A recent debate in the literature is the extent to which remittances can promote access to financial services and financial development. This is an important question considering the extensive literature that has documented the growth-enhancing and poverty-reducing effects of financial development. However, how remittances impact financial development is complex issue. Early work on the link between remittances and financial development was mainly descriptive in nature and suggested that remittances may be a potential catalyst for financial development by providing migrants’ families with increased demand for credit and other financial services. In addition, remittances can also affect banks willingness to loan money to households in remittance receiving areas. Risk can play a central role in low-income environments. A high default rate may reduce the willingness of banks to lend to poor households, and may also reduce the demand for credit among poor households who do not want to lose their collateral.
In recent work, scholars have attempted to directly measure the link between remittance flows and financial development using existing data sources. Aggrawal, Demirguc-Kunt and Peria (2006) find that remittances promote financial development in a large sample of developing countries. Their study also highlights several potential channels through which remittances can affect financial development. Remittances may increase financial development by paving the way for recipients to demand and gain access to financial services. For example, remittance receipts are often lumpy, and may lead to a higher demand for formal financial services such as savings products. An additional possibility is that remittances can provide financial institutions with information about remittance-receiving households, previously excluded from the formal banking sector, leading to the expansion of credit for small business start-up capital and other investments. Transaction fees associated with remittance flows may also spur the expansion of financial institutions into previously underserved areas.
A key question raised in the literature is whether there are limitations to the financial deepening impact of remittances in countries with less-developed financial systems. In particular, where trust in financial institutions is low, recipients may prefer to save outside the formal banking sector. In addition, where financial systems are less-developed, migrants and their families tend to rely mainly on informal channels to transfer and save resources. However, Gupta, Pattillo, and Wagh (2007) find that remittances have a positive impact on financial development in sub-Saharan Africa, a region where a large share of financial transactions takes place outside the formal sector. Their study documents that remittances promote financial deepening in this region, and their results hold even after accounting for the possibility that reported remittances are likely to be higher in better-developed financial markets.
Finally, one possibility is that remittances may relax credit constraints among recipients lowering the demand for credit and insurance services. In an important contribution, Guiliano and Ruiz (2005) find that in countries with less-developed financial systems, remittances can act as a de facto substitute for financial services, providing households with credit and insurance and increasing investment opportunities, leading to higher growth. Due to data limitations, there are very few studies that allow researchers to study the impact of remittances on financial development by creating counterfactuals with and without remittances.
Topic 14 – Articles
Aggarwal, Reena, Asli Demirguc-Kunt, and Maria Soledad Martinez Peria. 2006. Do Workers’ Remittances Promote Financial Development? In World Bank Policy Research Working Paper No. 3957 Washington, DC: World Bank.
The authors use cross-country balance of payments data on workers’ remittance flows to 99 developing countries from 1975-2003 to study the impact of remittances on financial sector development. This study examines whether remittances contribute to increasing the aggregate level of deposits and credit intermediated by the local banking sector. The authors conclude that remittances have a positive and significant impact on financial development. In particular, a one percentage point increase in the share of remittances to GDP is associated with a 0.5-0.6 percent increase in the ratio of bank deposits to GDP and about a 0.3 percent increase in bank credit to the private sector to GDP. The results are robust to the inclusion of country and time fixed-effects, and instrumental variables to deal with measurement error and potential endogeneity concerns.
Using a cross-country of data series covering about 73 developing countries between 1975 and 2002, the authors investigate the interaction between remittances and financial development and its impact on growth. The analysis emphasizes how a country’s capacity to use remittances may be influenced by local financial sector conditions. The empirical findings suggest that remittances can promote growth in less financially developed countries. A one percentage point increase in remittances as a share of GDP is associated with a 0.2 percentage points, controlling for the level of financial development. The authors conclude that in countries with less-developed financial systems, remittances act as a de facto substitute for financial services, providing households with credit and insurance and increasing investment opportunities, leading to higher growth. The analysis accounts for the endogeneity of remittances and financial development using a Generalized Method of Moments (GMM) approach, and is robust to various measures of financial sector development used, and is robust to a number of sensitivity tests.
Gupta, Sanjeev, Catherine Pattillo, and Smita Wagh. 2007. Impact of Remittances on Poverty and Financial Development in Sub-Saharan Africa. In International Monetary Fund Working Paper No. 07/38. Washington, DC: International Monetary Fund.
This paper investigates the impact of remittances on financial development in 44 African countries over six time periods, composed of five-year averages from 1975 to 2004. The authors find that remittances promote financial deepening in sub-Saharan Africa, after controlling for macroeconomic and institutional variables that are commonly used to explain financial development in low-income countries. These results are robust to accounting for the possibility that reported remittances are likely to be higher in better-developed financial markets.