The Macro-Economic Impact of Remittances in Latin America- Dutch Disease or Latin Cure?

The Macro-Economic Impact of Remittances in Latin America-
Dutch Disease or Latin Cure?

Claudio Loser, Caitlin Lockwood
with Adam Minson, and Lucia Balcazar
of the Inter-American Dialogue1

1. Remittances and Macroeconomic Flows - Introductory Remarks


The Report of the Inter-American Dialogue’s Task Force on Remittances, All in
the Family: Latin America’s Most Important International Financial Flow, states that
remittances constitute the most important source of new funds for the region. In 2005 the
amount of remittances is estimated to have exceeded $53 billion, some 2 ½ percent of
regional GDP. This is a significant amount by any standard. It is equally remarkable that
these remittances are largely concentrated in just a few countries. According to IDB and
ECLAC data for 2005, when total remittances amounted to US$53.6 billion ($40 billion
from the United States), most are destined for Mexico ($20 billion), Brazil (estimated
$6.4 billion), Colombia ($4.1 billion), Guatemala ($3 billion), El Salvador($2.8 billion),
Dominican Republic ($2.7 billion), and Ecuador($2 billion). Remittances as a percentage
of GDP were as high as 19 percent for Jamaica, 17.1 percent for El Salvador and 16.9
percent for Nicaragua.


Remittances are comparable in magnitude to private capital flows to the region. In
recent years, remittances have even exceeded capital inflows. This large volume of
remittances raises a number of important questions about their effect on economic
outcomes in Latin America.


Most research has focused to a large extent on the microeconomic and
banking/transfer aspects of remittances, with only a cursory discussion of the
macroeconomic aspects of these flows. For example, the economic analysis of
remittances has been covered very effectively in the recent past by H. Rapoport F.
Docquier, in “The Economics of Migrant Remittances.”2 It differs from the current
presentation, however, in that it discusses the implications of emigration and remittances
on resource allocation and relative prices, but does not explore in detail the links of
remittances and macroeconomic balances.


1 This paper was written, during Mr. Loser’s tenure as Senior Fellow at the Inter-American Dialogue, Adjunct
Professor of Economics at George Washington University, and more recently member of Centennial Group
Latin America. The IDB provided support at the early stages of the projects as part of their continued interest
on the subject. The draft has benefited particularly from the authors’ association with the Inter-American
Dialogue, and his President Peter Hakim, as well as Mr. Loser’s previous thirty year association with the
International Monetary Fund. The authors want to thank Virginia Sopyla for the support work during her
internship at the Dialogue. Of course, all assertions and all possible mistakes remain the sole responsibility of
the authors.

2 Rapoport, Hillel, and Docquier, Fredric-The Economics of Migrants’ Remittances, in Handbook on the
Economics of Reciprocity, Giving and Altruism, Varet, Kolm and Ythier, Editors.;North Holland (2003)

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As scholars worldwide have begun to lend more importance to the
macroeconomic impacts of remittances, the literature on this subject has grown.3 Some
questions that this study seeks to address are how remittances impact (a) the external
current account, (b) the exchange rate, (c) domestic interest rates, (d) domestic savings,
(e) investment and (f) GDP growth?


A related concern is the possibility of the so-called Dutch disease, defined as the
appreciation of the currency in response to new flows.4 The appreciation of the currency
will have an adverse effect on other sectors of the economy, and will change their growth
prospects. The effects and policy responses depend on whether the remittance flows are
taken as short-term or long-term phenomena. If they are seen as a short-term
phenomenon, fiscal and monetary policy intervention may become advisable. However,
if, as is most likely, the flows are of a longer-term nature, the receiving country would
need to accept that the remittances are there to stay and will have to make more
fundamental and lasting macroeconomic adjustments.5 To the extent that recipients save
in the financial system (which to date has been a small proportion of total flows) the
monetary policy may need to change. Also, policies will depend on the extent that
recipients spend domestically (e.g. construction) or externally (e.g. imports of goods and
services), with different effects on the exchange rate.


The overall response of remittances to cyclical conditions is also important. These
flows constitute voluntary and targeted flows that seek to improve the conditions of
family members in the countries of origin.6 Flows may increase with improved economic
conditions in the country of residence of remitting individuals, and also in response to
deteriorating conditions in the country of origin. In the latter case, these flows will have a
stabilizing effect at times of crisis.


This study is devoted mainly to the questions outlined above, and incorporates a
review of the literature. Furthermore, it provides a set of conclusions and
recommendations regarding the adjustment of domestic policies to these flows. The goal
is to provide the best conditions for macroeconomic stability and economic growth in the
recipient countries, while preserving the core objective of remittances, namely to benefit
those individuals that receive these transfers and their families.




2. Conceptual issues and related review of the literature

3 See Durand, Kandel, Parado, and Massey, 1996 for a broad discussion of macroeconomic issues. See Buch
and Kuckulenz, 2004 for links with capital flows. See Solimano, 2003, and Lowell, 2005, for links to remitting
countries.
4 The term Dutch disease originated from the effect that gas findings in the North Sea had on the Dutch
economy. It was found that the increase in the supply of exports would lead to an appreciation of the local
currency, with an adverse effect on other exports or import competing items. The term is now used as a
description of the same or equivalent (higher prices for commodities) effects in other economies.
5 Amuedo-Dorantes and Pozo, 2004 and Rajan and Subramanian, 2005 analyze this effect.
6 Global Economic Prospects 2006, World Bank; Guiliano and Ruiz-Arranz, 2005.

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a) Remittances and the Macroeconomic Accounts


Remittances are incorporated into the national accounts of the receiving economy
as a transfer from abroad. As such, they go directly into the expenditure path of the
economy, and are oriented either toward consumption of goods and services (food,
shelter, education), or otherwise savings and investment.


Leaving aside the complex issue of whether the emigrants would have provided
greater value added residing in their country of origin, the money they remit plays a
positive role in the economy. It contributes to national savings, except when the entire
remitted amount is consumed. The savings take the form of direct investment, cash, or
deposits into the financial system. Chart 4 provides an illustration of the contribution of
remittances to domestic investment. On the assumption that the percentage of savings
from remittances is equivalent to that from the overall economy (no hard macroeconomic
data is available to prove a different assumption), the chart shows that remittances
contribute an increasing proportion of resources for domestic investment, possibly
substituting for some domestic savings, while foreign capital inflows have declined in
importance. 7


The key point to keep in mind is that remittances will have to be accommodated
within the macroeconomic flows of the economy. In turn remittances will be reacting to
underlying conditions in the economy. As remittances come into the receiving economy,
expenditure and savings will tend to increase. The increase of expenditures, as illustrated
below, will put pressure directly on some accounts within the balance of payments, as
imports increase, and exports decline, because of increased domestic demand. This effect
will take place directly through an increase in the demand for “tradable” goods (exports
and imports), or through changes in relative prices. In simple terms, as domestic demand
increases because of the purchasing power of remittances, domestic prices and wages will
tend to rise, in practice resulting in a real appreciation of the local currency. This
phenomenon, discussed below as “Dutch disease”, would result in a loss of
competitiveness for some exports and import substitutes, and thus in an increase in
imports and lower exports as well. In any circumstance, this will have an impact on the
balance of payments (as illustrated in the next section).

Other macroeconomic effects would come about from the increased availability of
resources for savings, which could be reflected as a result in more resources and lower
interest rates, thus inducing higher investments. This is illustrated in chart 1, which shows
the effect of an increase in remittances on the equilibrium in the external and the
domestic market. The chart shows the curve X, which provides the balance between
interest rates and the exchange rate, where depreciation is shown as an increase.

7 One possible simplification is to include all remittances as part of savings, thus underestimating the
contribution of domestic savings. This assumes that remittances displace all other savings and do not
contribute whatsoever to consumption, although it can be expected that there will be some substitution
between domestic savings and remittances. The assumption used in this paper is more realistic, and still shows
an increasing importance of these flows in financing investment.


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Increased remittances are reflected by a shift downward to X’, as additional foreign
exchange can be adjusted by an appreciation or lower interest rates and capital inflows.
The equilibrium exchange rate appreciates and the interest rate declines, to attain
equilibrium in the external and the domestic market (DD). Box 1 provides a description
of the formal model on which the graphs are based, and that incorporates remittances to
the macroeconomic accounts.

Chart 1
Exchange
1. An increase in remittances
X
Rate
leads to a decline in interest rates
X”
and an appreciation of the
currency
D
X’
e
2.Increases in imports partly reverse
the effect of remittances on the
e”
exchange rate and interest rates
e’
X
D
X”
X’
Interest
Rate


Remittances will respond to changes in economic conditions in the receiving
country. An external shock that affects domestic income will tend to induce emigrants to
send money to their families and thus offset in part the adverse effect on the external
crisis, by providing a stabilizing impact that may act as a strong countercyclical
mechanism. This has been the evidence in the region in recent years, particularly as
remittances have become a significant portion of foreign receipts. Moreover, this
countercyclical effect on remittances will tend to be magnified to the extent that an
external shock results in a balance of payments crisis, and a more depreciated currency,
that tends to induce greater remittance inflows because of increased opportunities for
remitters. This is illustrated in Chart 2, which shows the combined effect of a balance of
payments crisis, a domestic adjustment, and the reaction of remittances to deteriorating
conditions in the receiving country. The external shock may require adjustments in the
interest rate and exchange rate that may be further accentuated if the government needs to
make further adjustments to deal with the decline in resources from abroad. In turn, the
increase in remittances, may lead to some appreciation of the currency, but the end result
will be that the currency depreciates after all movements have taken place. Interest rates,
on the other hand will end up below the intermediate equilibrium, but the final outcome is
uncertain.


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Chart 2
X’
2. A fiscal tightening to offset the decline
Exchange
in foreign flows reduces iD’
nterest rates,
X*
Rate
X
and results in a depreciation
D
3. Increased remittances will help
e**
reduce the needed depreciation,
and interest rates but the
e*
e’
outcome for interest rates is
ambiguous
e
e
X’
D’
1. An external crisis (lower inflows)
shifts curve X from X to X’. Increased
X*
D
remittances shift the curve to X*
X
Interest
Rate

Chart 3 shows the traditional macro economic IS model, making explicit the
external sector (XX), and leaving the monetary sector (LM) as an implicit adjustment
mechanism typical of an open economy. The chart shows the moderating effect of an
increase in remittances, in response to a negative external shock accompanied by a pro-
cyclical (tightening) fiscal policy, to accommodate lower real income and capital inflows.
This would be the typical case of a country with limited reserves and low access to
countercyclical financing. Remittances are shown to allow for a higher level of
expenditure, offsetting in part the effect of adverse external conditions. Of course, if
remittances are adversely affected by external conditions, this positive effect would be
partly offset as well. For example, remittances will tend to be reduced if income in the
remitting country (say the US or Europe) declines, with adverse consequences on the
income of the immigrants.

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Chart 3
X**
X*
Interest
IS
Rate
IS”
X
1.The external balance is
affected by external adverse
events
3.Equilibrium income wil be
higher with remittances (e*),
than without them (e**),
providing counter-cyclical
e*
adjustment during hard times.
2.Fiscal Adjustment becomes
e**
necessary as there is less
e
availability of resources for the
government because of adverse
external conditions
IS
X** X*
IS”
X
y** y* y
Income


In the end, the results will depend on the overall behavior of the economy, and
cannot be subject to broad generalizations. The next sections seek to explore some of
these aspects, supported by the discussion of the more formal model in Box 1. 8

8 These illustrations present a look at the links between remittances and key macroeconomic
variables. Even though the charts reflect different markets, they describe the same phenomena, based on
stylized assumptions that simplify the discussion of the behavior of the domestic economy and foreign
markets. However, they help understand the complex relations among variables and how they may end up
showing up in “unexpected” results from a simple partial equilibrium point of view.



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Chart 4
Financing of Investment
(Simple average for 7 countries)
100%
80%
60%
40%
20%
0%
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Savings from Remittances
Foreign Borrowing
GNS - Savings from Remittances



The literature on remittances shows contradictory results with regard to the
behavior of remittances in response to changing conditions in the receiving country.
Rajan and Subramanian found that remittances had no real impact on alleviating
financing constraints throughout the 1990s in a broad range of countries (Rajan and
Subramanian, 2005, p 20). By contrast, other studies have shown that remittances impact
macroeconomic accounts by acting as a source of financing for countries that otherwise
have fairly restricted options. In this regard, banks in several countries in Latin America,
including Brazil, El Salvador and Mexico, have begun using the securitization of future
remittance flows in order to raise inexpensive and long-term financing from international
capital markets. For example, between 1994 and 2000, Mexico, El Salvador and Turkey
were able to raise about $2.3 billion through remittance securitization (World Bank,
Global Economic Prospects, 2006, p 103). Ketkar and Ratha offer another example – in
August 2001, Banco do Brasil issued $300 million five-year bonds using as collateral
future yen remittances from Brazilian workers in Japan (Ratha, 2003, p 161). Giuliano
and Ruiz-Arranz show that remittances can help alleviate credit constraints and work as a
substitute for development finance (Giuliano and Ruiz-Arranz, 2005). While it would be
tempting to suggest, that the increase in remittances resulted in a decline in foreign
financing, this may be an oversimplification. Foreign financing and investment have
declined in recent years as a consequence of the increasing absorption of world savings
by the US, and the perceived reduced (reduced perceived?) attractiveness of the region as
a destination of private capital (chart 4).

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Chart 4
Financing of Investment
(Simple average for 7 countries)
100%
80%
60%
40%
20%
0%
1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Savings from Remittances
Foreign Borrowing
GNS - Savings from Remittances



An important but insufficiently developed issue is the impact of remittances on
total investment and economic growth. Different researchers are not in agreement about
whether or not remittances serve as an important source of investment capital. The basic
principle is that either directly or through the process of intermediation and leverage,
remittances will tend to increase investment, as shown above, thus increasing potential
growth.


Durand notes that, in the case of Mexico, under the right circumstances (a high-
paying US job, secure attachment to the US labor force, access to complementary
resources in Mexico), the odds of productive investment of remittances rise substantially
(Durand, Kandel, Parrado, Massey, 1996, p 261). Some studies indicate that remittances
from the United States are accountable for about one fifth of the capital invested in
micro-enterprises in urban Mexico (Ratha, 2003, p 162). A study conducted by Mishra
found that a one percentage point increase in remittance inflows in 13 Caribbean
countries increased private investment by 0.6 percentage point (all measured relative to
GDP) (Global World Prospects 2006, World Bank, p 104).9 10

9 Brown’s regression analysis concluded that in addition to support family needs, Pacific islanders are motivated to remit for
reasons of self-interest, especially for asset accumulation and investment in their home countries. As such, their remittances
are vital as a major source of loanable funds for investment (Brown, 1997, p 623).
10Bouhga-Hagbe’s study of Moroccan immigrants finds that “there is no evidence that portfolio diversification motives
could be behind the remittances in the long-run” and that the price index for housing “does not show any specific pattern
that could significantly tie real estate construction by Moroccans living abroad to some form of investment”
(Bouhga-Hagbe, 2004, p 14) In his assessment of the growth impact of remittances in the Mediterranean
countries of Greece, Morocco, Jordan, Portugal and Egypt, Glytsos warns that “the growth generating capacity
of rising remittances is much smaller than the growth destroying capacity of falling remittances” (Glytsos, 2001,
p 16). He establishes this by demonstrating that the elasticities of negative growth are much higher than the
elasticities with respect to rising remittances. He suggests that strong negative growth occurs because
remittance receivers become comfortable spending during long periods of stable remittance flows and do not
save or invest much of money they receive in case of economic downturn.

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Of course the process of investment and economic growth cannot be extricated
from other developments, like domestic policies, and changes in the availability of
foreign financing, which will affect the way remittances may contribute to investment.
Thus it becomes extremely difficult to determine empirically the exact contribution of
remittances to total investment, unless it is possible to assume that all other external
factors remain unchanged.11

Box 1: The Underlying Macroeconomic Model for Remittances
The basic macroeconomic identity of income and expenditure for a receiving country can
be modified to include remittances, as follows:
Y = C + S + S + T + (X + R − M − M ) , (1) for income
d
d
r
d
r
Y = C + C + I + G , (2) for expenditure
d
r
(S + S − I ) + (T − G) = (X + R − M − M ) , (3) for the domestic balance;
d
r
d
r
Where
Y is national income; C is consumption; S is saving; T is taxes; X is
exports; R is remittances; M is imports; I is investment; and G is government
expenditure. The subscripts d and r , refer to domestic and remittance related, e.g. C is
r
consumption out of remittances. Remittances in this definition is defined as excluding
emigrant expenses in the form of travel to the home country and nostalgic (home related)
consumption, which would be accounted as increased exports of goods and services.
If for purposes of the argument, it is assumed that the public accounts are balanced, that
is (T = G) , the equation becomes
(S + S − I ) = (X + R − M − M ) , (3’), or
d
r
d
r
(S + S ) = (X + R − M − M ) + I , (4)
d
r
d
r
and (X + R − M − M ) = −KI ,
d
r


Where KI represents net capital inflows.

Equation (4) can be seen also as follows,
I − KI = S + S .1 , where savings is equivalent to total investment less capital flows.
d
r
These equations represent the macro-accounting of remittances.

11 See among others, Global Economic Prospects, World Bank, 2006; Durand, Kandel, Parrado, and Massey,
1996; Ratha, 2003; Brown, 1997.

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The link of remittances with key macroeconomic variables can be presented in a stylized
fashion on the basis of the following set of equations:
The Foreign Exchange Balance is defined by the following relationship

XXB = 0 = f (ER,i, fd, R) (1)

Where XXB is the external balance, ER is the exchange rate (local currency in terms of
foreign currency), i is the domestic interest rate (assuming no change in foreign interest
rates), fd is foreign demand conditions in the goods and capital markets, and R stands
for remittances.

∂XX
∂XX
∂XX
Furthermore,
> 0 ;
> 0 ;
> 0 1
∂i
∂fd
∂R

The Domestic Demand Balance is defined by

DDB = 0 = f (ER,i, D ; D ) ( )
2
fp
mp

Where D stands for domestic fiscal policy conditions and D for monetary policy
fp
mp
conditions and weaker policies are described as having a positive (expansionary)
direction.
∂DD
∂
∂
∂
>
DD
DD
DD
0 ;
> 0 ;
> 0 ;
> 0
∂ER
∂i
∂D
∂D
fp
mp

b) Remittances and the Balance of payments


As noted, remittances constitute a voluntary and unilateral transfer of resources to
the receiving country, and as such appear in the current account of the balance of
payments, and national accounts (Box 1)


Remittances can be expected to cause a widening of the external trade account
deficit (including services as travel), or a narrowing of the current account surplus. As
remittances increase purchasing power in the receiving country they augment domestic
demand. Bouhga-Hagbe found that in the case of Morocco, “remittances almost cover the
trade deficit and have contributed to the recent surpluses of the external current account,
as well as the overall BOP. The BOP surpluses have contributed to the strengthening of
Morocco’s external position through the accumulation of reserves, which now cover the
external public debt (Bouhga-Hagbe, 2004, p 10).12A related phenomenon, resulting in
positive flows, is the nostalgic expenditure of emigrants described by Orozco.13 This

12 El-Sakka and McNabb found that imports financed with remittances depend on the level of income in Egypt and on the
relative price for imported goods and their domestic substitutes (El-Sakka and McNabb, 1999, p 1500).
13 Orozco and Lowell, 2005; Orozco, 2004

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