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Financial instruments of the poor: Initial findings from the Financial Diaries study

CSSR Working Paper No. 130

Daryl Collins

Centre for Social Science Research (CSSR)

October 2005

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A new data set called the Financial Diaries has been produced, based on a sample of 166 households, drawn from three different areas (Langa, Lugangeni and Diepsloot), from a range of dwelling types and wealth categories. A unique methodology was used to create a year-long daily data set of every income, expense and financial transaction used by these households. Within this sample, households used, on average, 17 different financial instruments over the course of the study year. A composite household portfolio, based on all 166 households, has an average of 4 savings instruments, 2 insurance instruments and 11 credit instruments. Of these financial instruments, for the same composite household portfolio, 30% are formal and 70% are informal. Interestingly, it was found that rural households use as many financial instruments as urban households.

Introduction and review of the literature

There is a strange irony when thinking about financial management in poor households. One assumes that by the very nature of not having money, the poor cannot possibly work to manage what they do have. However, empirical facts do not support this assumption. In Financial Diaries surveys in both Bangladesh and India (see Rutherford, 2002; Ruthven, 2002; and Ruthven and Kumar, 2002), it was found that the poor tended to manage their money through a variety of financial instruments. The same is true for South Africa.

The environment within which households operate in low-income countries makes the process of financial decision-making quite different from those in developed countries. The life-cycle hypothesis (Modigliani, 1970), for example, states that earnings are less than consumption after retirement and exceed consumption during the middle years of earning. Rational people should base their consumption decisions on expected lifetime income rather than current income. However, many researchers (Deaton, 1993; Ando et al, 1992; Spio and Groenewald, 1996) reject this hypothesis in most low income countries. Savings seems, instead, to be precautionary and held for insurance reasons.

Another classic economic theory, the permanent income hypothesis (Friedman, 1957), proposes that rational individuals will try to smooth consumption if income is disrupted. Therefore, transitory income shocks should have no effect on consumption. Permanent income shocks (like suffering a major disability) will, however, translate into changes in consumption. This theory works reasonably well in developed countries where mechanisms like insurance and credit can be used to effectively smooth income streams with little disruption in consumption. However, in low income countries, existing mechanisms do not always work well, and households may be forced to cope following a shock by drawing on savings, selling assets, working longer hours, doing without key services such as health and education or without key goods such as certain foods.

Based on data generated by a financial diaries method, Rutherford (2002) tracked household financial flows over the course of a year in Bangladesh and confirmed that households actively manage their portfolio of cash assets with a wide range of instruments. Moreover, different levels of poverty do not mean different levels of active management. Taken all together, financial flows in poor areas are substantial, but mostly small per transaction.

Ruthven (2002) used the same financial diary methodology in India and her results echo much of what was found in Rutherford (2002) in Bangladesh. The results confirmed that lifecycle purposes (births, marriages, deaths) were the primary motivation for raising lump sums of money. However, health spending was also disproportionately high for poorer households and a key reason for saving or borrowing large sums of money. House construction was also extremely important. The results also confirmed that the most widely and frequently used financial devices were family and reciprocal contacts. The transactions were small and interest free. Leaning on friends and neighbours was a regular strategy to cover deficits and to bridge cash flow. Lastly, it confirmed that slightly different portfolios of financial devices were used by households of differing levels of wealth/livelihoods, although all levels of wealth used financial devices. Most respondents were saving by hiding money at home, giving interest-free loans, or putting money into a bank savings account. Most were borrowing by taking an interest free loan, taking a wage advance, or taking a private loan with interest.

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