suggests that remittances are acyclical with respect to the recipient country’s business cycle.<sup>2</sup> Remittances, unlike other types of capital flows, are unrequited transfers that do not have to be paid back and target the very consumers who are more likely to be liquidity constrained. They are intra-household, private flows, likely driven by altruism and hard to expropriate selectively. As such, they have the potential to disentangle fluctuations of consumption from those of output, thus improving standard measures of international risk sharing.

Foreign aid flows also have the potential to improve risk sharing outcomes. Unlike other types of private flows, aid flows are voluntary transfers between countries. They are not expected to be paid back if they take the form of gifts and grants (or they can be low-interest loans). They often target the poorest segments of society who do not have insurance arrangements to smooth income fluctuations. Since aid flows can help dampen the impact of adverse shocks on consumption, they can lower consumption volatility and improve risk sharing (Canova and Ravn 1996; Pallage, Robe and Beroube 2006).<sup>3</sup> Both remittances and aid flows appear to be relatively more stable forms of foreign financing (Figure 2). The volatile and procyclical nature of private capital flows has been documented extensively (Reinhart and Reinhart 2009). However, remittances and aid flows do not display these types of sharp movements and they do not comove with other types of capital flows.<sup>4</sup> Indeed, <mark>during periods of financial crises, remittances tend to be resilient, often continuing their upward trend when other types of capital flows decline significantly (De et al. 2019).</mark><sup>5</sup> <mark>Aid flows tend to increase when recipient countries experience adverse shocks (Dabla-Norris, Minoiu, and Zanna 2015). R</mark> emittances can help stabilize consumption inter-temporally by supporting saving and improving access to financial services (Adams and Cuecuecha 2013; Acosta, Lartey and Mandelman 2009; Mandelman and Zlate 2012). Both remittances and aid flows have the potential to facilitate better consumption smoothing outcomes through their positive impact on financial sector development (Aggarwal, Demirguc-Kunt, and Martinez Peria 2011; Maruta 2019). <mark>These</mark>

> 2 See De et al. (2019) for a detailed review of the motives to remit. They find that remittances and aid flows are typically acyclical. This implies that they have the potential to de-link consumption growth from business cycle fluctuations. While they present a survey of the behavior of remittances and aid flows over the business cycle, they do not undertake econometric exercises to quantitatively analyze the risk sharing implications of remittances and aid flows   In contrast to De et al. (2019), this paper formally tests the risk sharing ability of remittances and aid inflows using a battery of econometric exercises.

> 3 An extensive literature focuses on the impact of aid flows on economic growth (see Arndt, Jones and Tarp (2010) for a review). Some studies consider the relationship between aid flows and business cycle fluctuations (Pallage and Robe 2001; Faini 2006; <mark>Dabla-Norris, Minoiu, and Zanna 2015; Chauvet et al. 2019).</mark> Balli, Pierucci and Fu (2019) document that for a sample of 22 developing countries aid flows help de-link national income from domestic output fluctuations whereas Gardberg (2019) finds no robust correlation between aid inflows and risk sharing for a sample of 78 EMDEs during 1970-2014.

> 4 The correlation of remittances with other types of capital flows, including FDI, has been found to be weak. For example, De et al. 2019 document that <mark>remittances are not strongly correlated with capital flows, with the median correlation equal to 0.08. Remittances are weakly correlated with portfolio equity flows, total inflows, official development assistance (ODA), and net exports.</mark>

> 5 De et al. (2019) report that <mark>whereas other types of capital flows on average decline about 15 percent during the initial year of a sudden stop episode and continue to fall, on average, by another 10 percent the following year, remittances tend to increase by 6.6 percent during the first year and another 5.7 percent in the subsequent year. Aid flows also increase during sudden stop episodes. The results are similar during episodes of financial crises, including debt, banking and exchange rate crises.</mark>

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