Manual Finance and Development, September 2013: 50

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Journal of Comparative Economics 41 1 , Journal of Economic Issues 45 1 : On money and trust from c. AD Palgrave MacMillan, forthcoming Buijten en Schipperheijn The Amsterdamse Wisselbank.

A World of Change

In : Encyclopaedia of Central Banking, ed. Palgrave MacMillan Credit Cycles. In J Toporowski and J Michell eds. The Handbook of Critical Issues in Finance. Edward Elgar Consequences of the Commodity Bubble. Chapter 5 in : The Commodity Report. Edward Elgar, forthcoming Finance for Development. Remember me on this computer. Enter the email address you signed up with and we'll email you a reset link. Need an account? Indeed, the IMF and the World Bank recently recognized the increased significance of remittances as a stable and countercyclical source of external financing in its assessment of how much debt low-income countries can safely handle.

Remittances enable countries to borrow more, which permits them to use that extra borrowing power to fund investments that facilitate economic growth. On the other hand, Abdih, Barajas, and others have found evidence that remittances hurt the quality of institutions in recipient countries, precisely because they increase the ability of governments to spend more or tax less.

By expanding the tax base, remittances enable a government to appropriate more resources and distribute them to those in power. At the same time, remittances mask the full cost of government actions.

Remittances can give rise to a moral hazard problem because they allow government corruption to be less costly for the households that receive those flows. Recipients are less likely to feel the need to hold the authorities accountable, and, in turn, the authorities feel less compelled to justify their actions. This reduces the likelihood that the fiscal space created by remittances will be used for productive social investments. In other words, the interactions that determine the impact of remittances on the overall economy are complex, which is why it is difficult to make generalizations regarding their net effects.

The complex effect of remittances on the economy is also apparent when the business cycle is taken into account. Because remittances increase household consumption, fluctuations in remittance flows can cause changes in output in the short term. But a shock that reduces economic output is also likely to induce workers abroad to send more remittances home, which then has the effect of reducing output volatility Chami, Hakura, and Montiel, However, the increase in remittances is also likely to weaken the incentive to work, which could lead to a more volatile business cycle.

Recipient countries also are affected by economic conditions in the countries that are the sources of remittances. Barajas and others showed that remittance flows increase the simultaneous occurrence of business cycles in remittance-sending and remittance-receiving countries. This effect is likely to be especially pronounced during economic downturns in the sending countries, which tend to be wealthier than the recipient countries.

So, again, the evidence is mixed. Remittances do stimulate consumption, which for some economies will help reduce the size of the swing between recession and growth by putting a floor under total demand. But for other economies, remittances may increase the severity of business cycles, by inducing workers to stay home when the economy turns down, as well as by linking the business cycles of some developing economies more strongly to the business cycles of remittance-sending countries.

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Over the past decade, the most studied aspect of remittances has been their impact on economic growth, partly because of the policy importance of this issue and partly because of the many and complex ways remittances might affect economic growth. A useful way to organize the large and diverse body of findings on this question is to use a growth-accounting approach in which the effect of remittances on capital accumulation, labor force growth, and total factor productivity TFP growth is studied. TFP is essentially growth that is not accounted for by increases in traditional inputs such as labor and capital and encompasses such things as technology and finance.

Capital accumulation: Worker remittances can affect the rate of capital accumulation in recipient economies in various ways. First, they can directly finance investment. Remittance inflows can also facilitate the financing of investments by improving the creditworthiness of households, effectively augmenting their capacity to borrow. Remittances may also reduce the risk premium that lenders demand, because they reduce output volatility. But if remittances are perceived to be permanent income, households may spend them rather than save them—significantly reducing the amount of flows directed to investment.

And, in fact, the amount of remittances devoted to investment tends to be low. For example, remittance flows into the Middle East and North Africa region fuel the consumption of domestic and foreign goods, with very little going to investment. Remittances could stimulate increases in so-called human capital by enabling younger members of a household to continue schooling rather than having to work to contribute to household income.

For example, evidence from the Philippines and from Mexico suggests that receiving remittances leads to increased school attendance. However, that extra education would likely have little effect on domestic economic growth if it simply makes it possible for the recipients to emigrate. Labor force growth: Remittances may also influence growth by affecting the rate of growth of labor inputs. One channel through which remittances could affect labor inputs is in labor force participation—the percentage of the population that is working or seeking work. But as has been noted, those effects can be negative.

Remittances enable recipients to work less and maintain the same living standard, regardless of how the distant sender intended them to be used say, to increase household consumption or investment. Anecdotal evidence of this negative labor effort effect is abundant, and academic studies have detected such an effect as well.

Maximizing Finance for Development

Thus, remittances appear to serve as a drag on labor supply. Total factor productivity: Researchers have identified two main ways through which remittances may affect the growth of TFP. First, remittances may enhance the efficiency of investment by improving domestic financial intermediation channeling funds from savers to borrowers. For example, remittances may help GDP growth when the financial markets are relatively underdeveloped because remittances loosen the credit constraints imposed on households by a small financial sector.

This, in turn, may lead to enhanced financial development and thus to higher economic growth through increased economies of scale in financial intermediation.

Financial Development and Economic Growth: A Meta-Analysis

A second way remittances may affect TFP growth is through the exchange rate. Barajas and others have shown how remittances can lead to real exchange rate appreciation, which in turn can make exports from remittance-receiving countries less competitive. The industries or companies that produce the exports may be transferring know-how to the rest of the economy or providing opportunities for other local companies to climb up the value chain.

This is often the case, for example, with manufacturing. Therefore, if these companies become less competitive owing to exchange rate changes which are themselves caused by remittances , then these firms must scale back or close, and their beneficial impact on productivity is reduced.

There have been many attempts to estimate the impact of remittances on growth. Since then, many studies have been performed, and their main findings vary widely. Some find remittances help growth and others find they hurt growth—and some find no discernible effects. When a positive effect of remittances on growth is found, it tends to be conditional, suggesting that other factors must be present for remittances to enhance economic growth.

For example, some studies have found that remittances tend to boost economic growth only when social institutions are better developed.

Sustainable development goals: all you need to know

Perhaps most disappointing is the lack of a remittances-growth success story: a country in which remittances-led growth contributed significantly to its development. Given that in some countries remittances exceeded 10 percent of GDP for long periods of time, one would have hoped to find at least one example of remittances serving as a catalyst for significant economic development. It is worth noting, however, that researchers have also failed to find clear and consistent evidence that other financial flows, such as capital flows and official aid, enhance economic growth and development.

The mixed evidence regarding the macroeconomic impact of remittances reflects a number of underlying truths about their role in an economy.