HOUSEHOLD DEBT AND FINANCIAL WELLBEING IN PAKISTAN

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(1)al. ay. a. HOUSEHOLD DEBT AND FINANCIAL WELLBEING IN PAKISTAN. ve r. si. ty. of. M. WAJIHA HAQ. U. ni. FACULTY OF ECONOMICS AND ADMINISTRATION UNIVERSITY OF MALAYA KUALA LUMPUR. 2018.

(2) of. M. al. WAJIHA HAQ. ay. a. HOUSEHOLD DEBT AND FINANCIAL WELLBEING IN PAKISTAN. si. ty. THESIS SUBMITTED IN FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY. U. ni. ve r. FACULTY OF ECONOMICS AND ADMINISTRATION UNIVERSITY OF MALAYA KUALA LUMPUR. 2018.

(3) UNIVERSITY OF MALAYA ORIGINAL LITERARY WORK DECLARATION. Name of Candidate: Wajiha Haq Registration/Matric No: EHA140015 Name of Degree: Doctor of Philosophy Title of Project Paper/Research Report/Dissertation/Thesis (“this Work”): Household debt and financial wellbeing in Pakistan Field of Study:. ay. a. Household Economics. ni. ve r. si. ty. of. M. al. I do solemnly and sincerely declare that: (1) I am the sole author/writer of this Work; (2) This Work is original; (3) Any use of any work in which copyright exists was done by way of fair dealing and for permitted purposes and any excerpt or extract from, or reference to or reproduction of any copyright work has been disclosed expressly and sufficiently and the title of the Work and its authorship have been acknowledged in this Work; (4) I do not have any actual knowledge nor do I ought reasonably to know that the making of this work constitutes an infringement of any copyright work; (5) I hereby assign all and every rights in the copyright to this Work to the University of Malaya (“UM”), who henceforth shall be owner of the copyright in this Work and that any reproduction or use in any form or by any means whatsoever is prohibited without the written consent of UM having been first had and obtained; (6) I am fully aware that if in the course of making this Work I have infringed any copyright whether intentionally or otherwise, I may be subject to legal action or any other action as may be determined by UM.. Date:. U. Candidate’s Signature. Subscribed and solemnly declared before,. Witness’s Signature. Date:. Name: Designation:. ii.

(4) HOUSEHOLD DEBT AND FINANCIAL WELLBEING IN PAKISTAN ABSTRACT With changing economic situations, problem of household debt is becoming one of the main highlights. However, in the developing world, there are some countries where efforts of increasing financial inclusion through debt provision are being made. About one-third of the population in Pakistan does not borrow. Around 80 per cent of the non-. a. borrowing population does not even plan to borrow in next two to three years (Nenova et. ay. al., 2009). Although efforts to increase the outreach of financial services have been made but credit products do not really excite people to take debt. Debt is one of the financial. al. resources that can be used for financial management as well as to increase financial. M. wellbeing if the financial management remains wise (Lown & Ju, 1992). Understanding socioeconomic and demographic factors influencing debt is very important to guide. of. policy design. Debt is not important unless it helps to increase financial wellbeing. The. ty. aim of the research is to investigate the characteristics of people (household heads) which. si. affect their debt decision and the amount of household debt. This research also investigates the effect of debt on the financial wellbeing along with other demographic. ve r. and socioeconomic characteristics. This research also models the random variations in household debt decision, household demand and financial wellbeing at provincial level. ni. using multilevel analysis. The Household Integrated Expenditure Survey (HIES) data. U. from 2001-2014 which includes six survey rounds. The study revealed that the likelihood of taking debt was influenced by employment status, residential region, age, education, financial assets and household sizes. It was also seen that the decision of taking household debt randomly varies at provincial level. After knowing the characteristics affecting the decision to take debt, it is important to know the characteristics affecting size of participation in order to understand that whether same characteristics affect both. People having higher financial assets, higher income and larger household sizes have higher. iii.

(5) amount of debt. The amount of debt also increases with education and age. This study also investigates the role of debt in financial wellbeing. It aims to investigate financial wellbeing of people at different levels of income in Pakistan and to explore how the financial wellbeing is affected by demographic and socioeconomic measures. This study found that different demographic factors may affect the financial wellbeing of Pakistani households in different ways. It is not a postulate that the rich are always happier than. a. poor, but rather they derive their happiness differently. People in urban areas are more. ay. likely to have higher financial wellbeing than rural ones. The mediation between household debt and financial wellbeing was also tested and found to be absent. The. al. significant variation in the financial wellbeing was present at provincial level. This study. M. provides a national representative, decade scenario of the debt behaviour of household heads which can be used as a guide to influence household’s demand for debt. This study. of. also reveals the financial wellbeing of Pakistani households and how it can be affected. ty. by debt along with other socioeconomic and demographic characteristics.. U. ni. ve r. si. Keywords: Debt, financial wellbeing, household, multilevel, Pakistan.. iv.

(6) HUTANG ISI RUMAH DAN KESEJAHTERAAN KEWANGAN DI PAKISTAN ABSTRAK Dengan perubahan keadaan ekonomi, masalah hutang isi rumah telah menjadi salah satu fokus utama. Walau bagaimanapun, terdapat beberapa negara membangun yang berusaha untuk meningkatkan rangkuman kewangan melalui akses pembiayaan atau pinjaman. Kira-kira 80 peratus daripada penduduk di Pakistan yang tidak melakukan pinjaman tidak merancang membuat pinjaman dalam tempoh dua hingga tiga tahun yang akan datang (Nenova et al., 2009). Walaupun usaha untuk meningkatkan jangkauan. a. perkhidmatan kewangan telah dibuat tetapi produk kredit yang dipasarkan tidak. ay. merangsang isi rumah untuk terlibat dengan hutang. Hutang adalah salah satu daripada sumber kewangan yang boleh digunakan dalam pengurusan kewangan serta dapat. al. meningkatkan kesejahteraan kewangan jika pengurusan kewangan itu dilakukan secara berhemah (Lown & Ju, 1992). Pemahaman terhadap faktor sosioekonomi dan demografi. M. yang mempengaruhi pengambilan hutang sangat penting dalam pembentukan sesuatu dasar. Selain daripada membantu meningkatkan kesejahteraan kewangan, pengambilan. of. hutang dianggap tidak penting. Tujuan penyelidikan ini adalah untuk mengkaji ciri-ciri yang mempengaruhi individu dalam membuat keputusan berkaitan hutang dan jumlah. ty. yang diambil. Penyelidikan ini juga mengkaji kesan hutang terhadap kesejahteraan kewangan mereka berdasarkan ciri-ciri demografi dan sosioekonomi yang lain. Kajian ini. si. juga mengambil kira variasi rawak dalam keputusan hutang isi rumah, permintaan isi. ve r. rumah dan kesejahteraan kewangan di peringkat wilayah melalui analisis berhirarki. Data Penyiasatan Perbelanjaan Bersepadu Isi Rumah (HIES) dari tahun 2001-2004 yang merangkumi enam pusingan tinjauan telah digunakan. Kajian ini mendedahkan bahawa. ni. kebarangkalian pengambilan hutang adalah dipengaruhi oleh faktor seperti pekerjaan, kawasan tempat tinggal, umur, pendidikan dan saiz aset kewangan isi rumah. Kajian ini. U. juga menunjukkan bahawa keputusan untuk mengambil hutang isi rumah adalah berbeza di peringkat wilayah. Setelah mengenal pasti faktor-faktor yang mempengaruhi keputusan isi rumah untuk mengambil hutang, adalah penting untuk turut mengkaji ciriciri yang mempengaruhi saiz penyertaan dalam pengambilan hutang bagi melihat sekiranya kedua-dua ini dipengaruhi oleh ciri-ciri yang sama. Isi rumah yang mempunyai nilai aset, pendapatan dan bilangan isirumah yang tinggi mempunyai jumlah hutang yang lebih tinggi. Jumlah hutang isirumah juga meningkat mengikut tingkat pendidikan dan umur.. v.

(7) Kajian ini juga mengkaji kesejahteraan kewangan isi rumah berhubung dengan hutang. Kajian ini bertujuan untuk mengenal pasti kadar kesejahteraan kewangan rakyat di pelbagai peringkat pendapatan di Pakistan dan untuk meneroka bagaimana kesejahteraan kewangan dapat ditingkatkan melalui ciri-ciri demografi dan sosioekonomi. Kajian mendapati bahawa faktor demografi yang berbeza mempengaruhi kesejahteraan kewangan individu Pakistan dalam pelbagai cara. Individu yang mempunyai keuapayaan kewangan yang tinggi tidak semestinya lebih bahagia daripada mereka yang miskin, tetapi kebahagiaan mereka didefinasikan secara berbeza. Orang kaya di kawasan bandar. a. lebih cenderung mempunyai kesejahteraan kewangan yang lebih tinggi daripada yang. ay. miskin. Tiada kesan pengantara ditemui antara hutang isi rumah dan tahap kesejahteraan kewangan. Terdapat variasi kesejahteraan kewangan yang ketara dilihat di peringkat. al. daerah. Kajian ini memberi gambaran secara nasional yang menunjukkan senario. M. berkenaan tingkah laku isi rumah mengenai hutang yang dapat digunakan sebagai panduan dalam mengenal pasti faktor yang mempengaruhi permintaan hutang isi rumah. Kajian ini juga menunjukkan tahap kesejahteraan kewangan individu di Pakistan dan. of. bagaimana ia boleh dipengaruhi oleh hutang dan faktor sosioekonomi dan demografi lain.. U. ni. ve r. si. ty. Kata kunci: hutang, kesejahteraan kewangan, isi rumah, hirarki, Pakistan.. vi.

(8) ACKNOWLEDGEMENTS I would like to thank first Almighty Allah for giving me this big opportunity of doing Ph.D, letting me fulfil my dreams and granting me ease through the whole journey. My sincerest gratitude is for Prof Dr. Noor Azina Ismail and Dr. NurulHuda Mohd Satar due to their inexhaustible supervision and determined deliverance of knowledge. They showed patience with my mistakes, taught me the corrections and helped me to ensure. a. smooth sailing of my work. I want to especially thank my supervisor Prof. Dr. Noor Azina. ay. Ismail for her continued guidance and encouragement. She was not only a thesis supervisor to me but was also a mentor and role model for me. She always inspired me. al. through her charismatic personality. She always had a welcoming smiling face and had. M. solutions for academics as well as for life problems. Dr. NurulHuda Mohd Satar, always tried to bring the best out of my thesis and made it a credible study based on interesting. ty. supervisors than them.. of. ideas. She also contributed a lot in building my research skills. I can never think of better. si. I also want to thank all my teachers who have made me able to reach this stage. I want. ve r. to thank my National Institute of Science and Technology (NUST) for funding my degree. I also want to thank my teachers at NUST especially Dr. Ashfaque Hassan Khan and Dr.. ni. Ather Maqsood for contributing a lot towards building my research skills in earlier degree. U. and helping me to make my dream of Ph.D come true. I want to dedicate this whole degree to my parents, especially my mother. This. dedication is not only the realisation of constant emotional support extended by my mother and deliverance of valour by my father, but also of their untiring efforts of bringing me up to this stage. My parents believed in my abilities and always encouraged me to move forward even against (my) society norms. Throughout this journey, they ensured that I remain physically and emotionally healthy. I cannot thank enough to my father when he was literally calling me every day during my emotionally low times and vii.

(9) ensuring me that I do not need to worry to go ahead because of fear of falling back as he is always there to catch me. The grace of Allah, my parents’ prayers made my dream become a reality. I also want to acknowledge my grandmother’s precious contribution in bringing me up and making my personality. She is not in this world now but she is missed badly. I also want to dedicate this degree to my daughter “Hoorab” whose contributions. a. towards the completion of my degree are difficult to describe. I started my Ph.D journey. ay. holding her in my lap when she was hardly 3 months old. She remained a complete source. al. of rejoice for me. Without her smiles, kisses, smooches and hugs, I would not have done this untiringly. My daughter! I was always ambitioned to do this degree so that I can set. of. than what I have accomplished.. M. a higher starting benchmark for you like my mother did. I want Hoorab to dream higher. I want to give special thanks to my brothers Muhammad Kashif Malik, Muhammad. ty. Atif Malik and Muhammad Wasif Malik for helping me become confident through their. si. counselling and setting higher goals for me through their achievements. I want to thank. ve r. Siti Fatimah and Alya Halim for taking very good care of my daughter in my absence. They always gave me peace from my daughter so that I can fully concentrate on my. ni. studies. In the last but not least, I want to thank my husband for everything he did because. U. that helped me to discover myself.. viii.

(10) TABLE OF CONTENTS Abstract ..................................................................................................................... III Abstrak ........................................................................................................................V Acknowledgements .................................................................................................. VII Table of Contents ...................................................................................................... IX List of Figures .......................................................................................................... XII. a. List of Tables.......................................................................................................... XIV. ay. List of Symbols and Abbreviations ....................................................................... XVII CHAPTER 1: INTRODUCTION ............................................................................ 1 Background of Study ............................................................................................ 1. 1.2. Problem Statement ................................................................................................ 5. 1.3. Research Questions ............................................................................................... 7. 1.4. Objectives of the Study......................................................................................... 7. 1.5. Significance of the Study ...................................................................................... 8. 1.6. Limitations of the Study ....................................................................................... 9. 1.7. Organisation of the Study ................................................................................... 10. si. ty. of. M. al. 1.1. ve r. CHAPTER 2: LITERATURE REVIEW .............................................................. 11 Introduction......................................................................................................... 11. 2.2. Household Debt .................................................................................................. 11. ni. 2.1. U. 2.2.1 Situations for Coexistence of Formal and Informal Sources of Borrowing ...................................................................................... 13 2.2.2 Theoretical Explanations of Household Borrowing ........................... 16 2.2.3 Factors Affecting Household Debt..................................................... 19 2.2.4 Role of Household Debt in Financial Inclusion ................................. 25. 2.3. Financial Wellbeing ............................................................................................ 30 2.3.1 Definition of Financial Wellbeing ..................................................... 30 2.3.2 Measurement of Financial Wellbeing ................................................ 31 2.3.3 Factors Affecting Financial Wellbeing .............................................. 34. ix.

(11) 2.3.4 Debt and Financial Wellbeing ............................................................ 36 2.4. Review of Methods ............................................................................................. 37 2.4.1 Shortcomings of the Single Level Regression Model ........................ 41 2.4.2 Multilevel Mixed Effect Regression .................................................. 42 2.4.3 Number of Group and Observations Needed to Fit a Multilevel Model ............................................................................................. 43. 2.5. Economic Background of Pakistan ..................................................................... 44. a. 2.5.1 Household Debt in Pakistan ............................................................... 48. ay. 2.5.2 Efforts of Authorities to Increase Household Debt ............................ 52 2.5.3 Financial Inclusion in Pakistan .......................................................... 58 Gaps in Literature ............................................................................................... 64. 2.7. Conceptual Framework ....................................................................................... 66. M. al. 2.6. CHAPTER 3: RESEARCH METHODOLOGY ................................................. 70 Introduction......................................................................................................... 70. 3.2. Data of HIES (Description of data design by Pakistan Bureau of Statistics) ..... 70. of. 3.1. ty. 3.2.1 Sampling Frame and Sampling Procedure ......................................... 70. si. 3.2.2 Sample Size and its Allocation .......................................................... 71. ve r. 3.2.3 Household Integrated Survey Questionnaire ..................................... 72 3.2.4 Data Screening ................................................................................... 73. Methods .............................................................................................................. 75. ni. 3.3. U. 3.3.1 Methodology to Investigate Debt Decision (Objective 1) ................. 79 3.3.2 Methodology for Finding Demand for debt (Objective 2) ................. 83 3.3.3 Methodology to Examine Role of Debt in Financial Wellbeing of Households (Objective 3) .............................................................. 87. CHAPTER 4: DEBT DECISION .......................................................................... 94 4.1. Introduction......................................................................................................... 94. 4.2. Descriptive Statistics .......................................................................................... 94. 4.3. Univariate Analysis ............................................................................................ 99. 4.4. Testing the Assumptions .................................................................................. 108. x.

(12) 4.5. Multivariate Analysis........................................................................................ 109 4.5.1 Discussion ........................................................................................ 117. 4.6. Summary ........................................................................................................... 122. CHAPTER 5: DEMAND FOR DEBT ................................................................ 124 Introduction....................................................................................................... 124. 5.2. Descriptive Statistics ........................................................................................ 124. 5.3. Univariate Analysis .......................................................................................... 135. 5.4. Testing the Assumptions of the Model ............................................................. 142. 5.5. Multivariate Analysis........................................................................................ 144. ay. a. 5.1. 5.6. al. 5.5.1 Discussion ........................................................................................ 151 Summary ........................................................................................................... 158. M. CHAPTER 6: FINANCIAL WELLBEING ....................................................... 160 Introduction....................................................................................................... 160. 6.2. Descriptive Statistics ........................................................................................ 160. 6.3. Univariate Analysis .......................................................................................... 164. 6.4. Testing the Assumptions .................................................................................. 170. 6.5. Multivariate analysis ......................................................................................... 171. si. ty. of. 6.1. ve r. 6.5.1 Discussion ........................................................................................ 178. 6.6. Summary ........................................................................................................... 183. ni. CHAPTER 7: CONCLUSION ............................................................................. 184 Summary of Findings ....................................................................................... 184. U. 7.1. 7.2. Implications and Recommendations ................................................................. 189. 7.3. Contribution of the study .................................................................................. 190. 7.4. Data Limitations and Suggestions for Future Research ................................... 192. References ............................................................................................................... 193 List of Publications and Papers Presented .............................................................. 211. xi.

(13) LIST OF FIGURES Figure 2-1: Microfinance outreach by province (Measured by number of active borrowers) ..................................................................................................... 45 Figure 2-2: Trend in category wise consumer finance growth .................................. 50 Figure 2-3: Rate of financial inclusion by gender and region 2014-15 ..................... 59 Figure 2-4: Percentage distribution of savings of Pakistani households by categories ...................................................................................................... 60. ay. a. Figure 2-5: Percentage distribution of borrowings of Pakistani households by categories ...................................................................................................... 61 Figure 2-6: Trustworthiness of financial services providers ...................................... 62. al. Figure 2-7: Commercial banks branches and ATMs in Pakistan ............................... 63. M. Figure 2-8: Conceptual framework ............................................................................ 67. of. Figure 3-1: Focus of the study ................................................................................... 76 Figure 3-2: Different levels of the data ...................................................................... 77. ty. Figure 3-3: Strategy to achieve objectives ................................................................. 79. si. Figure 3-4: Multistage decision process of taking household debt ............................ 84. ve r. Figure 3-5: Mediating relationship of household debt ............................................... 93 Figure 4-1: Frequency distribution of household debt, region and gender ................ 95. ni. Figure 4-2: Frequency distribution of employment status and marital status ............ 95. U. Figure 4-3: Percentage of people taking debt over years ........................................... 97 Figure 4-4: Percentage of households taking debt, by region over the years, in the sample ........................................................................................................... 97 Figure 4-5: Percentage of households taking debt, by province over the years ......... 98 Figure 4-6: Distribution of household size according to categories ........................ 105 Figure 4-7: Caterpillar plot of residuals ................................................................... 122 Figure 5-1: Frequency distribution of region, gender, employment status and marital status ........................................................................................................... 126. xii.

(14) Figure 5-2: Transformation of household debt into log form .................................. 127 Figure 5-3: Rural-urban distribution of debtors ....................................................... 128 Figure 5-4: Distribution of debtors according to provinces ..................................... 129 Figure 5-5: Mean age, household size and education over the survey period ......... 130 Figure 5-6: Trend of household income, consumption and debt over the years ...... 132 Figure 5-7: Savings and debt over the period .......................................................... 133. a. Figure 5-8: Mean amount of household debt taken by households, by region ........ 134. ay. Figure 5-9: Percentage of amount of household debt taken by household, by provinces over the years .............................................................................................. 134. al. Figure 5-10: Distribution of household size according to the categories................. 140. M. Figure 5-11: Random slope against random intercept ............................................. 151. of. Figure 5-12: Random intercept of household debt at provincial level ..................... 155 Figure 5-13: Normal quantile plot of residuals at level 1 (household level) ........... 156. ty. Figure 5-14: Normal quantile plot of residuals at level 2 (PSU level)..................... 157. si. Figure 5-15: Level 1 residuals plot .......................................................................... 157. ve r. Figure 5-16: Caterpillar plot of residuals at PSU level ............................................ 158 Figure 6-1: Frequency distribution of financial wellbeing, region and gender........ 162. ni. Figure 6-2: Frequency distribution of employment status and marital status .......... 162. U. Figure 6-3: Distribution of financial wellbeing by province ................................... 164 Figure 6-4: Caterpillar plot of residuals ................................................................... 182. xiii.

(15) LIST OF TABLES Table 2-1: Domestic credit to private sector of emerging Asia over period 20102013 .............................................................................................................. 51 Table 2-2: Domestic credit to private sector of Pakistan and other countries with comparable GDP over period 2010-2014 ..................................................... 52 Table 2-3: Microfinance outreach in Pakistan ........................................................... 54 Table 2-4: Percentage increase in loans of banks ...................................................... 54. a. Table 3-1: Variables used in the analysis ................................................................... 78. ay. Table 4-1: Descriptive statistics of the data used for analysing household debt decision ...................................................................................................................... 94. M. al. Table 4-2: Univariate analysis of gender and marital status; testing association with household debt decision .............................................................................. 100. of. Table 4-3: Univariate analysis of employment status; testing association with household debt decision .............................................................................. 101. ty. Table 4-4: Univariate analysis of independent variables; testing association with household debt decision .............................................................................. 102. si. Table 4-5: Univariate analysis of income and financial assets; testing association with household debt decision .............................................................................. 104. ve r. Table 4-6: Summary of the type of variables used .................................................. 107 Table 4-7: Test for multicollinearity of variable ...................................................... 109. ni. Table 4-8: Fitting three level model against single level ......................................... 110. U. Table 4-9: Three level model against two-level model ............................................ 111 Table 4-10: Multilevel mixed effect binary logistic regression showing the effect of different variables on the decision of debt .................................................. 112 Table 4-11: Multilevel mixed effect binary logistic regression showing the effect of interactions, level two variable and random slope on the decision of debt 114 Table 4-12: Final model for multilevel binary logistic regression ........................... 116 Table 5-1: Descriptive statistics of the sample used for the analysis of demand for debt .................................................................................................................... 125. xiv.

(16) Table 5-2: Univariate analysis of gender and marital status; testing association with household demand for debt ......................................................................... 135 Table 5-3: Univariate analysis of employment status; testing association with household demand for debt ......................................................................... 136 Table 5-4: Univariate analysis of independent variables; testing association with household demand for debt ......................................................................... 138 Table 5-5: Univariate analysis of income and financial status; testing association with household demand for debt ......................................................................... 139. a. Table 5-6: Summary of types of variables used in the analysis ............................... 141. ay. Table 5-7: Tests for multicollinearity ...................................................................... 142. al. Table 5-8: Checking sample selectivity bias through Heckman selection (Two-step) model .......................................................................................................... 143. M. Table 5-9: Fitting three level model against single level ......................................... 145. of. Table 5-10: Comparing three level and two level model ......................................... 146 Table 5-11: Adding explanatory variables to three level model .............................. 147. ty. Table 5-12: Adding interaction terms, level 2 variable and random slope .............. 149. ve r. si. Table 6-1: Descriptive statistics of the data used for the analysis of financial wellbeing .................................................................................................................... 161. ni. Table 6-2: Univariate analysis of gender and marital status; testing association with financial wellbeing ...................................................................................... 165. U. Table 6-3: Univariate analysis of employment status; testing association with financial wellbeing ..................................................................................................... 166 Table 6-4: Univariate analysis of independent variables; testing association with financial wellbeing ...................................................................................... 167 Table 6-5: Univariate analysis of income and financial assets; testing association with financial wellbeing ...................................................................................... 169 Table 6-6: Test for multicollinearity of variables .................................................... 170 Table 6-7: Test for parallel lines .............................................................................. 171 Table 6-8: Fitting three-level model against single level ......................................... 171. xv.

(17) Table 6-9: Three level against two-level model ....................................................... 172 Table 6-10: Multilevel ordinal logistic regression showing the effect of different variables on financial wellbeing ................................................................. 174 Table 6-11: Adding interaction term and level 2 variable in the model .................. 176 Table 6-12: Analysis of effects of variables on financial wellbeing and household debt .................................................................................................................... 180. U. ni. ve r. si. ty. of. M. al. ay. a. Table 6-13: Sobel test for testing the mediating relationship of household debt ..... 181. xvi.

(18) LIST OF SYMBOLS AND ABBREVIATIONS :. Access to Finance Survey. AIDIS. :. All-India Debt and Investment Survey. ATM. :. Automated Teller Machine. ACFS. :. Household Consumption and Financial Survey. HIES. :. Household Income and Expenditure Survey. IBF. :. Institute of Bankers Pakistan. ILO. :. International Labour Organisation. LCIH. :. Life Cycle Income Hypothesis. MOS. :. Measure of Size. MFBs. :. Microfinance Banks. MFIs. :. Microfinance Institutions. MDGs. :. Millennium Development Goals. MNOs. :. Mobile Network Operators. NIBAF :. National Institute of Banking and Finance. NBFCs :. si. ty. of. M. al. ay. a. A2FS. Non-Bank Finance Corporations. :. Pakistan Bureau of Statistics. PDS. :. Pakistan Demographic Survey. PIHS. :. Pakistan Integrated Household Survey. PSLM. :. Pakistan Social and Living Standard Measurement. PSUs. :. Primary Sampling Units. PPS. :. Probability Proportion to Size. SBP. :. State Bank of Pakistan. SDGs. :. Sustainable Development Goals. U. ni. ve r. PBS. xvii.

(19) CHAPTER 1: INTRODUCTION 1.1 Background of Study Debt is a blessing or a curse; it depends on situations and contexts. Mostly debt has negative intrinsic meaning and is normally associated with stress, depression and decrease in wellbeing (O'Neill et al., 2006). However, Bertola et al. (2006, p. 1) propose that debt can be desirable. In fact, the opportunity to take debt provides the ability to enhance. ay. a. economic welfare. Debt can yield positive outcomes if it is handled carefully and is not linked with low consumption in future. This is because, the lack of capacity to borrow. al. can reduce the welfare of the society (Tsai et al., 2016).. M. In the current changing economic scenario, rising household debt has become one of. of. the major problems to address but in developing economies, there are some countries which are still making efforts to increase financial inclusion. In particular, access and use. ty. of broad range of financial services including household debt are important for financial. si. inclusion. Over the years, financial inclusion has become important for policy makers and. ve r. researchers worldwide, as well as for the wellbeing of the consumer and lastly, for the inclusive and sustainable growth of the economy (Chen & Jin, 2016). In addition,. ni. provision of household debt is one of the tools to increase financial inclusion. Efforts for. U. increasing easy debt and customers’ acceptance for them will not only help to increase financial inclusion, but will also increase their standard of living. Human behaviour is susceptible to change and human beings act differently in several situations. It can also vary in gender, education, age, marital status and geographic area (Del-Río & Young, 2005; Yilmazer & DeVaney, 2005). Hence, economic choices of different households vary accordingly. Households always endeavour to have higher utility, so they normally work hard to obtain higher income in order to attain affordability of goods (Modigliani & Brumberg, 1954; Veenhoven, 1988). In this case, households. 1.

(20) sometimes tend to incur debts to supplement their income especially for maximizing utility purposes. The approach of research towards household debt has remained conventional. Mostly, the empirical research in this field of study has been advocating life cycle hypothesis and permanent income hypothesis. According to these theories, households borrow and save in order to smooth their consumption although household’s income and productivity. a. levels vary across different stages of life. According to permanent income hypothesis,. ay. households maximize utility and smooth their consumption throughout their life. al. expecting no change in their transitory income (Ando & Modigliani, 1963, Friedman, 1957). The life cycle hypothesis says that people use their savings in order to smooth their. M. consumption when their income and productivity falls (Modigliani, 1986b). Whenever. of. people are short of savings and income, in order to smooth their consumption, they used to take out debt. Therefore, income has been considered as the only main determinant of. ty. household debt over so many years. Nowadays, socioeconomic, demographic and other. si. economic factors are also considered important in determining the debt behaviour of. ve r. households (Yilmazer & DeVaney, 2005). However, economic factors cannot fully explain the debt behaviour (Wang et al., 2011). Meanwhile, each geographical area has. ni. its own dominant factors and unique characteristics affecting the debt behaviour (Stone. U. & Maury, 2006). Thus, there is a need to identify the factors in order to understand the country’s specific debt behaviour, and also to recognize the regional and provincial differences. Other than that, it is also essential to study the effect of debt on financial wellbeing of. households. Economic investment theory says that a consumer can derive utility from the judicial use of debt (Fisher, 1930; Herendeen, 1974). Although there is always remain a concern about the overuse of debt, but a moderate level of debt always helps consumers to increase their utility. Financial satisfaction is also an important aspect of overall life. 2.

(21) satisfaction but it is found that researchers have devoted less attention to the relationship between debt and financial wellbeing (Lown & Ju, 1992). Particularly in Pakistan, the average behaviour towards household debt involves the feeling of phobia towards debt and thus, they remain outside the debt market. The percentage of Pakistani people who use services offered by formal financial institutions are only 14% although 50.5% people have access to finance (including access to a. a. semiformal sector which includes shopkeepers and money lenders). When access to debt. ay. in different countries is considered, it is seen that 32% of the population in Bangladesh,. al. 48% in India and 59% in Sri Lanka have access to formal financial services in 2008 (Mundial, 2008). These countries, having comparable access to finance, have higher. M. percentage of debt in their country which is necessary for sustainable development and. of. reducing poverty. According to a report published by the World Bank, 50% of the population in Pakistan do not use any formal or informal financial service and 19%. ty. population have voluntarily left the market (Nenova et al., 2009).. si. One of the cited reasons for the lack of borrowing is narrow access to financial services. ve r. (Ahmed, 2016). However, for the case of Pakistan, access to financial services has significantly improved over the recent years. In 2008, 16% of the population had access. ni. to financial services offered by formal financial institutions and in 2015, the percentage. U. increased to 23% ("Pakistan Access to Finance Survey Protal: Transforming Pakistan's Latest Financial Inclusion Data Into Learnings and Insights," 2015). As the point has already been established that despite improvements in financial access in Pakistan, Bangladesh and other countries with comparable access have more debts in their society as compared to Pakistan. The domestic credit to private sector (% of GDP) is also higher in Bangladesh (around 42%) as compared to Pakistan (around 15%) (World Bank, 2014). It means that the cases of low debts in Pakistan offers another dimensions of rationale other than the problems of physical access to financial services. For example, hurdles to. 3.

(22) access may be considered as socioeconomic and demographic factors which affect the use of credit (Chen & Jin, 2016). Other than that, lack of borrowing may be due to the high interest rate on the loans but over the years, the Government has made the efforts to keep the interest rate low in Pakistan. According to the State Bank of Pakistan, interest rate for loans of 3-10 years is 6% for end consumer since July 1, 2015, till date ("Pakistan Federal Budget 2015-16,". a. 2015). However, lenders in informal sectors charge high interest on borrowed money.. ay. Only 6.57% of people included in survey (A2FS) said that they consider cheapest interest. al. rate as their first preference while taking loan so the pricing of loans is not the main reason holding consumers from taking debt ("Pakistan Access to Finance Survey Protal:. M. Transforming Pakistan's Latest Financial Inclusion Data Into Learnings and Insights,". of. 2015). In 2008, only one-third of population borrowed and only 8% of population entrusted their money to the formal institution (Nenova et al., 2009). However,. ty. semiformal savings are now high in Pakistan around 36% (Demirguc-Kunt et al., 2015). si. and people still choose to remain financially excluded. Statistics show a clear signal of. ve r. sceptical attitude of Pakistani households towards formal financial institutions and their lending services.. ni. Therefore, this study focuses on debt in a country like Pakistan because the poverty. U. rate in the country is prevailing. One of the Sustainable Development Goals is to eradicate poverty and microfinance; so, credit or debt is considered to be an important tool to help achieve this goal (Littlefield et al., 2003) as evidenced in Bangladesh. Lack of properly functioning financial markets (both formal and informal) has adverse effects, especially for poor people who require credit, but have fewer assets and unfortunately, formal institutions do not offer credit services tailored for them. This lack of demand leads to the shutdown of the formal credit market and eventually increases poverty. Thus, there is a. 4.

(23) need to provide access to debt to these group of people as this will also help them to increase financial inclusion. According to Yunus (1983, p. 50), he mentions that “…people were poor not because they were stupid or lazy. They worked all day long, doing complex physical tasks. They were poor because the financial institution in the country did not help them widen their economic base”. In order to make this market efficient, many institutions like microcredit. a. agencies and NGOs that provide tailored products to the unserved are required to be. ay. developed. In order to make tailored products, there is a need to shift the focus of research. al. more towards the demand side rather than supply side of the debt market. Also, it is imperative to understand the determinants which trigger a change in the amount of debt. of. household consumption and savings.. M. as well as to know the changing household debt demand in the perspective of changing. Financial exclusion1 is generally considered common for countries like Pakistan and. ty. Bangladesh because of poverty and low income but voluntary financial exclusion is. si. unique in Pakistan. Understanding the demand side of debt thoroughly can help formal. ve r. and informal institutions broaden their range of credit services, reduce voluntary financial exclusion. and. increase. financial. inclusion. by. serving. economically. and. ni. socioeconomically disadvantages. Tailored microcredit products according to demand. U. can be possible as it can help to reduce poverty. 1.2 Problem Statement Pakistani households have a strong aversion towards debt (Nenova et al., 2009). Only. 18% of the population in Pakistan borrow considering all sources of debt (InterMedia,. 1 Financial exclusion means that people leave the financial markets because either they do not have access to credit or they do not get desired services. Financial exclusion is a broad concept which explains the lack of access and use of credit services. It is also explained as the situation in which people do not have access to their desired financial products.. 5.

(24) 2015). In contrast to other countries with a developing economy, the household consumers in Pakistan are not inclined towards debt as a source to fulfil their expenditure needs. There are people in Pakistan who have knowledge and access to credit facilities but they do not avail those facilities. Realising the intensity of the problem, the government has also made efforts to increase access to credit, maintain lower interest rate and improve outreach as discussed, but the increase in household debt has not been. a. fruitful. Expanding access to credit also means an understanding of the hurdles in. ay. reception and adaption of credit facilities. The hurdles towards reception of credit can be socioeconomic, as for example, financial services are inaccessible to certain income class. al. or social group. Therefore, there is a need to understand the unique socioeconomic and. M. demographic characteristics that condition their debt behaviour so it will help to improve access and reception of debt that is necessary to eradicate poverty by providing money to. of. the poor households.. ty. Debt is considered as a tool to improve welfare as it provides finance to people who. si. are in need, but it is of no use if it does not help people to improve their financial. ve r. wellbeing. Thus, it is essential to know how debt affects the financial wellbeing of Pakistani households and to see how socioeconomic and demographic characteristics. ni. dictate their debt behaviour, and how their financial wellbeing can be improved along. U. with debt. Within the same country, regional and provincial differences in the debt behaviour are important to be investigated so that different credit policies can be applied to respective regions and provinces in order to achieve more effective results. As mentioned above, debt is one of the financial resources which is also linked to financial wellbeing. Therefore, it is important to know if debt plays a significant role in incrementing the financial wellbeing of households. This is because, income after certain level fails to increase the happiness of people. This leads to creating doubts about the debt in which it could be either financial wellbeing booster or not as a whole.. 6.

(25) 1.3 Research Questions This study aims to investigate the debt behaviour and how it affects the financial wellbeing of Pakistani households. It is imperative to examine the factors that affect the household decision to take out debt and to investigate the factors that affect the amount of debt (demand for debt). Both issues need to be addressed separately in order to see if same factors affect the decision and demand for debt. Besides that, financial wellbeing is. a. also included in this analysis as it provides the answer to the following research questions. ay. relating to debt. It might be the case that Pakistani household’s financial wellbeing is not. al. improved by the debt due to which they are phobic towards taking it. This study also investigates the regional differences existing in the debt behaviour and financial. of. the following research questions:. M. wellbeing so that region specific policies can be suggested. The study focuses to answer. 1. What are the demographic and socioeconomic characteristics that determine the. ty. entry of households into debt market?. si. 2. What are the different factors that condition low demand2 for debt?. ve r. 3. Does debt contribute towards the financial wellbeing of households?. ni. 1.4 Objectives of the Study. U. Based on the aforementioned research questions, this study aims to: 1.. 2.. Investigate decision of entry into debt market based on socioeconomic and demographic characteristics. Examine debt taking behaviour (demand/amount of debt) of households based on demographic and socio-economic characteristics.. 2. According to Access to Finance Survey, the demand for debt (the amount borrowed) was around 18% in 2015 (Pakistan Access to Finance Survey Portal: Transforming Pakistan's Latest Financial Inclusion Data Into Learnings and Insights, 2015). 7.

(26) 3.. Explore roles of debt in determining financial wellbeing.. 1.5 Significance of the Study Debt was not a well-researched topic in Pakistan because the issue was not in focus until May 2015 when the government launched financial inclusion strategy program. Financial inclusion strategy involves different tools in which household debt is also one of the tools to achieve the goal. It can be seen from the latest release of a detailed report. a. on financial inclusion dated back in 2008. The issue of debt has been explored using small. ay. scale primary data in the context of Pakistan (Adnan, 2005; Ahmed, 2016; Muhammad,. al. 2010) but this study investigates the issue by using recent national representative data. M. for 10 years which can be used to formulate a strategy to influence households demand for debt.. of. Earlier literature on household debt in the context of Pakistan usually revolved around. ty. access, outreach and financial stability of both demand and supply sides. However, it is. si. argued that debate of low household debt in Pakistan is far beyond the problem of access and outreach. We need to understand our demand base of the household debt market.. ve r. Only after understanding demand side hurdles, suppliers of credit can increase access and outreach of the services and their financial stability. Subsequently, institutions with which. ni. the sole purpose can give finance to poor at low affordable rates can work efficiently.. U. This research also provides an empirical evidence of Pakistan for the role of socioeconomic and demographic characteristics in affecting the household debt and financial wellbeing respectively as well as the role of debt in the financial wellbeing. The late realisation of the importance of the issue by the government need them to. work on many avenues in order to address the issue in totality. A better understanding of socioeconomic characteristics which are conditioning the use of debt among households can provide guidelines for policy design and interventions that aim to increase financial. 8.

(27) inclusion, reduce poverty and foster economic growth. One of the Sustainable Development Goals is to reduce poverty. In particular, microfinance, credit or debt is considered to be an important tool to help in achieving this goal (Littlefield, Morduch, & Hashemi, 2003). Finding the reasons behind low debt in Pakistan can be important to make people financially included and to reduce poverty as well. Providing credit to agricultural sector and targeted group of income class and education will not only help. a. them to grow personally but also increase their overall economic growth. The significance. ay. of the study is further discussed in the last chapter along the policy implications.. al. 1.6 Limitations of the Study. M. This study used cross-sectional survey data for different years collected by Pakistan Bureau of Statistics that comprehensively covers consumption aspects as well as debt.. of. The data was used to take the advantages of availability, sufficiency and accuracy but the quality of research would have been improved if more comprehensive details about debt. ty. were covered in the survey. Pakistan lacks any single database covering credit details but. ve r. Pakistan.. si. this database has also helped to reveal different aspects of debt and financial wellbeing in. In addition, data used in the study did not mention the source of debt defining that. ni. whether the loan was taken from formal market or informal market. The depth of analysis. U. was limited by the number of questions asked by Pakistan Bureau of Statistics (PBS) during the data collection procedure. Reliability, accessibility and generalizability of the results were achieved through a nation-wide representative data at the cost of limitations of the data. Willingness to borrow and attitude towards debt were interesting to explore but unfortunately, the survey did not include any questions related to psychology. Lastly, further collection of the data for this research was limited by cost.. 9.

(28) 1.7 Organisation of the Study Chapter 1 explains the background of the study, discusses the problem statement, research questions and research objectives. It also introduces the significance of the study. Chapter 2 summarises the theoretical literature about the relationships between different socioeconomic and demographic variables with household debt and financial wellbeing. This chapter has four themes that includes household debt (explaining sources, theories. a. and factors affecting it), the role of household debt in financial wellbeing (explaining. ay. types of wellbeing, its determinants, measurement and role of debt in financial wellbeing),. al. review of the methods used in literature to study household debt and situation of household debt and financial inclusion in Pakistan. This chapter also highlights the gaps. M. in the literature and provides a conceptual framework. Chapter 3 elaborates on the data. of. and provides an empirical strategy to answer the research questions. Chapter 4 presents the findings of the decision of household debt from the data. Chapter 5 shows the. ty. outcomes of demand for debt. Whereas, Chapter 6 highlights the findings of financial. si. wellbeing of Pakistani households. Lastly, Chapter 7 concludes the study with the. U. ni. ve r. summary of main findings, implications, contribution and limitations of the study.. 10.

(29) CHAPTER 2: LITERATURE REVIEW 2.1 Introduction This chapter reviews the literature relating to factors affecting household debt and the effects of household debt along with other factors on financial wellbeing of households. The literature review is divided into four main components. The first component explains sources of household debt, its relevant theories and determinants. It also elucidates the. ay. a. implications of household debt in financial inclusion. On the other hand, the second component is about financial wellbeing explaining types, measurement and determinants.. al. An important concept which is attached to debt is financial wellbeing. It is found that. M. households who have higher financial wellbeing and are highly satisfied may not tend to aspire for material goods and may not take debt as well. This is because taking out debts. of. may seem to lower the household financial wellbeing. Therefore, it is very important to. ty. see the role of debt in financial wellbeing. In fact, understanding the concept of financial wellbeing is important for policy makers as it will help them to find more efficient ways. si. to improve the quality of life of households. Thus, any research investigating financial. ve r. satisfaction at the household level is important for future investigation of societal financial wellbeing (Joo, 2008). The second component illustrates the relationship. ni. between household debt and financial wellbeing while the third component reviews the. U. methods that have been used to study household debt and financial wellbeing. The fourth component elucidates household debt and financial wellbeing in the context of Pakistan.. In addition, gaps in the literature are also identified in this chapter. 2.2 Household Debt Household debt “is an obligation or liability…arising from borrowing money or taking goods or services “on credit” i.e. against an obligation to pay later” (Prinsloo, 2002, p. 63). The secured debt is the borrowed amount which is secured by collateral to reduce the 11.

(30) risk involved with lending. If the borrower defaults, then collateral will be seized by the lending body and used to compensate for their loss. The unsecured debt is the one which is not secured by any collateral (Bathala et al., 1994). In advanced economies, households owe their household debts mostly to formal institutions than to households (Georgarakos et al., 2014). Throughout this thesis, the terms of credit, debt and borrowings will be used interchangeably having the same intrinsic meaning defined above. The amount of. a. borrowed money of households is also called as household debt or the amount of debt.. ay. The amount of debt that people have actually borrowed is sometimes called as demand. al. for debt.. We sometimes observe that households borrow money from different sources. They. M. may borrow money to protect themselves from fluctuations in their income and needs.. of. Borrowing money can be considered as dissaving or transferring the future resources to present in order to satisfy the current needs. In other words, borrowing is an inter-. ty. temporal reallocation of the resources to smoothen the consumption. The act of taking. si. money with intention of returning it back is called borrowing whereas borrowed money. ve r. is called household debt or credit. Households take household debt for different reasons such as to finance daily consumption in periods of uncertain income, to buy land,. ni. buildings, houses, vehicles, durable goods, household appliances and others. In addition,. U. household debt is also taken to finance education, business and agricultural activities. However, households may always not be able to borrow the desired amount due to many constraints such as eligibility, credibility and limited amount offered by the creditor (MdSmail, 2001). The need to take debt from external sources arise when households face uncertain fluctuations in their income or consumption. Households seek credit from different sources as classified in the following three categories:. 12.

(31) 1. Formal institutions are those credit giving agencies which follow the banking regulations and general laws such as commercial banks. 2. Semiformal institutions are registered institutions which follow general rules but do not follow banking regulations. Non-bank financial institutions include microfinance institutes, committees (a group of people who pool money and give to each person of group turn by turn) and post-office banks.. a. 3. Informal providers are non-registered sources which are neither governed by. ay. general laws nor by banking regulations such as moneylenders, family and friends.. al. The above categorisation has been adopted by Charitonenko et al. (2004) in their. M. project for Asian Development Bank and it was proposed by Ledgerwood (1999).. of. 2.2.1 Situations for Coexistence of Formal and Informal Sources of Borrowing. Bose (1998) mentioned that usually, formal credit is unavailable to households for. ty. many reasons; one of the reasons is their low productivity. This phenomenon of low. si. productivity usually happens in rural areas of developing countries. Other reasons for low. ve r. credit access include lack of collateral or poor credit history. Formal lenders of credit evaluate an application for credit on the basis of ability to repay and risk of default. Mostly. ni. formal lenders are not interested in giving credit to those with low socioeconomic profile. U. which force them to seek credit from informal sources. According to Kochar (1997), this phenomenon of lack of interest of formal lenders to give credit to people with low credit worthiness profile is called credit rationing. He found this phenomenon while developing a model of credit outcomes for India in which people are rejected for sanction of credit despite their demand. He further explained in his research that households’ decision to avail credit from formal or informal sector depends on the amount to be borrowed from the formal sector and cost of credit. He used All-India Debt and Investment Survey (AIDIS) of 1982 and found that if informal credit is ignored, then the high ratio of credit. 13.

(32) rationing is observed considering all demand for the formal sector. However, if the informal sector is also considered, then the ratio of credit rationing is less as some demands are addressed by the informal sector. Formal and informal markets coexist in any country but the way these markets operate is different. Bell et al. (1997) found that formal and informal credit markets coexist in developing countries due to institutional differences. The formal market is regulated by. a. government authorities and banking regulations whereas informal market does not follow. ay. any regulation. They estimated an empirical model using the World Bank data and found. al. that despite a significant difference between interest rates of both markets, borrowing from informal lenders is still an attractive option for households. Both Bell et al. (1997). M. and Kochar (1997) have considered the coexistence of formal and informal markets. of. together based on the assumption of institutional differences. However, Kocher’s model does not assume that formal lending is cheaper than informal lending as interest rate in. ty. formal lending is being capped and regulated.. si. According to Stiglitz and Hoff (1993), the interest rate in the informal market is usually. ve r. higher than the formal market. They estimated that interest rate in informal sector may exceed 75% while interest rate in formal sector may exceed 31%. There are usually three. ni. main reasons for informal sector to charge a higher interest rate. The first reason is lack. U. of regulations due to which informal sector feels the freedom to charge as much interest rate as they can. The second reason is the high administration cost which includes selection, evaluation and enforcement. Aleem (1990) observed that informal markets in Pakistan usually take a year to ensure credit worthiness of the customer. In order to ensure the credit worthiness of customers, money lenders lend a small amount of money to borrowers and after monitoring and evaluating their repayments, they lend the desired amount of money to their customers. Money lenders then transfer this monitoring cost to their customers. The third reason is that most borrowers in rural areas usually do not have. 14.

(33) proper documentation to apply for a loan from the formal sector. They have property inherited from their siblings but not properly transferred to their name due to which they cannot apply for a formal loan. However, the money lenders in informal market can easily qualify for loans from formal markets because of having collateral and proper documentation so they take a loan from formal market to lend to borrowers in the informal sector and thus, charge arbitrage money. Besides that, serving the less creditworthy. a. borrowers mean that lenders are taking the high risk because they charge a high interest. ay. rate on loan (Bose, 1998).. al. Although informal lenders charge higher interest rate, but prospective borrowers prefer to approach them due to their accessibility and flexibility. Also, in the informal sector,. M. borrowers do not have to follow the strict procedures as regulated by the government and. of. the process of loan application usually takes shorter time as compared to the formal market. Informal borrowers can also get the loan very fast as compared to formal lenders.. ty. The ease of taking a loan also applies on the case where both lenders and borrowers live. si. in the same community (Md-Smail, 2001). Informal lenders are categorised into two. ve r. categories namely professional and associate informal lender. Professional informal money lenders include landlords, money holders and retail-shopkeepers while associate. ni. lenders include friends, family and neighbours. According to Aleem (1990), 75% of the. U. lending in the informal sector is usually done by professional lenders. The flexibility of their loan contracts takes different forms. Most of the informal lending in Pakistan is not in a conventional form requiring cash to be repaid in interest. Majority of the loan contracts require repayment in the form of delivery of goods such as agricultural product or services. Commodity linked contracts are mostly offered by the retail shopkeepers. Inkind linked contracts such as repayment of the loan in the form of services are mostly. offered by landlords. The phenomenon of borrowing from associates (friends, family or neighbours) is seen closely knit in rural communities where they share a mutual trust. In. 15.

(34) that setting, a borrower may act as a lender for others in their time of need and when he has surplus income. Deaton (1992) observed that very few loans borrowed from associates carry an interest rate. A loan contract without interest rate and collateral is generally administered by the nexus of people who influence the borrower to repay the loan in case of default. Some societies also have religious constraints against interest rate due to which they do not charge interest rate in informal lending.. a. Hence formal and informal market coexist, and their coexistence is necessary for. ay. fulfilling the needs of people who do not qualify for credit in formal markets. However,. al. informal markets lack the capacity to sustainably grow because of lack of skills and. M. training, limited access and outreach and limited capital.. 2.2.2 Theoretical Explanations of Household Borrowing. of. Households borrow because of three reasons namely income fluctuations (Lorenzoni. ty. & Guerrieri, 2017), less patient savings and investment (Eggertsson & Krugman, 2012).. si. According to the conventional economic assumption, households are rational and pursue utility maximization. Households try to smooth their consumption over their lifespan,. ve r. therefore, households save when they are young and dissave when they are older. Households sometimes borrow when faced with temporary income fluctuations in order. ni. to smoothen the consumption. Households also borrow when their income is low as. U. compared to the average lifetime income and repay when income is high. Income during the lifetime is hump-shaped, low in early age and after reaching some maximum point, it. decreases. Households try to maximize their utility by consumption, but income theoretically is hump-shaped; therefore, people will borrow whenever their income is less. The more the income is hump-shaped, the more debt is required. This theory of hump-shaped income is called Life Cycle Income Hypothesis (LCIH) and it was introduced by Modigliani (1986a). Prior to Modigliani’s LCIH, Friedman (1957) has. 16.

(35) proposed that current consumption was linked to permanent income which was negated by empirical investigation done by Hall (1978) and Flavin (1981). They did not find evidence that consumption is solely determined by the permanent income. This leads to the introduction of LCIH. Deaton (1992) discovered that consumption and current income are independent. Due to the situation, life cycle interpretations of consumer credit have been questioned (Barba & Pivetti, 2009).. a. Kőszegi and Rabin (2009) suggested incorporating ideas of prospect theory in a model. ay. of consumer choice. They said that household derives utility from two sources. Firstly,. al. the household derives utility from the difference between actual consumption and expected consumption and secondly, he derives utility from the difference of projected. M. future consumption and expected consumption for that future. Households tend to be loss. of. averse and they are more sensitive to the news that consumption at some point in time will be lower than it will be higher than expected. Besides that, households are more. ty. sensitive to the news that their current consumption will be affected than to the news. si. which affects their future consumption. This framework suggests that consumer may save. ve r. today in order to avoid the pain of reducing consumption tomorrow. Households may over-consume as they derive more utility from current consumption than future. ni. consumption. When households are short of savings, they borrow to finance their current. U. consumption. News about lower future consumption is relatively less painful than lower future consumption because when the future comes, expectations have already adjusted downwards. Consumer credit market is not always in an equilibrium position. The disequilibrium may be created due to non-willingness of households to borrow. They may choose to borrow less than they are allowed. Duca and Rosenthal (1993) used household preferences in order to calculate optimal credit level of households. Mainstream theories can only make room for excessive household indebtedness if they consider that. 17.

(36) households are not perfectly rational. Adverse unexpected macroeconomic shocks, such as reduction in income or changes in interest rate, can force households to borrow or curb their ability to repayment, hence starting the cycle of indebtedness (Barba & Pivetti, 2009). Household’s irrational behaviour is also explained by the prospect theory. Prospect theory was made as a theory of risky choice by Kahneman and Tversky (1979).. a. Households derive utility from consumption whereas the utility also has a diminishing. ay. sensitivity to losses (Kőszegi & Rabin, 2006). Thaler (1980) has explained the same. al. phenomenon, labelling it as “endowment effect” supporting the prospect theory of risky choice. There are two distinct findings of endowment effect which may not necessarily. M. be related which are exchange symmetries and the gap between willingness to pay and. of. willingness to accept.. Knetsch (1989) explained the exchange symmetries through an experiment. He gave a. ty. mug to half of the participants and a candy bar to rest of the half. After the lapse of few. si. minutes, they were asked few questions. Those who were given mugs were asked whether. ve r. they want to exchange it for the candy bar and those who were given candy bars were asked to exchange them for the mug. In economics, preference of goods is usually not. ni. related to the initial endowment and their preference of having anything does not depend. U. on their initial endowment. Knetsch found that 89% of the participants opted to keep the mug whereas only 10% of the participants who got candy bar wanted to exchange them for the mug. The concept of willingness to pay and willing to accept was well explained by. Kahneman et al. (1990) through their experiment. They gave half of the participants a mug. Those who had mugs were asked to state the price from a list of prices they would accept in exchange for a mug. Others without having mug were asked to state the price. 18.

(37) from a list of prices they were willing to pay in exchange for a mug. It was found that willingness to accept was higher than a willingness to pay in terms of price. In an exchange of symmetries, people viewed exchange as losing the item which they were initially given so they were loss averse. In the case of willingness to pay/willingness to accept, household’s loss aversion behaviour predicted that they were reluctant to give up their initial endowment. Households had perceived accepting household debt as their loss.. a. Their willingness to accept the household debt was also very low.. ay. 2.2.3 Factors Affecting Household Debt. al. Factors that affect household debt can be categorised into economic, socioeconomic. M. and demographic factors. Most of the time, socioeconomic and demographic factors are referred to as the same factors. In this research, the effects of different factors such as age,. of. marital status, education, household size, income, financial assets and region on household debt have been reviewed. The economic factors such as income and financial. ty. assets are mostly categorised as socioeconomic factors. Thus, all these factors are broadly. si. called as demographic and socioeconomic factors.. ve r. As the focus of research in household debt has shifted from economic factors to. different characteristics affecting debt behaviour including age, gender, education, peer. ni. influence etc., there is a need to conduct this study in every country in order to identify. U. debt behaviour for policy making because results of one country cannot be generalized to others. There are some unique and situational factors present in every geographical area that determine the debt behaviour of households (Yilmazer & DeVaney, 2005). Unfortunately, not every country has a comprehensive survey database for such study. Therefore, it offers room for researchers to study this area. The following section will discuss the relationship of each factor with household debt separately.. 19.

(38) When households choose to borrow for financing their purchases, many economic and demographic characteristics affect their borrowing decision. According to the life cycle theory, the decision to take a loan is affected by their age. Younger people are more likely to borrow than the older ones because of their lower future income expectations to repay the loan and they are also used to be risk avoidant (Modigliani, 1966). Meanwhile, accumulation of debt over life period is affected by age and is followed by the explanation. a. of life cycle hypothesis and permanent income hypothesis. Modigliani (1986a) proposed. ay. life cycle income hypothesis (LCIH) stating that a person seeks to smooth his consumption over his lifetime for which he takes the support of savings and debt. In an. al. earlier study, , Friedman (1957) suggested permanent income hypothesis theory, stating. M. that a consumer tries to smooth his consumption over lifetime when seeing his permanent. instead of current income.. of. income. His theory was similar to LCIH except that he focused on permanent income. ty. As far as age is concerned, debt is required in early career life in which a person has. si. less income than his or her expenses. The debt will keep increasing with age until the. ve r. person reaches middle career life and middle age when he or she starts having a higher income. Similar findings were found by other authors as well. Del-Río and Young (2005). ni. found age to be one of the strongest determinants of debt level after income. Moreover,. U. they found that the direction of relationship of the determinants is positive. Age was found to be positively affecting the amount of loans in the analysis of the data collected by Austrian Central Bank naming OeNB (2012). This cross-country analysis was conducted countries like Bulgaria, Czech Republic, Albania, Poland, Romania, Hungry, Serbia, Croatia, Herzegovinian and Bosnia. (Fidrmuc et al., 2013). However, there is also an empirical evidence report contrasting the findings from the previous study. Yilmazer and DeVaney (2005) for instance, observed that elderly US residents do not reduce savings,. 20.