The impact of remittances on financial development

Maria Soledad Martinez Peria

Remittances, funds received from migrants working abroad, to developing countries have grown dramatically in recent years from U.S. $3.3 billion in 1975 to close to U.S. $338 billion in 2008.

Remittances, funds received from migrants working abroad, to developing countries have grown dramatically

They have become the second largest source of external finance for developing countries after foreign direct investment (FDI) and represent about twice the amount of official aid received.

Relative to private capital flows, remittances tend to be stable and increase during periods of economic downturns and natural disasters.

Furthermore, while a surge in inflows, including aid flows, can erode a country's competitiveness, remittances do not seem to have this adverse effect.

As researchers and policymakers have come to notice the increasing volume and stable nature of remittances to developing countries, a growing number of studies have analyzed their development impact along various dimensions, including: poverty, inequality, growth, education, infant mortality, and entrepreneurship.

However, surprisingly little attention has been paid to the question of whether remittances promote financial development across remittance-recipient countries.

Yet, this issue is important because financial systems perform a number of key economic functions and their development has been shown to foster growth and reduce poverty.

Furthermore, this question is relevant since some argue that banking remittance recipients will help multiply the development impact of remittance flows.

Whether and how remittances might affect financial development-banking in particular-is a priori unclear.

On the one hand, money transferred through financial institutions might pave the way for recipients to demand and gain access to other financial products and services that they might not have otherwise.

As an added benefit, providing remittance transfer services allows banks to "get to know" and reach out to unbanked recipients or recipients with limited financial intermediation.

For example, remittances might have a positive impact on credit market development if banks become more willing to extend credit to remittance recipients because the transfers they receive from abroad are perceived to be significant and stable (i.e., serve as collateral, at least informally). However, even if bank lending to remittance recipients does not materialize, overall credit in the economy might increase if banks' loanable funds surge as a result of deposits linked to remittance flows.

Furthermore, because remittances are typically lumpy, recipients might have a need for financial products that allow for the safe storage of these funds, even if most of these funds are not received through banks. In the case of households that receive their remittances through banks, the potential to learn about and demand other bank products is even larger.

On the other hand, because remittances can help relax individuals' financing constraints, they might lead to a lower demand for credit and have a dampening effect on credit market development.

A rise in remittances also might not translate itself into an increase in credit to the private sector if these flows are instead channelled to finance the government or if banks are reluctant to lend and prefer to hold liquid assets.

Finally, remittances might not increase bank deposits if they are immediately consumed or if remittance recipients distrust financial institutions and prefer other ways to save these funds.

Two recent studies provide evidence in favour of the first hypothesis. They show that remittances have a positive and significant impact on financial development. Using municipality-level data for Mexico for 2000, my coauthors (Demirguc-Kunt, Lopez-Cordova, and Woodruff) and I show that remittances are strongly associated with greater banking breadth and depth, increasing the number of branches and accounts per capita and the ratio of deposits to GDP.

Workers at the Airport

These effects are significant both statistically and economically, and are robust to the potential endogeneity of remittances.

The most conservative estimate suggests that a one-standard deviation change in the percentage of households receiving remittances-roughly a doubling of the mean remittance rate-leads to an increase of 1 branch per 100,000 inhabitants (against a mean of 1.79), 31 accounts per one thousand residents (relative to a mean of 42 accounts), and an increase of 3.4 percentage points in the deposit/GDP ratio (compared to a mean of 4.2).

In another paper I wrote with Reena Aggarwal and Asli Demirguc-Kunt, we add to the previous study by showing that the contribution of remittances to financial development is not specific to Mexico, but holds across countries and over a longer time period.

We utilize data on remittance flows to 109 developing countries during 1975-2007 to examine the association between remittances and the aggregate level of deposits and credit intermediated by the local banking sector.

The paper provides evidence of a positive, significant, and robust link between remittances and financial development across a large sample of developing countries.

Both these studies' findings add another important channel through which remittances can affect the development of recipient economies.

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