title: An Empirical Analysis of Foreign Aid and Remittances in Developing Countries
Creators: name: Abbas, Syed A
Publisher: name: Griffith University
Year: 2021
Subjects: subject: Foreign aid
subject: remittances
subject: external development finance
subject: developing countries
subject: effectiveness
subject: macroeconomic stabilisation
subject: growth

description: Foreign aid and remittances are the two major sources of external development finance for many developing countries. Levels of foreign aid received have improved gradually over the last few decades, while remittances have increased phenomenally in the developing world—especially over the last two decades. There is, therefore, a great amount of interest from researchers in the effectiveness of remittances and foreign aid in promoting macroeconomic stabilisation, growth and development. Apart from the important roles played by these financial flows, the question arises as to whether these two flows—foreign aid and remittances—are interlinked. Very little is known about the relationship between foreign aid and remittances because only a limited number of studies have analysed their relationship, and these do not provide an insight into how they are related. Furthermore, despite improved economic growth, developing countries have, in recent years, faced structural changes and rapid urbanisation. This thesis analyses these issues empirically by employing recent developments in econometric methods, using data for the period 1980–2016 from 50 aid-dependent developing countries. It also conducts an in-depth analysis of these issues through a specific case study that uses data for that same period from four South Asian countries. The thesis firstly conducts a review of literature to identify a number of factors which influence remittance flows in developing countries. One of the findings reveals that foreign aid is a significant factor in determining remittances and has a negative effect, indicating that the two financial flows can be substituted for one another. The thesis then examines the functional form of the relationship between remittances and foreign aid and the different transmission channels or mechanisms through which they are interconnected. In contrast to more traditional literature, this thesis identified a non-linear relationship between remittances and foreign aid to the South Asian countries—a U-shaped relationship. Its findings also suggest that an increase in foreign aid reduces remittances to countries with lower aid-dependency while increasing remittances to countries with higher aid-dependency. Using a dynamic model for the South Asian countries, the thesis finds that, in the short-run, foreign aid helps increase remittances while, in the long-run, it reduces remittances. An analysis of the transmission channels reveals that increasing foreign aid improves human capital, which then positively influences remittances. Moreover, the effect of foreign aid on remittances through the economic growth channel is significant and robust in developing countries. Importantly, due to the potential impact of human capital on economic growth, the thesis also examines the human capital-led growth channel of foreign aid. Its findings indicate that the human capital-led growth channel of foreign aid has a significant and positive impact on remittances in developing countries. Secondly, the thesis examines the impact of all external financial flows (including foreign direct investment—FDI) on the well-being of the relevant economies. It contributes to the literature by analysing various channels of financial flows by considering the effect of other variables—such as political stability (democracy), trade openness and human capital—on different measures of well-being. In developing countries, its findings indicate a significant and positive effect of all three external financial flows—foreign aid, remittances and FDI—on economic growth; the impact of FDI is relatively greater than the other two. Considering only the South Asian countries, foreign aid has had a significantly negative impact on economic growth, while FDI and remittances have a significantly positive impact. Besides economic growth, the thesis also examines the impact of financial flows on income inequality, which is a better measure of well-being. In developing countries, foreign aid and remittances both significantly reduce income inequality. The results for the South Asia countries show that foreign aid directly reduces income inequality while remittances do not have a directly significant effect on it. However, remittances are effective in reducing income inequality through their impact on the human capital development channel, providing better livelihood opportunities to skilled people. The thesis thirdly investigates the relationship between structural transformation, urbanisation and remittances. The short-run dynamic analysis reveals that structural transformation and urbanization Granger cause remittances in the South Asian countries. However, when considering all developing countries, only structural transformation has Granger-causation on remittances. Furthermore, the empirical findings indicate a two-way (bi-directional) causal relationship between urbanization and structural transformation as well as between remittances and structural transformation. In summary, the findings of the thesis indicate a negative relationship between remittances and foreign aid, and that the two flows are interconnected through various channels (human capital, economic growth, migration). In addition, the results also suggest that external financial flows improve economic growth and reduce income inequality in developing countries. Moreover, its findings indicate a short-run dynamic relationship between structural transformation, urbanisation and remittances. Most significantly, this thesis offers important findings that are beneficial for policymakers in developing countries, donor countries and international financial institutions. The findings suggest that policymakers should focus more on human capital development which can be effective in increasing remittance flows, thus increasing their impact on economic growth and reducing income inequality.