metadata: authors: 0: author: Lartey,Emmanuel Kwasi Koranteng
count: World
docna: 0: docna: The effect of remittances on the current
            account in developing and emerging economies
docty: Policy Research Working Paper
abstracts: cdata!: This paper presents an analysis of the
            effect of remittances on the current account in developing
            and emerging economies, incorporating an assessment of the
            extent to which exchange rate regimes impact the
            relationship. The main findings suggest there is a positive
            effect of remittances on the current account
            contemporaneously, but that the lagged effect is negative,
            which could be indicative of the existence of some
            underlying mechanisms characteristic of the Dutch disease
            phenomenon. In addition, the results show that a more
            flexible exchange regime dampens the contemporaneous
            positive effect that remittances have on the current
            account. The paper, therefore, asserts that policy makers
            face trade-offs pertaining to the use of exchange rate
            policy in managing the effects of remittances on the current
            account, which should be given due consideration when such
            policy choices are made.
repnme: repnme: The effect of remittances on the current
            account in developing and emerging economies
display_title: The effect of remittances on the
            current account in developing and emerging economies
listing_relative_url: /research/2018/06/30209492/effect-remittances-current-account-developing-emerging-economies
publishtoextweb_dt: 2018-06-27T00:00:00Z
no_of_pages: 26
author_keys: 0: author_key: 1407197
model_extractions: WPS8498 Policy Research Working Paper 8498 The Effect of Remittances on the Current Account in Developing and Emerging Economies _Emmanuel K.K. Lartey_ Africa Region Office of the Chief Economist June 2018
Policy Research Working Paper 8498

# **Abstract**

This paper presents an analysis of the effect of remittances on the current account in developing and emerging economies, incorporating an assessment of the extent to which exchange rate regimes impact the relationship. The main findings suggest there is a positive effect of remittances on the current account contemporaneously, but that the lagged effect is negative, which could be indicative of the existence of some underlying mechanisms characteristic of the Dutch disease phenomenon. In addition, the results show that a more flexible exchange regime dampens the contemporaneous positive effect that remittances have on the current account. The paper, therefore, asserts that policy makers face trade-offs pertaining to the use of exchange rate policy in managing the effects of remittances on the current account, which should be given due consideration when such policy choices are made.

This paper is a product of the Office of the Chief Economist, Africa Region. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/research. The author may be contacted at elartey@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
The Effect of Remittances on the Current Account in Developing

# and Emerging Economies

Emmanuel K.K. Lartey<sup>∗</sup> JEL Classification: F24 F41 O11 Keywords: Remittances, Current account, Exchange rate regimes, Panel Data, Macroeconomic imbalances

- ∗The World Bank, 1818 H St. NW, Washington DC 20433. Email: elartey@worldbank.org.
# 1 Introduction

Remittances to developing countries have been growing in the last decade, reaching $431.6 billion in 2015, which represents an increase of 0.4 percent over $430 billion in 2014 according to World Bank records. Although the growth pace of remittances has diminished since the global financial crises, remittances have become an important component in total international financial flows to developing countries, and currently, are more than three times the size of official development assistance and have become the second largest source of external finance behind foreign direct investment (FDI). The magnitude of remittance flows, especially to developing countries has given rise to questions pertaining to the potentially undesirable consequences they may be associated with, as was the case during periods of massive capital inflows to emerging market economies in the 1990s. For example, in spite of some of the documented benefits, remittances could cause a real exchange rate appreciation and loss of international competitiveness, and eventually lead to resource reallocation away from the tradable sector and toward real estate and other nontradables that tend to experience rising prices in the face of capital inflow, which could potentially hurt economic growth (Amuedo-Dorantes and Pozo, 2004; Lartey et al, 2012).

There is evidence to suggests that remittances, in general, have either financed the consumption of goods and services or capital accumulation, directly through investments or indirectly through savings. To this end, remittances should be expected to influence the behavior of the current account in recipient countries, in the same fashion as private capital inflows did in the 1990s. There has, however, been very limited research on the impact of remittances on the current account.

The aim of this paper, therefore, is to conduct an empirical analysis of the impact of remittances on the current account balance. Remittances can improve the current account when directed toward domestic investments, particularly in exporting firms in the manufacturing sector. Remittances can also serve as additional source of foreign income that can go towards financing trade deficits, thereby improving the current account. On the contrary, should remittances go toward financing an increase in the consumption of imports, the current account will deteriorate. Other channels through which remittances could affect the current account include the appreciation of the nominal exchange rate following the inflow of foreign currency, and through the Dutch disease phenomenon, both of which would serve to decrease demand for exports, increase imports and consequently worsen the current 2
account balance.<sup>1</sup> Singh (2014) notes that during part of the 2014 fiscal year, remittances to Nepal was 360 billion rupees, and was associated with a decrease in the trade balance by about 271 billion rupees. In the preceding fiscal year, remittance receipts amounted to 360 billion rupees, whereas exports receipts and import payments were 72 billion and 462 billion rupees respectively. Remittances are considered to have primarily financed the consumption of imports; 79 percent of remittances have gone directly to consumption,3 percent toward capital formation, and the remainder has financed education and existing debts. The publication also mentions that there is evidence for Dutch disease effects caused by remittances, and that there is a strong correlation between remittances and trade deficit in Nepal. In constrast, remittances have been a significant source of external finance and contributed to the current account surplus in Bangladesh in recent years. Persistent current account deficits can cause sharp declines in the current account, with potentially negative consequences for long-run growth (Edwards, 2004). Moreover, current account reversals do cause financial crises, which in turn increases poverty and worsens income inequality (Frankengerg et al., 2003). To the extent that dynamics of the current account balance has important implications for developing and emerging market economies, this study should be an important contribution to the literature on the macroeconomic consequences of remittances.

# 2 Related Literature

Bugamelli and Paterno (2009) analyze the impact of remittances and current account reversals, and find that remittances increase financial stability in emerging and developing economies by decreasing the likelihood of current account reversals. Hassan and Holmes (2014) study the relationship between remittances and the sustainability of the current account, rather than the size of the current account balance. They find that more remittances facilitate a weakly sustainable current account balance, and that higher levels of remittances lead to a faster speed of adjustment or lower persistence of the current account following shocks. Milesi-Ferretti and Razin (1998), in a broader discussion on external imbalances, note that the size of the export sector, the level of international competitiveness and the degree of exchange rate flexibility and exchange rate policy, among others,

> 1 See Acosta et al. (2009) and Lartey et al. (2012) for details on how remittances affect the nominal exchange rate, as well as how they generate dynamics that result in the Dutch disease phenomenon.

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are important factors that can be linked to current account sustainability. Gnimassoun (2015) examines whether exchange rate regimes affect the magnitude of external imbalances in sub-Saharan Africa, and shows that a flexible exchange rate regime is the best at preventing absolute external imbalances, and also, that remittances represent one of the main determinants of the current account position in sub-Saharan Africa.

Following in the tradition of the extensive literature on the extent to which exchange rate policies influence the macroeconomic effects of capital inflows, there has been some research on how macroeconomic dynamics following the inflow of remittances vary under different exchange rate regimes. Mandelman (2012) shows that in a small open economy that is subject to remittances fluctuations, a fixed exchange regime provides a better outcome for households facing rising trend in remittances, while a flexible regime does better when unanticipated shocks over the business cycle are considered. Lartey (2016) presents results to suggest that an increase in remittances leads to an increase in nontradable inflation under a fixed exchange rate regime, whereas for an inflation targeting regime, an increase in remittances generates dynamics that result in a decrease in nontradable inflation. Furthermore, Lartey (2017) shows that the current account dynamics generated by inflow of remittances depends on both the end-use of remittances and exchange rate policy. The combination of the findings from these theoretical analyses, and the extant literature on capital inflows suggest that exchange rate policy should carry implications for movements in the current acoount following the inflow of remittances.

Thus, this paper addresses two main questions as follows. Firstly, what is the nature of the relationship between remittances and the current account in developing and transition countries, and secondly, does exchange rate policy influence how remittances affect the current account? This represents the foremost attempt to conduct an empirical analysis of the effect of the interaction between exchange rate regimes and remittances on the current account.

The next section discusses the specification of the model, presents the empirical methodology for the analysis and comments on the data set. Section 4 discusses the results, and section 5 presents some concluding remarks.

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# 3 Data and methodology

## 3.1 Description of the data

The data set consists of an unbalanced panel of annual observations for a group of developing and transition countries, covering the period, 1970-2014.<sup>2</sup> The data for exchange rate regimes is based on the Reinhart and Rogoff de-facto exchange rate regime (COARSE) classification, the current account data is from UNCTADStat database, eurodollar deposit rate is from the Federal Reserve System database, and the dataset for remittances and all other variables is from the World Bank’s World Development Indicators (WDI) database.<sup>3</sup> Table 1 presents a description of the exchange rate regime classification scheme. The applicable exchange rate regimes for this analysis vary between categories 1 and 5, with an increase in the index indicating a movement towards a more flexible exchange rate regime.

Table 2 shows descriptive statistics for the data on the main variables used in the analysis. As pertains to the variables of interest, current account as a percentage of GDP has a mean value of -4, but ranges between -44.7 and 50. Remittance receipts amounted to about 3.5 percent of GDP on average, and GDP per capita varies across countries over the sample period, ranging between US$219 and US$5665, with a mean of about US$1680. Table 3 presents correlation coefficients for remittances and the current account across the five exchange rate regime classes. Each regime class, with the exception of regime 3, shows a negative correlation between remittances and the current account. The estimates further show that when the regime classes are categorized into two groups only, as well as when the entire sample is considered, the correlation coefficient is negative in all cases.

Figure 1 presents a plot of the variation in remittances (% of GDP) and current account (% of GDP) in the Philippines and El Salvador between 1980 and 2013. Remittances as a percentage of GDP reached a peak of 13% in 2005 for Philippines, whereas the peak is 19% in 2006 for El Salvador. The current account as a percentage of GDP was at its lowest, -8%, in 1982 for Philippines, and -22% in 1981 for El Salvador. For both countries, there is not a clear pattern on how remittances relate to the current account. However, the graph shows that between 1999 and 2005, remittances

> 2 The selection of countries in the sample and the coverage period was on the basis of data availability.

> 3 Trade openness is measured as the sum of exports and imports expressed as a share of GDP.

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are associated positively with the current account in Philippines. Figure 2 plots mean estimates of remittances (% of GDP) and current account (% of GDP) for a randomly selected set of countries that are among the top recipients of remittances: Nigeria, Bangladesh and Philippines (remittances in US$); Lesotho and Nepal (remittances as percentage of GDP). The top panel shows a plot of mean estimates covering the period 1995 to 2011, and the bottom panel plots mean estimates for the period, 1980 to 2013.<sup>4</sup> For the period averages, a clear pattern emerges between remittances and the current account; the country with the highest average value for remittances (% of GDP) is associated with the lowest average current account balance (% of GDP) and vice versa.

# 3.2 Model specification and estimation

A number of empirical studies have examined the determinants and the sustainability of the current account using different approaches, and have featured a wide range of variables. Milesi-Feretti and Razin (1996) examine a number of indicators of current account sustainability for a group of industrial and emerging market economies, and identify variables including exchange rate policy, levels of savings and investment, trade openness and world variables like interest rate and GDP in industrial countries. Calderon et al. (2002) highlight variables like national savings, exports, debt, terms of trade and the real exchange rate. Chinn and Prasad (2003) specify a model that incorporates relative per capita income (to the U.S.), trade openness, government budget balance, financial deepening and net foreign assets.

In line with the literature, the set of control variables employed in this analysis include government spending, real exchange rate, gross domestic product (GDP) per capita, exchange rate regime, savings, investment and the eurodollar rate and GDP for OECD countries as a proxy for variables representing the state of the economy of the rest of the world. Net exports, net foreign assets and relative GDP (to OECD countries) are also subsequently introduced into the specifications as explanatory variables, to assess the robustness of the results.<sup>5</sup> The relationship between remittances and the current account balance is formally analyzed by specifying a static panel model that is estimated using fixed effects estimator, as well as a dynamic panel model that is estimated using a generalized method of moments (GMM) system estimator,

> 4 Nepal and Lesotho drop out of the bottom panel because of data limitation.

> 5 The choice of explanatory variables is determined by data availability.

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tailored to deal with potential endogeneity in all explanatory variables and particularly with the introduction of the lagged dependent variable as an explanatory variable.<sup>6</sup> The static panel model is given by The dynamic equation is represented by an autoregressive-distributed lag model of the form, This is a dynamic model for , where −1 is the one period lag of ,  is a vector of other explanatory variables, () is a vector of associated polynomials in the lag operator,  is a country specific effect which is unobserved, and  is an error term. The dependent variable for the analysis is the current account expressed as a percentage of GDP, and the main explanatory variables include remittances as a percentage of GDP, exchange rate regime, investment as a percentage of GDP, government spending as a percentage of GDP and an interaction term for remittances and exchange rate regimes. The interaction term is introduced to analyze the extent to which exchange rate flexibility influences the impact of remittances on the current account.<sup>7</sup>

# 4 Results

## 4.1 Preliminary estimates: static model specifications

The first set of estimates are based on the fixed effects estimator and the model specification given in equation (1), with a focus on the relationship between remittances and the current account, and a consideration for the role of exchange rate regimes. The existing literature provides some evidence for the variable impact of remittances on macroeconomic variables under different exchange rate regimes (Lartey et al., 2012; Lartey, 2015). The estimations, therefore, explore the hypothesis that exchange rate regimes and changes in exchange rate policy do generate variable effects of remittances on the current account. The approach adopted is to introduce the exchange rate regime as a control

> 6 The GMM system estimator has been applied extensively and discussed in a number of studies. See Blundell and Bond (1998) for details on the system GMM estimators.

> 7 For all estimations, I use a logarithmic tranformation of all variables, with the exception of the exchange rate regime index, remittances and the current account.

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variable, and an interaction term for remittances and exchange rate regime in the specifications. The results are given in Table 4. Remittances are shown to have a positive relationship with the current account contemporaneously, with estimates being statistically significant across all columns. The interaction of remittances and exchange rate regime is negative and statistically significant across the different model specifications as well. The initial regressions, therefore, indicate that flexible exchange rate regimes, in general, allow for dynamics that dampen the positive effect of remittances on the current account. The signs on the coefficient estimates for the control variables are consistent with what theory suggests in general. Of particular interest are the real exchange rate (negative), government spending (negative), savings (positive) and investment (negative).

# 4.2 Robustness checks

## 4.2.1 Comparing static and dynamic model specifications

A dynamic model is estimated based on the model specification in equation (2) to account for any potential persistence in the current account. In addition, the specification allows for the use of instruments to deal with any endogenous relationship between the current account and control variables like GDP per capita and the real exchange rate. Moreover, this set of regressions considers the sample without outlier observations for both remittances and GDP per capita.<sup>8</sup> The estimates are presented in Table 5, comparing estimates from the static model to those from the dynamic specification. Columns 1 through 3 feature estimates based on the fixed effects estimator, and 4 through 7 show results from the GMM system estimator.

These estimates are supportive of the preliminary results, and indicate that remittances are positively associated with the current account balance contemporaneously. However, the dynamic model estimates reveal that remittances have a negative impact on the current account with a lag. Moreover, the interaction term bears a negative and statistically significant coefficient based on the fixed effect estimates whereas the estimates for the dynamic model are not statistically significant.<sup>9</sup> This further signals a potentially weakening effect of exchange rate flexibility on the positive contemporaneous impact of remittances on the current account. The nonlinear combination

> 8 This accounts for high GDP per capita and remittance observations for some countries in the sample including China, India and Mexico to assess the impact on the estimates.

> 9 The one-period lag of the interaction term is included in the specifications in columns 6 and 7 of Table 5 but not reported. The coefficients are not statistically significant in both cases.

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of the coefficient on remittances and the interaction term, however, is positive, as reflected in columns 6 and 7. This suggests that impact of remittances on the current account is positive at the mean level of exchange rate regime (≈ 2).

The next set of regressions provides an additional check for the robustness of the preceding results by considering the sample excluding outlier observations for GDP per capita only, the results of which are presented in Table 6. The estimates from the dynamic model specification are consistent with respect to the contemporaneous standalone effect of remittances on the current account but mixed when considering the effect at one-period lag. There is still some evidence to suggest that exchange rate flexibility diminishes the positive contemporaneous effect of remittances on the current account, given the negative and statistically significant coefficients on the interaction term, particularly in column 6, where the non-linear combination of the coefficients on remittances and the interaction term is also positive and statistically signficant, but smaller in magnitude relative to the standalone effect of remittances. In terms of the impact of remittances with a lag, the coefficient is negative and statistically significant when the interaction variable does not enter the regression. The impact is positive, however, when the one-period lag of the interaction variable is included. The evidence, therefore, is inconclusive when considering the standalone effect as well as the interaction with exchange rate regime at one-period lag.

# 4.2.2 Introducing variant control variables

In order to account for other control variables that have been utilized in the extant literature, a variant specification of the model introduces relative GDP (to OECD countries), net exports and net foreign assets.<sup>10</sup> The results, as shown in Table 7, are generally supportive of the prior findings. Specifically, coefficient estimates for remittances are positive and statistically significant in all cases. Moreover, while the interaction of remittances and exchange rate regime is negative but not statistically significant across all columns, the nonlinear combination of the coefficient estimates for remittances, and the interaction of remittances and exchange rate regime is positive and statistically significant in all specifications, with the coefficient for the interaction being less than that for remittances in each specification.<sup>11</sup> Thus, the introduction of the variant control

> 10 Net foreign assets is proxied by the difference between savings and investment.

> 11 The introduction of the variant control variables causes a reduction in the number of observations due to missing observations for variables across different years, as well as the unbalanced nature of the panel.

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variables does not change the main finding, that the positive impact of remittances on the current account diminishes as exchange rate flexibility increases. It is noteworthy that each of the variant control variables that was introducted into the specifications bears the expected sign; relative GDP (negative), net exports (positive) and net foreign assets (negative) but only net exports is statistically significant across all specifications.

## 4.2.3 Accounting for cross-sectional dependence in errors

Panel-data models are likely to exhibit substantial cross-sectional dependence in the errors. The final set of estimations account for any potential cross-sectional dependence in the errors. A set of model specifications using the original explanatory variables as well as the variant ones are estimated and the results are given in Table 8. The estimates, for the most part, are consistent with the main results that an increase in remittances is positively associated with the current account contemporaneously, but when interacted with exchange rate regime, the coefficient estimate is negative and significant. The average effect of remittances on the current account when taking into consideration flexibility of the exchange rate, therefore, is lower than the standalone impact of remittances.

# 4.3 Quantitative implications of the estimates

The main quantitative implications of these results can be summarized as follows. When remittances expressed as a percentage GDP increases by 1, it will be associated, on average, with an improvement in the current account (as a percentage of GDP) contemporaneously by, between 0.6 and 1.1. This effect, however, decreases by, between 0.2 and 0.3 for a unit increase in the flexibility of the exchange rate regime (Table 4). Based on the estimations that exclude outliers for both GDP per capita and remittances (Table 5), an increase in remittances (% of GDP) by 1 will increase the current account (% of GDP) by, between 0.3 and 1.1. when considering the standalone effect. A focus on column (7) of Table 5 shows that the standalone effect of remittances is 0.7, but the effect at the mean level of exchange rate flexibility is about 0.5. Thus, although the interaction term coefficient is not statistically significant in this case, to the extent that the nonlinear combination of the standalone coefficient and the interaction term is found to be statistically significant, this can be considered as evidence to suggest that a unit increase in exchange rate flexibility diminishes 10
the contemporaneous positive effect of remittances on the current account balance by about 0.2. The statistical significance of the coefficient estimate for remittances (0.3), the interaction term, as well as the parameter estimate for the nonlinear combination of the standalone coefficient and the interaction term (0.1) in column 6 of Table 6 lend credence to this assertion. In addition, the estimates in Tables 7 and 8 indicate that the magnitude of the dampening effect of exchange rate flexibility on the positive impact of remittances on the current account could be larger. Still and all the results in Table 7 suggest on average, exchange rate flexibility would decrease this effect by, between 0.2 and 0.5.<sup>12</sup>

# 4.4 Discussion of the main results

One main finding of this study suggests that an increase in remittances will have a positive effect on the current account contemporaneously, which is consistent with the finding in Hassan and Holmes (2014) that more remittances facilitate a weakly sustainable current account balance. The results, however, also suggests on the contrary, that the lagged impact of remittances is negative, which is indicative of the existence of some underlying mechanisms that may cause the current account to deteriorate in subsequent periods, potentially the Dutch disease phenomenon.

The findings also suggest that when the exchange rate regime moves towards greater flexibility, the contemporaneous positive effect of remittances decreases. In comparison, based on the dynamics within a theoretical model, Lartey (2017) finds that a fixed exchange rate regime facilitates a current account deficit in the short-run, irrespective of whether remittances are allocated to consumption or investment, and that a monetary regime that combines inflation targeting with some flexibility in the nominal exchange rate delivers a current account surplus. These outcomes are observed because of the resource reallocation and movement in the price of nontradables that are generated by remittances, which tend to occur beyond the immediate aftermath of remittance inflow. Gnimassoun (2015) also shows that a flexible exchange rate regime performs better in terms of preventing absolute external imbalances, lending support to a policy stance that promotes exchange rate flexibility.

> In spite of these differences, the dampening effect of exchange rate flexibility on the impact of

> 12 Notably, the number of observations used in the regressions featured in Tables 7 and 8 represent a subset of the sample used in the other regressions.

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remittances on the current account is quite plausible, to the extent that remittances have been documented to generate real exchange rate appreciation with consequences for the external competitiveness of recipient countries. The following are potential mechanisms that underlie such an outcome. Foremost, the inflow of remittances causes a nominal appreciation, and consequently a real appreciation that decreases exports. Secondly, this is attributable to a nominal depreciation as remittances are allocated to imports which increases the value of imports. Notably, the diminishing effect of exchange rate flexibility is also observed at a one-period lag.

# 5 Conclusion

This paper examined the effect of remittances on the current account in developing and emerging economies, with analysis of the extent to which exchange rate flexibility influences the dynamics of the relationship. Although the paper shows a positive contemporaneous effect of remittances on the current account, it also suggests the existence of the Dutch disease phenomenon. The results also show that an increase in exchange rate flexibility dampens the observed positive effect of remittances on the current account. It is noteworthy, however, that the moderating impact of exchange rate flexibility likely highlights the more immediate effects of remittances on the current account, potentially through the appreciation of the nominal exchange rate.

These findings suggest that policy makers face trade-offs as pertains to the use of exchange rate policy in managing the effects of remittances on the current account, in that while exchange rate appreciation following the inflow of remittances could either reduce surpluses or increase deficits in the current account, the results from existing studies are generally supportive of flexible exchange rate policies in dealing with some of the unfavorable effects of remittances beyond the short-run, particularly the Dutch disease phenomenon. Moreover, it is arguable that limiting exchange rate flexibility as a policy option would likely lead to currency overvaluation, if adopted for an extended period, and would potentially trigger a sharp depreciation and decline in the current account subsequently, with potentially disastrous consequences for these economies.

Policy makers, therefore, should give consideration to these trade-offs associated with exchange rate policy choices aimed at addressing the potential dynamics in the current account precipitated by an increase in remittances.

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