Diaspora Financing: How Remittances Affect Developing Countries

Updated: Aug 24

By Vivian Zhang

Worldwide, one in nine people are supported by remittances, transfers of money from migrant workers abroad to their families in native countries. Pro-remittance arguments are undoubtedly strong. Remittances are free of the repayment obligations that are tied to capital flows and the political conditions that come with foreign aid. Unlike government-to-government aid, remittances do not require potentially corrupt regimes to serve as intermediaries; there is little bureaucracy, and three-quarters of remittances go directly towards food, rent, education, and other essentials. The majority of remittances are sent to rural areas, where leftover money is injected into savings accounts or used in investments to stimulate the local economy. In many developing countries, the banking system is known for under-serving the poor; remittances are a source of stable income that decreases financial stress. In terms of the quantity of money transferred, remittance flows in conflict-affected situations represent 5 times foreign aid and foreign direct investment and are far more stable. Remittance-securitized bonds are a borrowing option that receives high credit ratings, lowers government borrowing costs, and decreases government dependency on western financial institutions; with the growing popularity of remittances comes access to a wider range of investors. Thanks to remittances, there is improved educational attainment and living conditions in many of the most impoverished regions. As such, one of the UN 2030 Sustainable Development Goals is to limit the cost of transferring remittances to 3 percent of the total amount sent, a significant decrease from 10 percent of the total sent in the Philippines and African corridor right now.

According to the World Bank, remittances represent the greatest share of GDP in Tonga, Haiti, Nepal, Tajikistan, and the Kyrgyz Republic, small economies with independent currencies. In 2018, remittances as a percentage of GDP were 40.7 percent in Tonga, 32.5 percent in Haiti, 27.8 percent in Nepal, 29.0 percent in Tajikistan, and 33.2 percent in the Kyrgz Republic. Given these shocking proportions, it is worth asking: what are the effects of remittances on the inflation rates of economies with a high proportion of GDP coming from overseas? Should their governments be decreasing dependency on foreign inflows, and could the UN SDG on transfer costs incentivize an unhealthily high number of remittance transfers?

Through economic theory, we can explain the inflationary pressures linked to remittances. When a family in a developing country receives a transfer, their income expands. An increase in household income translates into a decrease in labor supply, as individuals constantly make trade-offs between income and leisure. There is likely already a shortage of labor supply, given that the remittances come from migrant workers who left the labor market in the developing country to seek opportunities abroad; brain drain is a major challenge. Since the labor supply shrinks, producers must pay higher wages per unit of the output they manufacture. Higher production costs lead to a contraction of the tradable sector, increasing inflation. Economists have developed literature on the general connection between remittances and inflation rates. In 2011, Narayan et al. studied 54 developing countries, finding that the effects of remittances on inflation become far more prominent in the long run. Ball et al. used a regression technique to study 21 countries in 2012, reporting that remittances increase inflation in only fixed exchange rate regimes. In 2014, Khan and Islam studied remittances in Bangladesh, discovering that for every 1 percent increase in remittances, long term inflation increased by 2.48 percent. Interestingly, most economies with a large proportion of GDP derived from remittances have fixed exchange regimes: pegged currency, money aggregate targets, and other exchange rate anchors. Thus, most of the literature suggests that remittances would contribute to long-run inflation.

Furthermore, some worry about Dutch Disease, a term coined by The Economist after the Dutch discovered large gas reserves in 1959. Foreign currency from the UK, the US, Canada, and other popular destinations for migrant workers pours into small, developing countries and is converted into a domestic currency. Most of this money is spent within that developing country, on essentials such as food, infrastructure, and local services, leading to demand-pull inflation in the consumer market. Since more of the local currency is demanded in the currency exchange market than before, the money supply rises and real exchange rates increase. Many small economies are export-based and dependent on maintaining low prices for buyers abroad; the net remittance recipient thus has difficulty competing in the long-run global market. To worsen this issue, remittances are rising in popularity. On average, worker remittances increased fivefold from 1990 to 2004; this growth seems to be a recipe for inflation and high real exchange rates.

The impact of remittances on small economies is largely determined by the fiscal policies of national governments. Without remittances, the people push governments to build basic infrastructure and fund all of it. With remittances, migrants often pool their money, creating something called “hometown associations” to fund public projects. This can lead to a moral hazard; with the government’s duty to cater to the people taken care of, leaders may become complacent. Government projects are meant to protect citizens at times of economic shock, but it is difficult to do so when there is no robust social safety net. Moreover, when a significant portion of public funds come from migrant workers abroad, instability in the financial systems of other countries easily spreads to small developing economies. However, if governments are willing to play a more active role in community-wide projects, instability is less of a concern. For instance, the Mexican state of Zacatecas implemented a program called Dos por Uno beginning in 1993. The government matched every dollar that citizens contributed to hometown associations. Not only did the program encourage residents to donate more, but it also demonstrated that governments do not all become detached from public spending. Depending on the administration’s policies, remittances can either crowd out public spending or increase the total pool of funds.

Another major critique of the UN’s plan to decrease remittance transfer costs is that it would increase emigration, removing a young and vital force from a developing economy. However, this is not a fair comparison. The reality is that many of the countries that rely heavily upon remittances have small economies. Migrant workers would likely pursue jobs abroad either way since they are attracted by higher wages, better conditions, and appealing educational opportunities abroad; these are pull factors that exist regardless of the UN’s Sustainable Development Goals. At most, the UN would be cutting the profit of wealthy banks that take advantage of migrant workers eager to send money home.

Critics of remittances also claim that when decreasing the labor supply, remittances take more women out of the labor market than men. Though this is an interesting observation about gender divides, this unfortunate outcome is linked more to the social attitudes of the country than remittances themselves. If women are the first to leave the workforce, they likely did not hold very high-up positions to begin with in the labor market; we are talking about countries where their options are limited to menial labor or other low-skilled work. Governments should encourage all remittance recipients to continue with their jobs, but this is not a reason to stop remittances.

Remittances, if combined with the correct set of government policies, are beneficial on net to the development of many economies. Rural communities can access improved infrastructure, governments can become less dependent on foreign lenders, and educational attainment can increase even in countries with small economies.