Remittances and the real exchange rate
Humberto López, Luis Molina and Maurizio Bussolo[*]
Abstract
Existing empirical evidence indicates that remittances have a positive impact on a good number of development indicators of recipient countries. Yet, when flows are too large relative to the size of the recipient economies, as those observed in a number of Latin American countries, they may also bring a number of undesired problems. Among those probably the most feared in this context is the Dutch Disease. This paper explores the empirical evidence regarding the impact of remittances on the real exchange rate. Our findings suggest that indeed remittances appear to lead to a significant real exchange rate appreciation. The paper also explores policy options that may somewhat offset the observed effect.
I. Introduction
Existing empirical evidence (Fajnzylber and Lopez, 2005) indicates that at the country level higher remittances inflows tend to be associated with lower poverty indicators and higher growth rates. Beyond these typical income dimensions of welfare, remittances seem to reduce output volatility (a measure of risk faced by countries[1]), and at least in some countries and for some socio-economic groups lead to improvements in social indicators. Yet, the magnitude of these flows relative to the size of the receiving economies[2] implies that remittances may also pose an important number of challenges. For while these inflows may ease external financing constraints and therefore hold the potential for higher investment by developing countries, in many circumstances remittances are so large that they can impact macroeconomic stability and more specifically carry a potential for Dutch Disease type of phenomena (see the International Monetary Fund’s World Economic Outlook 2005, and the Work Bank’s Global Economic Prospects 2006).
Workers remittances can be viewed as a capital inflow, and therefore the theory on the Dutch Disease phenomenon associated to surge in inflows (perhaps because of a discovery of new natural resources) can also be applied in this context. In order to isolate the specific channels transmitting remittance shocks through the economy, consider first a small open economy model with no leisure-consumption trade off. In this setup, an increase in remittances is equivalent to a (permanent) increase in incomes of the households.
Assuming that non-tradables are normal goods, this positive income shock results in extra spending on both tradables and non-tradables. Since most Latin American countries are price takers in international markets, a growing demand does not raise prices of tradables. However, since the prices of non-tradables are determined in the domestic economy, they increase due to additional demand, the so-called ‘spending effect’. There is also a ‘resource movement effect’. The relative price change between tradables and non-tradables makes production in the latter more profitable. Output growth in the non-tradable sectors will push up factor demands, especially for those factors used intensively in these sectors. Increased factor demand by the expanding sectors will be accommodated by factors released from other sectors (the resource movement effect) and, depending on the behavior of total supply of factor, will normally result in higher factor returns in the final equilibrium. The price shift and resource reallocation in favor of non-tradables erode the competitiveness of export oriented sectors and hurt import competing sectors. The final result of this real exchange rate appreciation is normally increased import flows and lower export sales. When the above assumption of no consumption-leisure trade-off in the household utility function is removed the above effects are exacerbated. Without this assumption, an increase in non-labor income, as is the case with remittances, influences household decision to supply labor; namely, individuals can now consume more of both goods and leisure (i.e. the income effect dominates) and thus their labor supply is reduced. In turn, reduced labor supply implies raising wages and this additional pressure on wages intensifies the effects of real exchange rate appreciation described earlier.
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;[3]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 connectedmacroeconomic effects that can result from a real exchange rate appreciation associated to remittances flows. They include the following:
- Adverse effects on the tradable sector of the economy. 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.[4]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.
- Widening of the current account deficit. 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.
- Weaker monetary control, inflationary pressures, and the sectoral allocation of investment. 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).
On the whole, the previous discussion highlights a number of problems that policy makers may have to face in the context of a surge in remittances. True, to the extent that these Dutch Disease phenomena are part of the natural adjustment process towards a new equilibrium, they should not be a matter of particular concern for policy makers. Indeed, if we view remittances as a positive shock to the economy, then the real appreciation and related effects experimented by the receiving country would simply be part of the inevitable relative price adjustment process that goes with favorable shocks. Yet if this real appreciation is very dramatic, or the adjustment process towards the new equilibrium is uneven (i.e. not fully consistent with the change in economic fundamentals at each point in time) policy makers may wish to mitigate, to the extent possible, its adverse effects on export industries.
In principle, one could also mention two additional reasons of concern for policy makers that are usually mentioned in the context of surges of capital inflows. One is the potential for a flow reversal over the medium run. This is important because if there is hysteresis in the real sector, a real exchange rate appreciation may wipe out important sectors of the economy that would not reappear even if the currency subsequently depreciates. The other potential concern is a very sudden appreciation that cannot be accommodated and therefore brings a very painful adjustment. However, it must be noted that the documented stability[5] and counter-cyclicality of remittances would lead one to assume that the probability of short-run reversals or sudden adjustments is quite low, leaving as main reason for concern the magnitude of the real appreciation associated to the remittance inflows.
Against this background, what does the economics literature has to say about the evolution of the exchange rate in countries that have experienced important increases of remittances? The truth is that the existing empirical literature is very limited and less than unanimous. For example, Amuedo-Dorantes and Pozo (2004) rely on cross country econometrics techniques and find that in a sample of 13 Latin American countries[6] a doubling of workers remittances would lead on average to a real exchange rate overvaluation of about 22 percent. This estimate would be robust to the presence of fixed effects in the data, and to the use of IV estimation techniques to account for reverse causality from the exchange rate to remittances.
However, Rajan and Subramanian (2005), who rely on a cross national dataset of 3-digit industry value added growth data to explore whether remittances have a differential impact depending on the labor intensity of the different industries, find that unlike other types of capital flows (particularly aid flows) remittances do not seem to have a negative impact on external competitiveness. Rajan and Subramanian (2005) argue that this could be the result of remittances being directed to a large extent towards unskilled-labor intensive activities – e.g. goods and services provided by micro-enterprises – and/or tradable sectors such as manufacturing, and thus having limited effects on the prices of skilled labor and other relatively scarce resources.
This paper addresses these issues and contributes to the existing limited literature along several dimensions. First, it discusses the different channels through which remittances can affect the real exchange rate using a framework where the equilibrium exchange rate is characterized by an external equilibrium similar to those analyzed in asset market models (Mussa, 1984 and Frenkel and Mussa, 1985) and an internal equilibrium based on a productivity differential model as those in Balassa (1964) and Samuelson (1964).
Second, it provides estimates of the impact of remittance flows on the real exchange rate using a large cross national data set rather than information for a limited number of countries. Our approach allows testing whether there are regional differences and more specifically whether Latin America is different in this context. Note that one of the main differences between the work of Amuedo-Dorantes and Pozo (2004) and Rajan and Subramanian (2005) is the coverage of the data. Thus if the impact of remittances on the real exchange rate is different in Latin American than in the rest of the world, then the different findings of Amuedo-Dorantes and Pozo (2004) and Rajan and Subramanian (2005) should not be surprising. In fact, to anticipate some of the results in Section IV, this paper argues that remittances flows appear to affect the real exchange rate at a global level and that Latin American countries do not appear to be an exception. These results are robust to the presence of fixed effects in the data, potential reverse causality from the exchange rate to remittances, and variations in the set of control variables.
Third, the paper also explores the extent to which the estimated appreciation in Latin America is consistent with the change in economic fundamentals implied by the increase in remittances or instead whether it can be attributed to changes in the misalignment component of the real exchange rate (i.e. changes in the underlying real over/undervaluation of the currency). To also anticipate our results on this, we find that the evolution of the Latin American real exchange rate seems to be driven by a combination of changes in the equilibrium real exchange rate and changes in the degree of misalignment.
Finally, on the basis of its empirical results the paper discusses a number of options for policy makers concerned with the impact that a surge in remittances may have on the external competitiveness of the country. In particular, we discuss the possibility that a revenue-neutral policy of a partial switch from direct to indirect taxation may reduce labor costs and thus(at leastto a degree) sterilize the negative labor supply effect as well as the real exchange rate appreciation due to rising remittances—an encouraging outcome for countries under budget constraint pressure. The rest of the paper is organized as follows. In Section II we consider an additional number of theoretical considerations that may explain why remittances may lead to a real exchange rate appreciation and review the evolution of remittances, the real exchange rate, exports and imports for the 8 largest receivers of remittances (as a percentage of GDP) in Latin America. Section III reviews the empirical strategy used to assess the impact of remittances on the real exchange rate. In Section IV, we present the results of estimating two econometric models. One relates changes in the real effective exchange rate to the ratio of remittances to GDP. The second uses as explanatory variable the changes in a measure of real exchange rate overvaluation. The basic idea here is trying to disentangle how much of the observed changes in the real exchange rate are due to changes in the equilibrium exchange rate and hence consistent with the evolution of economic fundamentals. Section V discusses whether one specific policy option (shifting the tax structure from direct towards indirect taxation) can contribute to somewhat alleviating the loses in competitiveness that seem to come associated to a surge in remittances. Note that this intervention would aim at expanding the labor supply. Finally Section VI closes with some conclusions and a review of policy options.
II. Remittances and the real exchange rate.
Theoretical considerations
Remittances can potentially affect the real exchange rate through three main channels (see the technical annex for a formal discussion). First, remittances may affect the external equilibrium of the economy by raising the net foreign asset position of the country. For example, the theoretical models of Mussa (1984), Frenkel and Mussa (1985), Alberola and Lopez (2001) and Aberola et al. (2002) imply that the external equilibrium of the economy will be reached when any current account imbalance is compensated by a sustainable flow of international capital. In turn, the rate of sustainable capital flows will be a function of the stock of foreign assets and liabilities of the economy, so that changes to the net foreign asset position of the country will lead to changes in the real equilibrium exchange rate.
Given that international remittances are transfers of foreign currency that unlike other types of international flows have no obligation associated, remittances will have a direct impact on the net financial position of the country vis a vis the rest of the world. Note in this regard that the impact of remittances on the stock of net foreign assets differs from the impact of other flows such as loans or foreign direct investment flows. In the case of a loan, there is an associated liability (the repayment) and therefore the contribution to the net foreign asset position of the country is given by the difference between the proceeds and the net present value of the repayment obligations. In this regard, loans will positively affect net foreign assets to the extent that they have a positive grant component. On the other hand, foreign direct investment flows coming into the home country will increase the foreign liabilities and therefore, will lead to a decline of the net foreign asset position.
Second, remittances can also affect the internal equilibrium of the economy understood as the situation where domestic capital and labor are efficiently utilized. If as discussed above, remittances lead to an acceleration in thedemand for services, inflation will tend to be higher in these sectors which typically are not tradable (and hence somewhat protected from competition) leading to a real exchange rate appreciation (the traditional Balassa-Samuelson effect). Similarly, market rigidities may result in productivity differentials between sectors.
For example, if remittances raise the reservation wage, then excessive wage pressures in the tradable sector may lead to employment adjustments to maintain competitiveness, whereas in the non-tradable sector employers may admit these pressures because they can pass them onto prices. As a result, remittances can also lead to higher productivity growth and lower inflation in the tradable sector through their potential impact on the reservation wage. One implication of this discussion is that whether remittances are primarily used for household consumption or investment purposes will have a direct impact on the way they affect the real exchange rate, with remittances that are predominantly consumption oriented having more of an appreciating impact on the real exchange rate.