs are more likely to engage children in labor when they could be in school. While there is evidence that child labor increases with investment in self-employment, there is also evidence that it does not increase or at least does not eat into school time.

So, the evidence indicates the reality of the hypothesized mechanisms—income-source diversification and increased engagement in income-generating work—by which microfinance is supposed to support income-smoothing. But making the connection through these mechanisms from microfinance to income- and consumption-smoothing is a more difficult task. Portfolios of the Poor makes clear that the poor are using access to non-microfinance (mostly informal) loans and savings constantly to smooth consumption and to invest in a diversity of IGAs. What is the evidence that microfinance loans and savings generate impacts greater than or additional to the impacts of more traditional borrowing and saving? What is the added value of microfinance for income-smoothing?

Sebstad and Cohen cite an intriguing observation from a study of village banks in Cambodia (Pascal Bousso, Pierre Daubert, Nathalie Gauthier, Martin Parent and Cecile Ziegle. 1997. “The Micro-economic Impact of Rural Credit in Cambodia” (July). Paris: Groupe de récherches et d’échanges technologiques (GRET)). The study found that “program credit” (from the MFI) was used for a total of 1,590 different purposes, while informal credit (not from the MFI) was used for 282 different purposes. Sebstad and Cohen call this “a striking example of how program credit can increase options for borrowers” (p. 85). Certainly it indicates that microfinance can substantially augment existing sources of credit for the purpose of expanding opportunities to diversify income sources. But it doesn’t tell us why or how microfinance expands opportunities. The exploration in Theme Two suggests that microfinance may enable or allow greater latitude because it offers larger loans, more reliably delivered, with more structured rules and expectations.

Do the recent RCTs look for impacts on income-smoothing? Have they yielded any evidence one way or the other regarding the variability of household income from day to day, month to month or season to season? I refer you to David Roodman’s nice summary of the RCT results to date with links to most of the study reports. My interpretation is that these RCTs have not been looking at variability of income over time within the same household, with the exception of the Dupas and Robinson study of commitment savings accounts in Kenya. They found that women entrepreneurs with these accounts had higher business profits and household income, and their household income dipped slightly less during bouts of illness (such as malaria).

It is logical that diversification of income sources and mobilization of household labor (which itself can be seen as a form of diversification of income sources) would result in income-smoothing—making it more likely that at least one income stream is flowing at any point in time. Perhaps this causal connection is so logical that it has not been regarded as worthy of scarce research dollars and effort. Perhaps income-smoothing is just not as important as asset-building in the profoundly unstable income situation of poor households without salary earners. Perhaps measuring income variability over days, weeks, months and seasons is only possible with the financial diaries method, and we have yet to see comparison of financial diaries of treatment households compared to control households—but that is coming in new studies under way.

In short, we can say with confidence that most clients use their microfinance loans (and probably their savings, too) to diversify their sources of income. But we still lack solid evidence that microfinance thereby substantially improves client success in actually smoothing incomes through the week, month and year.

Onward to asset-building in the next post.