Kevin Z. Chen and Ling Jin International Food Policy Research Institute and

1. Risk Coping Strategies for Farmers in Transition: Labor Supply Flexibility versus Precautionary Saving Kevin Z. Chen and Ling Jin International Food Policy Research Institute and Zhejiang University, respectively April 26, 2012

2. Typical Risks Farmers Face in Developing Countries Source: Quoted from Dercon (2005): Risk Insurance and Poverty: A Review. And the author’s calculation is based on Ethiopian Rural Panel Data Survey (1994-1997).

3. Impact of Risk • In the short run, risk induces income and consumption fluctuations • Heathcote, Storesletten and Violante (2012): 40% of permanent wage shocks pass through to consumption • In the long run, risk has adverse effects on farmers’ investment in nutrition, health and human capital, and probably traps them in poverty • Jacoby and Skoufias (1997): negative rainfall shocks are associated with higher child mortality rates in landless households but not in households with significant landholdings in India

4. Risk Coping Strategies • Ex ante: income diversification, income skewing • Morduch (1995): Indian households of subsistence devote a larger share of land to safer, traditional varieties of rice and castor. • Dercon and Christiaensen (2011): the possibly low consumption outcomes when harvest fail discourage the application of fertilizer in Ethiopia. • Ex post: precautionary saving, labor supply, access to formal credit and insurance markets, informal risk-sharing mechanisms, and safety nets • Udry (1994): informal credit play a role in pooling risk between households in Nigeria, because repayments depend on realization of random shocks by both borrowers and lenders. • De Weerdt and Fafchamps (2011): inter-household transfers respond to reported illness, and net transfers to households with disabled members depends crucially on a kinship link.

5. Effectiveness of the Risk Strategies • The characteristics of these strategies • Self-insurance: income diversification, precautionary saving, and labor supply flexibility • Insurance supplied by institutional arrangements: access to formal credit and insurance markets, informal risk-sharing mechanisms, and safety nets • access to formal credit and insurance markets: moral hazard and adverse selection due to information asymmetry, contract enforcement • informal risk-sharing mechanisms: self-enforcement constraints, genetic limits to altruism, and the bounded reach of social networks • safety nets: fiscal budget constraints, targeting • The institutional environments

6. Why Labor Supply Flexibility and Precautionary Saving? • Relying less on external institutions • Incurring less costs • The underlying institutions of these strategies have experienced transition in China in the past 30 years • easy access to saving service supported by extensive financial branch networks • pervasive credit constraints in rural areas • majority of smallholders are discouraged from participating in agricultural insurance schemes • rural health reform does not significantly reduce the out-of-pocket payments • rural minimum living security system can only achieve meeting the food demands of the poor • high mobility and penetration of marketization undermine the informal risk-sharing mechanisms • gradual integration of the labor market facilitates consumption smoothing

7. Research Questions • Do farmers in China apply precautionary saving and labor supply flexibility to insulate against risk? • If they do, what is the relationship between the two self-insurance strategies?

8. Theoretical Framework (1) • The buffer-stock model (Deaton, 1991; Carroll, 1997; Caroll, 2009) • Theoretical implications • Prudent and impatient consumers have a target ratio as the balance between consumption and saving • A positive correlation between uncertainty and saving rate or the target ratio

9. Theoretical Framework (2) • A stylized fact on intertemporal substitution of labor supply • labor supply tends to be high early in life when wages are low, but low later in life when wages are high • Explanations from uncertainty • Approximation results: increased variability in leisure, wage and consumption lead to leisure being deferred (Low, 2005) • Simulation results: 1) Flexibility over labor supply allows the age profile of hours-of-work tracks coincident with the stylized fact (Low, 2005) and 2) Uncertainty about future wages raises current labor supply and reduces future labour supply (Floden, 2006) • Estimation results: the self-employed perform self-insurance in response to greater uncertainty by working longer hours (Parker, Belghitar and Barmby, 2005)

10. Labor Supply Flexibility and Consumption Path • Algan et al. (2003): both unemployment duration and job quits rise with holdings of short-term liquid assets • Low (2005): labor supply flexibility means individuals can accumulate assets through working longer hours rather than just through lower consumption • Pijoan-Mas(2006): households use their working effort as a self-insurance mechanism at least as much as they do with precautionary saving • Marcet, Obiols-Homs and Weil(2006): due to the ex post wealth effect on labor supply that runs counter the precautionary savings motive, equilibrium savings and output may be lower under incomplete markets • Floden (2006): labor supply flexibility facilitates intertemporal substitution, and raises precautionary saving • Kimball and Weil (2009): both aversion to risk and aversion to intertemporal substitution determine the strength of the precautionary saving motive

11. Data • Data source • An annual national rural household survey by the Ministry of Agriculture’s Research Center for Rural Economy (RCRE) • A balanced panel from Zhejiang, composing of 427 rural households from 10 villages and 7,686 observations altogether over 1986-1991 and 1995-2006 • Farmers’ saving rate and wealth accumulations • Trend of farmers’ saving rate • Wealth accumulations • Farmers’ participation in labor market • Transformation of income structure • Riskiness of income sources • Number of rural households who earn wage income • Number of rural households who take wage income as the first income source • Time allocation across economic activities

12. Trend of Saving Rate

13. Wealth Accumulations

14. Transformation of Income Structure

15. Riskiness of Income Sources

16. Percentage of Rural HouseholdsWho Earn Wage Income (%)

17. Percentage Who Take Wage Income as the First Income Source (%)

18. Time Allocation across Economic Activities (days per laborer)

19. Time Allocation across Economic Activities

20. Time Allocation on Agricultural On-farm Business

21. Time Allocation on Non-Agri On-farm Business

22. Time Allocation on Off-farm Labor Supply

23. Empirical Strategies • Constructing Measures of Various Sources of Risk • Testing the Functioning of Labor Supply Flexibility as a Self-insurance • Testing the Functioning of Precautionary Saving as a Self-insurance • Investing the Interaction of Labor Supply Flexibility and Precautionary Saving

24. Measuring Production Risk (1) • Just and Pope (1978) rural household i’s income in one of eight on-farm industries in year t the function indicating the effect of input on the mean of output the function indicating the effect of input on the variance of output the jth or kth input in production in one of eight on-farm industries dummy variable for survey year t error term for mean and variance function, respectively stochastic shock in production

25. Measuring Production Risk (2) • Production specification: a quadratic function • Estimation strategy: Feasible Generalized Least Square (FGLS) • Constructing a weighted measure of production risk: taking time of work on each on-farm industry as weight • Downside production risk: semivariance of estimated production risk after weighting estimated production risk after weighting

26. Measuring Price Risk (1) • Chavas and Holt (1990), Coyle (1992), Coyle (2007) • Step 1. calculating covariance matrix of the adapted price of agricultural Products price of agricultural product j and k in village i in year t expectation operator based on information in year t covariance matrix of price of agricultural product j and k

27. Measuring Price Risk (2) • Step 2. calculating revenue risk of agricultural products • Step 3. calculating aggregate Tornqvist output index revenue risk covariance matrix of adapted price of agricultural products vector of each agricultural product’s output number of agricultural products aggregate Tornqvist output index share of agricultural product i’s revenue

28. Measuring Price Risk (3) • Step 4. calculating aggregate Tornqvist price index • Step 5. calculating the variance of adapted aggregate Tornqvist price index to measure price risk

29. Measuring Health Risk • Chamon and Prasad (2010) health risk medical expenses consumption expenditure, expenditure on consumer durables and housing are calculated as their consumption flows after depreciation

30. Modeling Labor Supply Flexibility (1) • Heckman Two-step Estimation Strategy • The first-stage estimation: participation decision the latent variable indicating whether rural household i in village k participated in labor market or not in year t whether rural household i in village k participated in labor market or not in year t per capita income of other sources a vector of variables indicating household characteristics, including age of the head and its square, household size, dependency ratio, ratio of female members, number of labors, area of arable lands and forest lands dummy variable for survey year and village, respectively

31. Modeling Labor Supply Flexibility (2) • The second-stage estimation: wage equation (constructing instrumental wage rate) real wage rate a vector of variables indicating household characteristics, including age of the head, its square and cubic, education of the head, highest education of non-headed laborers, number of laborers with expertise, number of laborers with trainings, number of years members have participated in labor market before and its square, percentage of rural households with members participating in labor market in the village inverse Mill’s ratio disturbance term

32. Modeling Labor Supply Flexibility (3) • The second-stage estimation: time of work decision per laborer days of work in labor market instrumented wage rate a vector of variables indicating household characteristics, including age of the head and its square, household size and its square, dependency ratio, ratio of female members, area of arable lands, number of years members have participated in labor market before and its square, percentage of rural households with members participating in labor market in the village measures of production risk, price risk and health risk

33. Results: Labor Supply Flexibility

34. Modeling Precautionary Saving • The wealth accumulation equation total net wealth permanent income constructed by calibrating a dynamic income process a vector of variables including demographics (age of the head and its square, household size and its square, and number of laborers), social connections as proxies for risk preference (whether a rural household is a five-guarantee one, with members being martyrs, civil servants, cadres and party members), income structure (number of income sources, the first and second important income source, the principal on-farm business and the industry with most labor allocation)

35. Interaction of Labor Supply Flexibility and Precautionary Saving • The wealth accumulation equation with the interaction terms of risks and time of work the interaction terms of production risk, price risk and health risk and time of work

36. Estimation Results

37. Empirical Findings • Farmers adjust instantaneousand ex post labor supply in response to risk • Farmers increase days of work to mitigate production risk, but reduce days of work as a consequence of health risk • Farmers hold precautionary saving to insulate against risk • Farmers increase wealth in anticipation of production risk, but deplete assets to react to health shocks • Given the level of risk, adjustment in days of work functions as a substitute to precautionary saving • Dynamic relationship between the two strategies: when the severity of shocks exceeds the extent to which precautionary saving can insulate against, farmers increase days of work and deplete assets first. After accumulated precautionary saving due to increased days of work can perfectly insulate against shocks, farmers reduce days of work.

38. Policy Implications • Promoting the development of labor market improves the opportunities which poor rural households with low assets can exploit in response to risks • Promoting the development of labor market can also be an effective way to lessen rural households’ strength of precautionary saving • With precautionary saving and labor supply flexibility to insulate against idiosyncratic risk, policies should focus on severe shocks like catastrophes and major diseases • The functioning of precautionary saving and labor supply flexibility as self-insurance partly explains farmers’ low demand for agricultural insurance • Improving the effective coverage of social safety nets will be more helpful for the majority of smallholders

39. Limitations and Future Work • Estimating days of work and wealth accumulation equations simultaneously to avoid the endogeneity of labor supply and wealth holdings • Conducting a simulation to gauge the substitution between labor supply flexibility and precautionary saving • Introducing measures of the risk of return to capital and wage risk • Improving estimation strategy to exploit the advantage of panel data • Investigating the importance of labor supply flexibility by using individual information