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This study investigates the effects of exchange rate uncertainty and political risk, after controlling for the conventional macroeconomic determinants, on remittances transfers into eight Latin American countries during the period of 1990-2006. The results suggest that an increase in exchange rate uncertainty reduces remittances flows into these countries. Furthermore, an increase in political risk seems to have a negative but statistically insignificant impact on remittances transfers. Based on the findings of this paper, we can say that governments of the remittance receiving countries can influence the inflow of remittances by means of adopting appropriate macroeconomic policies to reduce exchange rate uncertainty and also by improving their political environments.
Introduction
Remittances have become an increasingly important and fast growing source of external finance for many developing countries. (1) By 2005, the total remittances inflows into developing countries reached $167 billion. This amount had more than doubled from its value of $58 billion in 1995 (United Nations Habitat, 2006). The increase in remittances flows into developing regions is welcomed because remittances have a potentially significant impact on the recipient country's economy. First, remittances are a more stable source of external finance as opposed to capital flows which tend to rise during favorable economic cycles and fall during less favorable ones. This acyclical nature of remittances exerts a stabilizing influence, and thus helps insulate vulnerable countries from economic shocks (Ratha, 2003; Global Economic Prospects, 2006). Moreover, remittances increase the recipient country's foreign exchange reserves and promote economic growth if households use remittances for investment. If they are used for consumption, they can also generate positive multiplier effects, offsetting some of the output losses that a developing country may suffer from emigration of its highly skilled workers (Ratha, 2003).
By 2005, Latin America and the Caribbean (LAC) were the largest remittances destination in the world, with inflows around $53.6 billion. This amount exceeded, for the third consecutive year, the combined flows of all net Foreign Direct Investment (FDI) and Official Development Assistance (ODA) to the region (Inter-American Development Bank, 2006). Because of their increasing volume and their potential to reduce poverty and enhance economic growth, remittances are receiving growing attention from policymakers in the developing countries of Latin America.
There is a wide range of important issues related to remittances. In this study, we focus on a very important issue, namely, the determinants of remittances to Latin American countries. Assuming that remittances have a positive effect on the recipient economy, what are the determinants of remittances into Latin American economies? The remittances literature is divided into two broad categories. The first category of determinants deals with microeconomic determinants of remittances such as the social and demographic characteristics of migrants and their families, while the second category considers macroeconomic variables of the host (sending) as well as home (receiving) countries. Our study fits into the second category as we investigate the macroeconomic determinants of remittances into nine Latin American countries. (2)
Generally, studies that investigate the determinants of remittances assume that migrants are risk neutral in their preferences with respect to risk and return in that they do not include risk variables in their regressions (Higgins et al., 2004). However, remittances for investment would be influenced by risk and return considerations. Ratha (2003) reviews cross-country studies on remittances and reveals that remittances are affected by the investment climate in recipient countries in the same manner that capital flows are; though to a lesser degree. Therefore, determinants of remittances in an investing framework would have to include rates of return to investment and the risk of investing in the home (receiving) country such as political risk and/or exchange rate uncertainty. However, to our knowledge, only one study (Higgins et al., 2004) has considered risk variables as determinants of remittances and no study has used the rate of return to investment measure that we use in this study? We employ a measure of political risk that captures multiple facets of risk faced by investors in the Latin American countries. We use the political risk index from the International Country Risk Guide (ICRG) that measures the combined effects of political and institutional instabilities faced by investors. We also include a GARCH measure of exchange rate uncertainty to investigate the exchange rate risk faced by investors. These risk variables are included in addition to the traditional determinants used by other studies. Thus, this paper contributes to the literature by filling a long-standing void in exploring the links between remittances, risk and return in Latin America.
The rest of the paper is organized as follows. Section 2 discusses some basic facts about remittances inflows into Latin American countries and provides a brief literature review. The sources of data and the variables used in the study are discussed in Section 3. Section 4 outlines the empirical methodologies and discusses the empirical findings. Conclusions and policy implications are included in Section 5.
Facts About Remittances to Latin America and Brief Literature Review
Facts about Remittances to Latin America
In 1995, the share of remittances going to Latin America and the Caribbean accounted for 23.2% of the total world remittances, but by the year 2005 this share had increased to 31%, making it the largest remittance recipient region in the world. In dollar terms, LAC received about $53.6 billion in remittance transfers in 2005. Out of the $53.6 billion sent, an estimated $20 billion were sent to Mexico, nearly $6.4 billion were destined to Brazil, and about $4.1 billion were sent to Colombia (Inter-American Development Bank, 2006). In most Latin American countries, remittances have exceeded official development assistance and other capital inflows such as FDI (see Table 1).
Some key factors could explain the tremendous growth seen in remittances inflows into Latin American countries over the last decade. One of the most important reasons has been the increase in emigration of workers from Latin American countries to regions with demand for labor such as the U.S. and Western Europe. The Inter American Development Bank estimates that in 2005 over 25 million Latin American born adults were living outside their countries of origin. Out of these 25 million migrants, approximately 65% send money home on a regular basis. The amount of money they send typically ranges between $100 and $300 a month (Inter-American Development Bank, 2006).
The main source of remittances to Latin America is the U.S. as about 75% ($40 billion) of Latin American remittances originate in the U.S. The next largest source of remittances is Western Europe with a share of almost 15% (about $7.5 billion).
Brief Literature Review
There is a wide range of important issues related to remittances. In this study, we focus on the macroeconomic determinants of remittances to Latin American countries. However, much of the remittances literature has focused on the microeconomic determinants of remittances (for example, see Lucas & Stark, 1985; Russell, 1986; Djajic, 1989; Hoddinot, 1992; Durand et al., 1996; Ilahi & Jafarey, 1999; Agarwal & Horowitz, 2002). The studies that have recognized the importance of the macroeconomic determinants of remittances include Straubharr (1986), Faini (1994), El-Sakka and McNabb (1999), Chami et al., (2003), Higgins et al., (2004), and Vargas-Silva and Huang (2006). These studies investigate the impacts of home (receiving) and host (sending) country variables such as inflation, income, exchange rates, wage levels, interest rates, and interest rate differentials on remittances flows. Studies have found mixed evidence on the impacts of these variables on remittances flows.
For example, a higher host country interest rate compared to the home country rate (a high premium) is expected to discourage remittances flows. However, Straubhaar (1986), using data of remittances from Germany to Turkey, finds that interest rate differentials between the host and home countries have no effect on remittance flows. Similarly, Elbadawi and Rocha (1992), using data from Western Europe and North Africa, find the interest rate differential to have no significant impact on remittances. In contrast, Katselli and Glytsos (1986), and El-Sakka and McNabb (1999) argue that interest rates and interest rate differentials significantly affect remittances inflows into Greece and Egypt respectively.
The real exchange rate (XR) also has the potential to affect remittances. Many studies have investigated the impact of exchange rates on remittances. These studies have found exchange rates to be important in explaining remittances flows (see Chandavarkar, 1980; Amuedo-Dorantes & Pozo, 2004; Higgins et al., 2004). Most studies expect the depreciation of the real exchange rate to encourage the flow of remittances from the host to home country (see Higgins et al., 2004). Intersetingly, Amuedo-Dorantes and Pozo (2004) also find that surges in workers' remittances may contribute to real exchange rate appreciation. Furthermore, Higgins et al. (2004) show that exchange rate volatility (a measure of risk) is an important determinant of remittances.
The macroeconomic variables mentioned above have also been used to test the altruistic versus self-interest motive for remitting. If downturns in the receiving economy prompt workers to increase remittances to their home countries, then their motives can be thought of as altruistic. If, on the other hand, immigrant workers are self-interested, remittances will respond positively to economic conditions in the receiving country. Faini (1994) and Glytsos (1997), using income to measure the economic condition of the receiving country, find that workers motives are altruistic because downturns in the home economy prompt workers to increase the amount they remit. In contrast, Higgins et al. (2004) find evidence for the investment or self-interest hypothesis since they find favorable economic conditions at home increase remittances inflows into the home country. This paper investigates if risk and return variables, in addition to the conventional macroeconomic determinants, have a role in determining remittances flows into Latin American countries.
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