Boosting economic growth

Remittances by international migrants to their countries of origin constitute the largest source of external finance for developing economies after foreign direct investment (FDI). Estimated official remittances are US$167 billion for developing countries in 2005, double total development aid.

Customer in the Daahab Shiil bank in Somalia, collecting remittances in US dollars from a relative overseas. Photo by: Sven Torfinn/Panos Pictures

In fifteen developing countries studied by the International Monetary Fund (IMF), remittances account for more than 10 percent of Gross Domestic Product. This is true for some islands in the Caribbean and Pacific and for several labour-exporting countries such as Albania, El Salvador, Jordan, Lesotho, Moldova, and the Philippines. Despite their increasing importance in total international capital flows, the relationship between remittances and economic growth has not been adequately studied.

This contrasts sharply with the extensive research on the relationship between growth and other sources of foreign capital, such as FDI and official aid. The accepted view seems to be that because remittances are used mostly for consumption by individual households, they have a minimal impact on long-term growth.

A recent IMF working paper examines how local financial sector development influences a country's ability to take advantage of remittances. In theory, the impact of remittances on growth can work either through the financial system or parallel to it:

• Relatively developed financial systems would presumably treat remittances like any other form of savings and, by reducing transaction costs, allocate them to projects that yield the highest returns. This might be expected in some emerging Asian countries where banking sector development is high.
• In countries with less developed financial systems (most of sub-Saharan Africa and some post-Soviet central Asian states), remittances might become a significant complement for inefficient or nonexistent credit markets by helping local entrepreneurs bypass lack of collateral or high lending costs to start productive activities.

How does it work in practice?

Using data covering 100 developing countries from 1975 to 2002, the IMF study finds strong evidence that the second theory works: remittances boost growth in countries with less developed financial systems by providing an alternative way to finance investment. Remittances act as a substitute for the domestic financial system.

There is no evidence, however, that the first channel works: even after controlling for differences in the level of income among countries, remittances do not seem to have an impact on growth in countries with well-functioning domestic financial markets.

Specifically, research findings show that:

• While more developed financial systems seem to attract more remittances (due to lower transaction costs and fewer restrictions on payments), they do not seem to increase their impact on growth.
• Remittances substitute for financial development in countries with less developed financial systems.

The study also challenges some common myths about remittances:

• Remittances are widely viewed as compensatory transfers between family members. Nevertheless, remittances respond to investment opportunities in the home country as much as to charitable or insurance motives. Many migrants invest their savings in micro businesses, real estate or other assets in their own country, probably expecting to return one day or because they know local markets better than in their host countries. In about two-thirds of developing countries, remittances are mostly profit-driven and increase when economic conditions back home improve.
• Remittances are used for investment particularly where the financial sector does not meet the credit needs of local entrepreneurs.

The evidence that remittances can help overcome difficulties with access to finances and undertake profitable investment in countries with less developed financial systems is encouraging.

But while policymakers stress the need to encourage remittance flows by reducing transfer costs, the biggest challenge is to understand why remittances do not seem to boost growth in countries with well-functioning credit markets, and to work out how policies could address this.

The views expressed in this article are those of the author and should not be attributed to the International Monetary Fund, its Executive Board, or its management.

Marta Ruiz-Arranz
International Monetary Fund, 700 19th Street, NW, Washington, DC 20431, USA
T +1 202 623 8564
F +1 202 623 9667
mruizarranz@imf.org
www.imf.org

See also

Remittances, Financial Development, and Growth, IMF Working Paper No. 05/234, IMF: Washington, DC, by Paola Giuliano and Marta Ruiz-Arranz, December 2005
www.imf.org/external/pubs/cat/longres.cfm?sk=18607.0

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