Impact of Remittances on Poverty and Financial Development in Sub-Saharan Africa
Author: Mr. Sanjeev Gupta, Ms. Catherine A Pattillo, and Ms. Smita Wagh

Contributor Notes

Author’s E-Mail Address: sgupta@imf.org, cpattillo@imf.org, swagh@imf.org
Publication Date:
01 Feb 2007
eISBN:
9781451866025
Language:
English
Keywords:
WP; remittance
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This paper assesses the impact of the steadily growing remittance flows to sub-Saharan Africa (SSA). Though the region receives only a small portion of the total recorded remittances to developing countries, and the volume of aid flows to SSA swamps remittances, this paper finds that remittances, which are a stable, private transfer, have a direct poverty mitigating effect, and promote financial development. These findings hold even after factoring in the reverse causality between remittances, poverty and financial development. The paper posits that formalizing such flows can serve as an effective access point for "unbanked" individuals and households, and that the effective use of such flows can mitigate the costs of skilled out-migration in SSA.

Abstract

This paper assesses the impact of the steadily growing remittance flows to sub-Saharan Africa (SSA). Though the region receives only a small portion of the total recorded remittances to developing countries, and the volume of aid flows to SSA swamps remittances, this paper finds that remittances, which are a stable, private transfer, have a direct poverty mitigating effect, and promote financial development. These findings hold even after factoring in the reverse causality between remittances, poverty and financial development. The paper posits that formalizing such flows can serve as an effective access point for "unbanked" individuals and households, and that the effective use of such flows can mitigate the costs of skilled out-migration in SSA.

I. Introduction

The flow of remittances into developing countries is attracting increasing attention because of their rising volume and their impact on the receiving countries. In 2005, they totaled US$188 billion—twice the amount of official assistance developing countries received.2 Moreover, there is evidence that such flows are underreported. Remittances through informal channels could add at least 50 percent to the globally recorded flows (World Bank, 2006).3 Since 2000, remittances to developing countries have increased on average by 15 percent in annual terms. Though at least some part of the growth is attributable to better reporting by recipient countries, it appears that over the last decade remittances have outpaced private capital flows and official development assistance (World Bank, 2006).

Remittances are perceived as being more stable than other external flows. To the extent that migrants are motivated by altruism and send more money home in times of economic distress, remittances may actually be countercyclical. The stability of these inflows also opens up an opportunity for developing countries to lower borrowing costs in international capital markets by securitizing future flows of remittances.4 Because remittance receipts are widely dispersed, they may not cause the real exchange rate to appreciate; they may also obviate the deleterious effect on home country institutions observed in short-lived natural resource booms.

There are marked regional differences in remittance flows.5 Since the 1980s, remittances to countries in Latin America, the Caribbean, and the East Asia and Pacific regions have grown more rapidly than the average for developing countries generally. In 2005, the top three recipients—China, India and Mexico—accounted for more than one-third of the remittances to developing countries. Among the top 25 recipients of remittances, only one (Nigeria) is in sub-Saharan Africa (SSA) but three of the eight countries in South Asia (Bangladesh, India, and Pakistan) appear on the list.6

Studies using household-level data from individual countries in SSA have yielded some insights into how remittances are used at the micro level. In studying the impact of remittances at the aggregate level most analysts have concentrated on Latin America or South Asia, where the volumes swamp those going to SSA. But at their core remittances are private intrafamily/intracommunity income transfers that directly address the single most relevant challenge for SSA—poverty. Further, the long-term development potential of such transfers is determined by the use of the portion of remittances left over after basic consumption needs are met. The purpose of this paper is to study both these issues in a part of the world where the role of remittances has received comparatively little attention.

This paper analyzes the size and significance of remittance flows to SSA. Section II documents the volume and characteristics of remittances to the region, and discusses the dimensions and the related cost of brain drain from SSA countries. Section III estimates their impact; first the immediate consumption effect of remittances on poverty is investigated, using a cross-section dataset comprised in significant proportion of SSA countries. This is followed by the analysis of the indirect consequence of remittances. Because migrant transfers entail cross-border flows of relatively modest sums of money to low-income households, they present an opportunity for these households to access formal financial services. The paper therefore investigates how remittances affect financial development in SSA countries. Section IV concludes with a discussion of the market for money transfers in SSA and suggests how to enhance the effectiveness of remittances in the region.

II. Remittances TO Sub-Saharan Africa

A. Recent Trends

Sub-Saharan Africa has been part of the increasing global trend; remittances to SSA have increased by over 55 percent in U.S. dollar terms since 2000, while they increased for developing countries as a group by 81 percent.7 However, the recorded remittances are only a small fraction of total remittances to SSA. Freund and Spatafora (2005) estimate that informal remittances to SSA are relatively high at 45–65 percent of formal flows, compared to only about 5–20 percent in Latin America.

In 2005, remittances to the 34 SSA countries reporting are estimated to have been about US$6.5 billion. Remittance flows to SSA are relatively small, 4 percent of total remittances to developing countries and just 33 percent of those to India, which receives the most. In contrast, countries in Latin America and the Caribbean received 25 percent of all remittances, as did the countries of the East Asia and Pacific region.8

Relative to GDP, too, the volume of remittances to SSA is generally smaller than in other developing countries. On average remittances in the region are about 2.5 percent of GDP, compared to almost 5 percent for other developing countries. However, there are striking exceptions in SSA. In particular, remittances were almost 28 percent of GDP in Lesotho, and more than 5 percent in Cape Verde, Guinea-Bissau, and Senegal. In absolute terms, however, Kenya, Nigeria, and Senegal are the largest recipients of remittances in the region.

For some countries, remittances are also an important source of foreign exchange. For Lesotho, Cape Verde, Uganda, and Comoros, for instance, remittances have since 2000 amounted on average to more than 25 percent of export earnings (Figure 1).

Figure 1.
Figure 1.

Top Ten Recipients of Remittances in Sub-Saharan Africa

Citation: IMF Working Papers 2007, 038; 10.5089/9781451866025.001.A001

Source: IMF, Balance of Payments Yearbook, 2006; World Economic Outlook, 2006; World Bank staff estimates.Note: Rankings are based on average remittance inflows for 2000–05.

In SSA, aid flows are considerably higher than remittance receipts (Figure 2). Since 2000 aid flows to the region increased on average by about 13 percent a year and reported remittances by almost 10 percent. However, during the 1990s, when aid flows to the region were more or less stagnant, remittances grew annually at more than 13 percent. And in 2005 when aid flows to the region (excluding Nigeria) fell, remittances were stable (OECD/DAC, 2006). While it is true that the region as a whole receives more aid than recorded remittances, for countries like Lesotho, Mauritius, Nigeria, Swaziland, and Togo, remittances are consistently greater than official assistance.

Figure 2.
Figure 2.

Inflows to SSA countries, 1975-2004

(Millions of U.S. dollars)

Citation: IMF Working Papers 2007, 038; 10.5089/9781451866025.001.A001

Source: IMF Balance of Payments Yearbook, 2006; IMF African Department database, 2006; OECD/DAC database 2006.

The balance of payments data used above probably underreports remittance flows between developing countries. Despite the paucity of records there is reason to believe that intraregional migration is common in SSA. Botswana and South Africa tend to attract migrants from neighboring countries (largely unskilled) in search of employment. The strong sociocultural ties in West Africa also encourage labor mobility. In East Africa, political turmoil seems to be the driving force in migration.

B. Characteristics of Remittances to SSA

One reason remittances have attracted attention is that they are seen as more stable than other foreign currency flows to developing countries. This is especially relevant to SSA, where official aid flows have fluctuated considerably from year to year. Remittances to SSA are not just consistently less volatile than official aid, they are also less volatile than FDI, which is usually seen as the most stable private flow (Figure 3a). In the 1990-2004 period however export earnings are more stable than remittances.

Remittances might also be expected to be countercyclical to the extent that they are motivated by the altruism of migrant workers and increase in times of economic distress in their home countries. Remittances to SSA are counter-cyclical only in the 1980s (Figure 3b). Since 1990 remittances have been procyclical, though less so than either official aid or export earnings. The low (though positive) correlation coefficient demonstrates the stability of remittances over time rather than any strong relationship to growth cycles.9 The countercyclicality of FDI flows in the latter time period must be viewed in the context of the very high volatility of such flows.

Figure 3.
Figure 3.

Volatility and Cyclicality of External Flows to Sub-Saharan Africa

Citation: IMF Working Papers 2007, 038; 10.5089/9781451866025.001.A001

Source: IMF Balance of Payments Yearbook, 2006; IMF African Department database, 2006; World Bank staff estimates; OECD/DAC, 2006.

Remittances can also contribute to stability by lowering the probability of current account reversals. Because they are a cheap and stable source of foreign currencies, remittances are likely to stem investor panic when international reserves are falling or external debt is rising. These beneficial effects are particularly strong for countries where remittances are above 3 percent of GDP (Bugamelli and Paterno, 2006). While the average SSA ratio is just below that threshold and currrent account reversals driven by investor panic are rare, for some countries this effect might be an additional benefit from remittances.

The impact of remittances on the real exchange rate and export competitiveness, their Dutch disease effect, is a matter of debate. As in the case of any other transfer (for instance, official aid) the effect depends on the proportion of such flows spent on domestic goods, in particular non-tradables (Gupta, Powell, and Yang, 2006). Since remittances are private transfers dispersed over a large number of poor households it has been argued that their impact on domestic demand differs from that of donor-funded infrastructure projects (World Bank, 2006). Remittances may in fact be self-correcting as an overvalued currency deters remittances, and hence Dutch disease effects are not sustained (Rajan and Subramanian, 2005). However, studies in Latin America (Amuedo-Dorantes and Pozo, 2004) and Cape Verde (Bourdet and Falck, 2006) have found evidence that remittances do have Dutch disease effects on the competitiveness of the tradable sector. In countries where remittances inflows are large compared to the size of the economy, where supply constraints are a significant hindrance to the expansion of the nontradables sector, and where a significant portion of remittances are spent on domestic goods policymakers will need to be alert to the possibility of a Dutch disease phenomenon.

C. Remittances and Brain Drain

Remittances are only one dimension of the phenomenon of migration from low-income countries. In particular, skilled migration has always been associated with concerns about brain drain, which might be especially costly for some SSA countries (Kapur and McHale, 2005; Carrington and Detragiache, 1998). Pond and McPake (2006) detail the human resource crisis in the health sector in SSA countries that arises as skilled health care professionals increasingly find employment in the high-demand OECD countries. They calculate that almost a quarter of the new overseas-trained physicians that registered with the U.K.’s National Health Service between 2002 and 2003 came from SSA. Similarly, Bach (2006) documents the high job vacancy rates in the public health systems of countries like Ghana due to large-scale migration. He estimates that in Zambia and Zimbabwe the annual rate of attrition in public health employment can range from 15 to 40 percent.

On average 20 percent of the SSA tertiary-educated population older than 15 work in OECD countries. Less than 10 percent of the comparator group from South Asia is found there. For some countries, such as Angola, Guinea-Bissau, and Mozambique, expatriation rates are in excess of 50 percent of the educated population.

We look into the issue of brain drain by calculating the difference between the expatriation rates of the educated over-15 population from country i and the rate at which the general over-15 population migrate to an OECD country.10 Because the emigrant population tends to be better educated, it is to be expected that in general the difference between the educated and the general expatriation rates will be positive. With a few exceptions, such as Mexico, Turkey, Bulgaria, and several OECD countries, this holds true. Moreover, the larger the difference between the educated and general expatriation rates, the higher the propensity of skilled workers to emigrate compared to the general propensity to emigrate.11

There are interesting regional differences in the extent to which the educated exceeds the general expatriation rate (Figure 4). Within the OECD countries there is almost no difference. Among developing countries the largest difference is observed for SSA countries, reflecting the strain on domestic economies from skilled emigration.12

Figure 4.
Figure 4.

Regional Expatriation to OECD Countries

(Percent)

Citation: IMF Working Papers 2007, 038; 10.5089/9781451866025.001.A001

Source: OECD, Trends in International Migration database, 2006.Note: The data are from census and labor force surveys carried out in OECD countries in or about 2000.

For some countries in SSA the shortage of skilled personnel can be quite severe; more than a third of their educated workforce migrates (Table 1). Among the top 10 countries listed, six are from SSA. Among the top 20 countries, 75 percent are in SSA.

Table 1.

Expatriation Rates: Top Ten Countries

article image
Source: OECD, Trends in International Migration database, 2006.Note: Countries are ranked by the difference between the educated and the general expatriation rates.

III. Impact OF Remittances

A. Direct Income and Consumption Effect of Remittances

In SSA, remittances are part of a private welfare system that transfers purchasing power from relatively richer to relatively poorer members of a family or community. They reduce poverty, smooth consumption, affect labor supply, provide working capital, and have multiplier effects through increased household spending. Anecdotal evidence suggests that most often women head the recipient households.

For the most part, remittances seem to be used to finance consumption or investment in human capital, such as education, health, and better nutrition.13 In Zimbabwe, for instance, households with migrants have less cultivated land but tend to be slightly better educated (de Haan, 2000). Quartey and Blankson (2004) find that migrant remittances to Ghana are in fact countercyclical and are effective in helping smooth household consumption and welfare over time, especially for food crop farmers, who are typically the most disadvantaged socioeconomic group. Similarly, using data from a large household survey Adams (2006) finds that international remittances significantly relieved poverty among the “poorest of poor households.” Ratha (2003) suggests that remittances that raise the consumption levels of rural households might have substantial multiplier effects because they are more likely to be spent on domestically produced goods. Some studies (Hanson and Woodruff, 2003; Cox Edwards and Ureta, 2003) have found evidence for “forward” linkages between remittances and human capital formation in Latin America.

The evidence on the direct impact of remittances on poverty and inequality seems to vary according to the sample (Adams, 1991; Barham and Boucher, 1998). Earlier studies posited that migration was likely to increase rural inequality because only relatively better-off households were able to finance a member’s search for better employment in urban areas or abroad (Stahl, 1982; Lipton, 1980). More recently, it has been found that migration patterns in East European and former Soviet Union countries are such that richer households receive greater remittances than do poorer households (World Bank, 2007). However, Koechlin and Leon (2006) find that as migrant communities form close networks in a foreign country, the cost of migration falls and remittances no longer reinforce inequalities in the recipient country. Other localized studies have concluded that remittances tend to improve the welfare of poorer rural households (Stark and Taylor, 1989; Adams, 1991). Studies covering a larger sample of countries have found evidence that remittances tend to lower poverty (Adams and Page, 2005; Spatafora, 2005).

In the rest of this section, we investigate the direct poverty-reducing impact of remittances using a sample that gives greater representation to SSA countries than other studies.14

Empirical model

We use a methodology similar to that of Adams and Page (2005), to examine the impact of incoming remittances on poverty. We build on their model by adopting the three-stage least squares estimation technique that allows for the simultaneous determination of poverty and remittances. Based on Ravallion (1997) and Ravallion and Chen (1997) we model poverty as a function of mean income, some measure of income distribution, and the variable of interest, remittances. The baseline specification is

Log (Pit) = αi + β1 log (μit)  + β2 log (git)+β3 log (xit)+εit,(1)

(i = 1 ....N, t = 1 .....Ti),

where P is poverty in country i at time t; αi captures fixed effects; μ is per capita income, which functions as a measure of average consumption; g is income inequality as measured by the Gini index; and x is remittances. The model assumes that poverty is reduced as mean income rises; hence, β1 is expected to be negative. Based on previous studies we expect higher poverty to be associated with greater income inequality; hence, β2 is expected to be positive. Controlling for these two variables the model estimates the sign and magnitude of β3, which indicates the direct impact of remittances on poverty.

Data

Making use of poverty surveys beginning in 1980, the dataset consists of 76 countries and 233 observations.15 SSA countries are substantially represented: 23 percent of the observations come from the 24 SSA countries in the sample. To our knowledge giving this weight to SSA countries is atypical for cross-country studies on remittances.16

The poverty and inequality measures used here are from the World Bank’s PovcalNet database,17 which incorporates various measures of poverty: headcount poverty measures the percentage of the population living on less than one PPP dollar a day. The poverty gap, the mean distance below the poverty line as a proportion of the poverty line, tells us how poor the poor are—how far below the poverty line the average poor person’s income is. The squared poverty gap, which is the mean of the squared distance below the poverty line as a proportion of the poverty line, is more sensitive to the distribution of the poor below the poverty line. The income distribution measure, the Gini coefficient, is available from the same survey data.

Remittances are expressed as a ratio of the GDP of recipient countries. The income variable is per capita GDP in constant 2000 U.S. dollars. Other variables used in the three-stage estimation are educational attainment, proxied by average years of schooling for the over-25 population, and openness, measured by the ratio of imports plus exports to GDP. These variables are all measured as five-year averages corresponding to the survey year in the PovcalNet database. (Appendix Tables 3 and 4 provide detailed descriptions of the raw dataset.)

Results

The following estimation techniques were applied to equation 1. The log transformation of all the variables allows us to interpret the coefficients as elasticities. Regional dummies have been introduced to control for fixed effects.

Ordinary least squares (OLS) estimates from our sample conform to the predictions of the model (Appendix Table 5). Regardless of the measure of poverty used as the dependent variable, per capita income has a negative and significant coefficient. A positive and significant coefficient for the Gini index indicates that greater inequality is associated with higher poverty. We estimate a negative elasticity between poverty and incoming remittances; this result is quite consistent. Except in the case where the left side variable is the squared poverty gap, this result is always significant. Prima facie our findings indicate that a 10 percent rise in the inflow of remittances is associated with about a 1 percent fall in headcount poverty and the poverty gap.18 In keeping with the regional focus of the paper, we also introduce an interaction term between remittances and a dummy for SSA (Appendix Table 6). While the overall poverty reducing effect of remittances remains, the coefficient on the interaction term comes in with a positive sign. Although this effect is not always significant it raises the possibility that in SSA the severity of poverty might be motivating greater out-migration, so that poverty is positively associated with remittances.19 The issue of reverse causality is taken up next.

Ordinary least squares estimates are likely to be biased when any right side variable is endogenous. Moreover, we can argue that the relationship between poverty and remittances is unlikely to be unidirectional. To tackle this issue a system estimation technique that allows for both poverty and remittances to be determined simultaneously is adopted. Three-stage least squares is often described as the system equivalent of a two-stage least squares.20 The advantage is that estimating a system of equations where both poverty and remittances are endogenously determined allows us to observe not just the effect of remittances on poverty, but also the reverse effect of poverty of remittances. The price for this is that a misspecification error in one of the system equations is transmitted through the system.

The specification for the poverty equation is the same as in equation 1. We also estimate remittances (Rem) as a function of poverty (Pov), trade openness (Trade), schooling (Sch), distance (Dist) from the main remittance source country, a dummy for dual exchange markets (Dual), and lagged remittances (Remt-1).

Log (Remit)=αi+β1 log(Povit)+β2 log(Tradeit)+β3 log(Schit)+β4log (Dist)+β5Dual+β6log(Remit−1)+εit,(2)

(i = 1 .....N, t = 1 ....Ti),

Migration is the best determinant of remittances, but migration data are likely to suffer from the same problems as data on remittances. Thus we use other variables suggested by the literature on the motivation to migrate and remit. To the extent that remittances represent a private welfare transfer, we can expect them to be higher where there is widespread poverty; hence, we expect a positive sign for β1. If labor mobility and commodity trade are complementary in more open economies, we can also expect a positive sign on the openness variable. If, on the other hand, goods mobility substitutes for labor mobility, β2 would be less than zero.

The sign of β3 is subject to two countervailing influences. Because the general tendency is for the migrant population to be better educated than the general population, we can expect more schooling to be associated with greater migration and remittances. At the same time, educational attainment also serves as a proxy for development in the recipient country and hence more years of schooling may indicate less need to seek employment abroad. The distance variable here is the geographic distance between the recipient country and the OECD country with the largest migrant population from the recipient.21 The expectations for the sign of its coefficient are ambiguous. On the one hand, because distance captures the difficulty of migration, one can expect β4 to be less than zero. On the other hand, because of the implication that it takes a more educated migrant to overcome the higher cost of migration, one can expect higher remittances from the source country. Restrictions in the foreign exchange market can be deterrent to remittances (or at least the flows going through formal channels) and hence β5 is expected to have a negative sign. And finally, given the stability of out-migration and remittance flows, we can expect the previous period’s remittances to be a significant predictor of this period’s remittances, and hence β6 is expected to be greater than zero.

Table 1 reports the results from the three-stage least squares estimation. The hypothesis of reverse causality between poverty and remittances finds support in the positive coefficient on poverty as a right hand side variable when remittances are endogenously modeled. Trade openness is also a consistently positive and significant determinant of remittances in this two equation system. As expected lagged remittances are significant, positive predictor of current remittances. For our sample of countries, none of the other control variables are significant determinants of remittances.

Table 2.

Three-Stage Least Squares Estimation

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Note: ***,**,and *, indicate significance at the 1, 5 and 10 percent.

The effect of per capita income and income inequality is consistent with the OLS results. When endogenously determined in this manner, the poverty-reducing effect of remittances still remains, and the magnitude of this effect is very similar to the OLS estimates. However, the average remittance-inducing elasticity of poverty is consistently greater than the average poverty-reducing elasticity of remittances. This suggests that for SSA countries in the sample the impact of poverty on out-migration and remittances might be greater than the impact of remittances on poverty.

B. Impact on Financial Development

The immediate welfare-enhancing role of remittances is critical at both the household and the country level. However, it does not fully explain the usefulness of remittances as a source of development finance. To understand how remittances affect long-term growth potential we next turn our attention to an indirect consequence of cross-border money transfers: their impact on financial development. Because migrant transfers entail cross-border flows of relatively modest sums of money, they present an opportunity for low-income households to access formal financial services. This most likely begins with savings products but the growing interest that microfinance institutions have shown in this segment of the market raises the possibility of access to small business start-up capital for individuals previously excluded from the formal sector.

The impact of remittances on growth depends on how recipient households use them. Once again empirical studies yield an array of possibilities. One view is that remittances would mostly be used for consumption, sometimes even conspicuous consumption, and that the same community characteristics that led to migration also dampen the productive use of incoming remittances. Caceres and Saca (2006) find that in El Salvador remittances were accompanied by a sharp decline in savings, so that economic activity actually contracted. Yet Woodruff and Zenteno (2001) estimate that remittances accounted for about 20 percent of the capital invested in microenterprises in urban Mexico and that the impact is stronger for female-owned businesses. Lucas (1987) found that any effects on rural output of the loss of labor due to migration to South African mines from Botswana, Lesotho, and Malawi are offset in the long run by investments in farm technology. However, Rozelle, Taylor, and deBrauw (1999) estimate that farm investments only partially offset the decline in rural output due to migration.22

Given the decentralized decision-making process that characterizes the use of remittances, it is difficult to gauge their aggregate effect. The impact of remittances on growth in crosscountry studies is inconclusive. Studies that focus on the labor supply response of recipient households find that remittances lower growth (Chami, Fullenkamp, and Jahjah, 2003; Azam and Gubert, 2005). However studies that link remittances to investment, where remittances either substitute for or improve financial access, tend to conclude that remittances stimulate growth (Giuliano and Ruiz-Arranz, 2005; Toxopeus and Lensink, 2006). While the evidence on the contemporaneous impact of remittances on growth may be mixed, it is likely that remittances can affect long-term growth by fostering financial deepening.

The positive impact of financial development on growth has been extensively documented (Levine, 1997, 2004; Rajan and Zingales, 1998; Beck, Demirguc-Kunt, and Levine, 2004). For SSA countries in particular, lack of access to formal financial services is a significant impediment to financial deepening (Gulde and others, 2006). Migrant transfers can create an avenue for unbanked households to avail themselves of some of the products offered by formal financial providers.

Data and model

We investigate the impact of remittances on financial development in SSA countries using an unbalanced panel of 44 countries and six time periods, composed of five-year averages from 1975 through 2004. Our baseline specification closely follows Aggarwal, Demirguc-Kunt, and Peria (2006), but we restrict our sample to observations from SSA only. Financial development is alternatively proxied by the ratio of bank deposits to GDP and the ratio of M2 to GDP. Remittances are measured in relation to recipient country GDP, as defined elsewhere in the paper. The regressions also include the following control variables:23

  • The size of the economy is captured by the log of GDP in constant U.S. dollars.

  • Per capita GDP is a proxy for the degree of institutional development.

  • Inflation is measured as the annual change in the CPI.

  • A dummy variable signifies a dual exchange rate regime as a measure of capital account openness.

  • The ratio of import and exports to GDP proxies current account openness.

  • The sum of FDI and development assistance to GDP serves as an alternative measure of openness.

The core model can therefore be written as

FDit=β1Remit+β2Xit+αi+uit(3)

where i identifies the cross-section and t the time period, Rem is the variable of interest, X is the vector of control variables, αi captures the country-specific effect, and uit is the error term.

Results

Table 3 reports the results from both the random and the fixed effects panel regressions. In all instances remittances are significant as a positive determinant of financial development. For SSA countries the size of the economy seems unrelated to financial development.24 Similarly, while per capita GDP seems to significantly affect financial development, the magnitude of the effect is surprisingly small. Capital and current account openness are both associated with greater financial development. 25

Table 3.

Baseline Panel Estimation

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Note:***,**, and * signify 1, 5, and 10 percent significance levels.

Once again these estimates can be biased by endogeneity between financial development and remittances. It can be argued that better-developed financial institutions have a positive effect on remittances flowing through formal channels. To address this we adopt three instrumental variables from Aggarwal, Demirguc-Kunt, and Peria (2006) based on macroeconomic conditions in source countries. Unemployment, GDP growth, and per capita GDP in the source country, while related to remittances, are independent of financial development and other conditions in the recipient country. The results are reported in Table 4.

Table 4.

Fixed Effects Panel Instrumental Variables Estimation

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Note:***,**, and * signify 1, 5, and 10 percent significance levels.

The instrumented remittances variable comes in with a positive coefficient of a magnitude greater than previously estimated. While the impact of per capita GDP on financial development is consistent with the panel estimation, in this specification current and capital account openness are less significant. Source country variables do not perform very strongly as instruments for remittances in our sample, although the Cragg Donald statistic is above the critical value. 26In general, however, the estimated effect of remittances on financial development in SSA compares well with the effect estimated by Aggarwal and others (2006) using a larger sample.

IV. Improving the Effectiveness of Remittance Flows

A. Channeling Remittance Flows to Formal Providers

While remittances can facilitate the entry of households into formal financial markets, only a fraction of the sums remitted by migrant workers from SSA finds its way into the formal system. The high fees formal providers charge is a deterrent for poor migrants who want to send small sums of money home, and even if a migrant has access to banks the recipient may not. So migrants rely more on import-export operators, retail shops, and currency dealerships—but there are no records of the transactions these conduct (Sander and Maimbo, 2005). Informal money transfer systems modeled closely on the hawala system in the Middle East dominate the remittance market in several African countries (El Qorchi, Maimbo,and Wilson, 2003). Informal providers offer numerous client-friendly features, such as anonymity, minimal paperwork, and speed.

The cost of transferring funds, especially small sums, is indeed high. A survey of money transfer operators (MTO) in the U.K. found that the fee on money transfers was lower in high-volume corridors like U.K.-India and higher for UK-Africa (Table 5).27

Table 5.

Fees for Remittances Sent Through Money Transfer Operators in the U.K.

(Percent of amount)

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Source: DFID, 2006.Note: Since the fees can change due to exchange rate changes, the number should be interpreted as indicative rather than precise.

The market in money transfers between developing countries in SSA is underserved by formal institutions, and the prohibitive fees they charge severely depress their use. A study in South Africa (Genesis Analytics, 2003) found that the comparative cost of an R250 international transfer was the lowest when a “friend” or taxi driver was used to effect the transfer and highest when banks were used. Though cross-border Post Office transfers are competitively priced, they are not as fast or as secure. Table 6 compares the cost of remitting R300 from South Africa by provider and method of transfer.

Table 6.

Fees for Remittances from South Africa

(Percent of 300 Rand Transfer)

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Source: DFID and FinMark Trust, 2006.Note: Shaded cells indicate the rand value of the money transfer since the transfer is converted to local currency by the receiving organization.

The absence in South Africa of a major MTO like Western Union further limits competition among the players in the formal market and increases the likelihood that migrant workers will use informal channels to send money home. The terrorist attacks of September 11, 2001, have increased the scrutiny of international money transfers and many banks are imposing more identification requirements on both individuals and small MTOs (Sander and Maimbo, 2003). In South Africa only authorized dealers, who must have a banking license and have invested in an expensive exchange control reporting system, can remit funds. By further increasing the effective cost the rules discourage remittances through formal channels (Genesis Analytics 2005).

Banks are not always interested in the small remittances market. Most analysts see significant opportunities for banks to reduce the transaction costs on remittances, especially small remittances sent by poor migrants. Freund and Spatafora (2005) find that concentration in the banking sector, financial risk, and exchange rate variability typically increase transaction costs. Financial sector reforms that address any or all of these structural problems in the receiving and sending countries are also likely to lower the cost of remittances.28 Cross-border uniformity in the regulations related to remittances and regulatory interventions where fees are prohibitive have been proposed as other cost-reducing measures (Ratha and Riedberg, 2005; Sanders and Maimbo, 2005).

Among formal providers many smaller banks and microfinance institutions have already gauged the untapped potential of this market. Where there is a long history of migration some small banks have adapted to the needs of the migrant community. For instance, Theba Bank, a miners’ bank, offers low-cost transfers from South Africa to families that have bank accounts in Mozambique and Swaziland (Orozco, 2003). International Remittance Network (IRnet) consists of about 200 credit unions that offer low-cost services in 40 countries in Asia, Africa, Europe, and Latin America (Samuels, 2003). The network does not require that the receiving family have an account with a credit union.

Lately, in well-developed financial markets like the United States the growing demand for remittance services has caught the attention of major commercial banks like Citizen’s Bank and Wells Fargo. These banks see remittance services as an effective way to draw the attention of a significant unbanked population to their more mainstream financial products. In an arrangement with two banks in Cape Verde Citizen’s Bank offers Cape Verdean migrants a remittance facility that is low cost compared to Western Union. In three years of operation this program has made over 1,000 formerly unbanked migrants Citizen’s customers.29

There are already signs that the window of opportunity for financial institutions to tap into this highly profitable and rapidly innovating market might be narrow. Recent strides in cell phone encryption technology have facilitated fast, low-cost money transfers between OECD countries and recipient countries as diverse as the Philippines and Zambia, allowing customers to avoid the higher fees and longer waiting periods associated with MTOs and banks (Jordan, 2006).

B. Using Remittances Effectively

Bringing recipient households into the formal financial sector is only the first step in using remittances more effectively. Country-specific surveys indicate that while typically a large proportion of remittances are spent the propensity to save from remittances among some households can be as high as 40 percent (UNDP, 2005). For policy-makers the challenge is to channel these savings into productive uses.

Most studies indicate that remittances not used to pay for the immediate consumption needs of the recipient household are used for human capital development or conspicuous consumption. While the long-term benefits of the former are apparent, not all conspicuous consumption is wasteful. The construction of very large houses for migrant workers in West Africa has spurred local economic activity through multiplier effects. In Mexico, the Sociedad Hipotecaria Federal, a government financial institution established to build primary and secondary mortgage markets, provides long-term financing and partial mortgage insurance to Mexican sofols (mortgage providers) that extend loans to immigrants for housing construction (Serrano, 2006). The loans are denominated in Mexican pesos. Migrant workers are given some flexibility about the method of income verification and there is no credit history requirement. Mortgage payments are made in the workers place of residence. Inadequate financial infrastructure makes launching of similar schemes in Africa more challenging, but they can spur a sustained housing boom with positive spillovers on both real and financial sectors of the economy.

By bundling financial services like savings products and entrepreneurial loans for remittance-receiving households, financial institutions, especially banks, can activate the investment channels through which remittances can promote growth.30 Given the paucity of assets that can serve as collateral in SSA a steady future flow of migrant remittances could be used to secure small business loans—though small retail businesses started entirely with remittance savings face expansion limits unless they can access additional long-term funding. 31

The surge in remittances to India over the last few years is attributed in some part to incentive schemes launched by the government such as the Resurgent India Bond to encourage the inflow of diaspora savings. While such flows are more likely to be subject to speculative reversals than intrafamily transfers they can significantly supplement domestic investible resources (World Bank, 2006).32

Remittances are not a panacea for all that ails low-income countries. They cannot be a substitute for a sustained, domestically engineered development effort. Moreover, large-scale migration can have a deleterious effect on domestic labor markets in specific sectors, particularly where those leaving are largely skilled workers. Nevertheless, migrant transfers can help ease the immediate budget constraints of recipient households. For developing countries as a whole they are a larger transfer of resources than all development assistance and have a more direct impact on poverty. And the vast untapped market in money transfers is an opportunity for small savers to gain a foothold in the formal financial sector.

APPENDIX

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Appendix Table 1.

Workers’ remittances, compensation of employees, and migrant transfers

(Millions of U.S. Dollars)

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Source: World Bank (2006)
Appendix Table 2:

Poverty Dataset Details

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Appendix Table 3.

Descriptive Statistics of Regression Variables

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Note: These are raw data series, before the log transformation.
Appendix Table 4.

Bivariate Correlations of Regression Variables

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Note: * indicates significant at 10 percent.
Appendix Table 5.

Ordinary Least Squares Estimation (With and Without Regional Dummies)

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Note: ***,**,and * indicate significant at 1, 5,and 10 percent. T-Statistics are reported in parentheses. Standard errors are clustered by country to eliminate any downward bias.
Appendix Table 6.

Ordinary Least Squares Estimation (With Interaction Term)

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Note: ***,**,and * indicate significant at 1, 5,and 10 percent. T-Statistics are reported in parentheses. Standard errors are clustered by country to eliminate any downward bias.
Appendix Table 7.

Ordinary Least Squares Estimation for Rem>1 Sample

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Note: ***,**,and * indicate significant at 1, 5,and 10 percent. T-Statistics are reported in parentheses. Standard errors are clustered by country to eliminate any downward bias
Appendix Table 8.

Descriptive Statistics for Regression Variables

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Appendix Table 9.

Bivariate Correlations of Regression Variables

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Appendix Table 10.

Baseline Panel Estimation

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Note:***,**, and * signify 1, 5, and 10 percent significance levels.The ICRG database measures political risk on a scale of 1 to 100 with higher values implying less risk. So a positive coefficient on political risk indicates that lower political risk is associated with greater financial development.
Appendix Table 11.

Fixed Effects Panel Instrumental Variables Estimation

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Note:***,**, and * signify 1, 5, and 10 percent significance levels. Instruments weighted by expatriation rate
Appendix Figure 1.
Appendix Figure 1.

Remittances to Developing Countries by Region, 1975-2005

(Millions of US dollars)

Citation: IMF Working Papers 2007, 038; 10.5089/9781451866025.001.A001

Source: IMF Balance of Payments Yearbook, 2006; World Bank staff estimates
Appendix Figure 2.