Obviously, the pressure on the real exchange rate will be somewhat mitigated if (i) there are productivity gains, particularly in the non tradable sector, that offset the effects of the increasing demand; (ii) governments implement policies that aim at stimulating labor demand by reducing labor costs;<sup>3</sup> and (iii) a large share of the remittances is channeled to the external sector via additional imports so that the price effect on non tradable goods is limited. Yet in principle it seems difficult to justify that these effects are enough to mitigate appreciating pressures.

In turn, there are a number of connected macroeconomic effects that can result from a real exchange rate appreciation associated to remittances flows. They include the following:

- <u>Adverse effects on the tradable sector of the economy.</u> Although remittance flows are likely to lead to an expansion of the non tradable sector (as a result of the increase experienced in the domestic demand), both export and import-competing industries (i.e. the tradable sector of the economy) would be adversely affected by the real exchange rate appreciation and the associated loss of international competitiveness. The negative impact of remittances on the tradable sector may be reinforced if they also fuel inflation and higher prices result in higher economy-wide wages.<sup>4</sup> As mentioned above this effect would further be magnified if remittances also reduce the labor supply. In these circumstances, the non tradable sector may be in the position of passing onto prices some of the wage pressures, but this is likely to be much more difficult for a tradable sector facing international competition which as a result will loose competitiveness.

- <u>Widening of the current account deficit.</u> In principle, it is difficult to justify that an increase in the domestic demand will be passed in full to the non tradable sector. So, to the extent that some of the remittances-induced-consumption is directed towards tradable goods, there will be an increase in the demand for imports. This coupled with the losses of international competitiveness of the domestic firms mentioned in the previous paragraph would likely result in deteriorations of the external position. For example, according to World Bank (2003) the surge in remittances observed in El Salvador during the 1990s was the most likely factor behind the worsening of the country’s trade deficit which over the 1990s deteriorated from less than 7 percent of GDP to almost 14 percent of GDP.

- <u>Weaker monetary control, inflationary pressures, and the sectoral allocation of investment.</u> If remittances flows do not leave the country (at least in full) through a widening of the current account, large flows will push up monetary aggregates, potentially derailing inflation targets. Experience also indicates that prices of financial assets and particularly of real estate can rise rapidly following a surge in remittances, something that in turn may introduce significant distortions in the economy and affect the sectoral allocation of investment and lead to overinvestment in some sectors (i.e. real estate).

> 3 A reduction of payroll (or other direct) taxes (compensated by an increase in indirect taxes) is the most straightforward of such policies; however, one can also think of other polices that increase labor market flexibility and ultimately reduce wage pressure (and support labor demand).

> 4 This is a typical result of economic models with labor mobility.

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