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Remittances Play a Dual Role in Developing Economies

Remittances play a vital role in spurring economic development and providing financial assistance to those in need.

Western Union’s distinct yellow and black signs litter small towns across America. One of their largest customer bases are migrants who regularly visit their local Western Union office to wire money to family members back in their home country. One of every $5 that a person sends using a money transfer service is handled by Western Union.

Western Union and other agencies like it do not transfer money out of charitable goodness. They receive a percentage fee based on where the money is going and from where the money is sent. For example, a transfer from New York will have a higher fee than one from a small Midwestern town. It is estimated that the average cost on remittances was 9% in 2012, and this is before fees are imposed upon reception of the transfer. Today, Western Union has an impressive half a million agent locations worldwide.

Big Money

Remittances have become a big business over the last few decades. With over 215 million people living outside their country of origin, the World Bank estimates that $414 billion was sent home by migrants in 2013 — $79 billion of it via Western Union. For instance, over a third of the $61 billion in remittances that went to Latin America in 2013 headed to Mexico. The World Bank estimates that three-quarters of this comes from the United States, where the majority of Latin migrants live. Unsurprisingly, transfers from the US to Mexico form the largest remittance corridor in the world.

As migration grows and transferring money becomes easier, that total is expected to rise to $540 billion by 2016. By developing country standards, these are huge sums of money. More often than not, remittances are significantly larger than external development assistance and traditional foreign direct investment (FDI) to developing countries.

This capital is a vital source of funding for developing countries for their economic advancement. However, continued reliance on remittances can produce a dangerous dependency that may inhibit long-term productive economic growth and inculcate a culture of reliance on income transfers.

Some of the poorest communities in developing countries rely on remittances for up to 50% of their income. This number may even be higher if unattributed transfers were taken into account. Their total value can make up a sizeable portion of a low-income country’s gross domestic product (GDP).

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The transfer of foreign currency can help correct trade imbalances and create a more favorable investment climate. Direct cash injections through remittances can also help impoverished recipients meet basic needs, lessen social inequality and include the poorest sections of a country in the banking system. They can help spur entrepreneurship, promote productive long-term investments, fund education and service outstanding debt.

New savings can also be turned into credit for cash-strapped banks, increase a family’s credit-worthiness and provide increased economic opportunity for those most in need. They can also make domestic investment in recipient countries more attractive to outside investors due to enhanced economic stability produced by remittances.

An Economic Crutch?

However, while it is true that remittances provide support to those in need and drive economic growth through consumption, there are also larger macroeconomic factors that need to be taken into account.

Many recipients of remittances do not invest productively, and instead use their extra financing on consumption, including leisure, which may also reduce their incentive to find work. An International Monetary Fund (IMF) paper using data from Armenia found that, on average, while recipients saved more, they also worked less and spent less on education. Of course, many recipients do not have the means to use remittances to start a new business, or to invest more or to add to their savings, but these activities are the engines of economic development.

The positive aspects of remittances are rightly lauded, but there are also very real downsides. They can foster dependency, affect the value of a local currency and weaken competitiveness. Many countries that are dependent on remittances as a source of GDP have become subsistent on the external capital. This can damage their competitiveness in the global economy if remittances come to be relied on as an alternative source of development funding, rather than forcing an impoverished country to undergo the reforms and developments necessary to increase competitiveness.

Unfortunately, it is also usually those who are the most talented who are able to emigrate. This is commonly referred to as “brain drain” or the migration of skilled workers from their country of birth, including talented students who remain abroad. These are the people who would be most likely to drive domestic economic growth and help their country escape poverty. Structural deficiencies are less likely to be remedied if labor is continually exported.

No Alternatives

Remittances, however beneficial, should not be used as a replacement for normal economic development reforms. But governments in the developing world are often wracked with their own difficulties that hamper growth. Therefore, remittances, even with potential downsides, are a vital portion of economic development. Such is the scale of the problems facing governments in developing countries that there are no alternatives to the vital role remittances play in economic development.

If remittances are viewed as a permanent source of income, then recipients may be less likely to spend productively or preserve their extra funding rather than use it strictly on consumption. Thus remittances are often treated by recipients as a form of “social insurance” rather than a positive investment in human capital.

In an IMF paper, a group of economists found that remittances did not have a significantly positive impact on long-term growth, and in some cases impeded it. In their data set, they did not find a single recipient country where remittances had actually led to significant growth. Remittances can also lead to moral hazard, whence they exceed a normal wage and, therefore, negate the necessity for the recipient to work, leading to an increase in leisure activity. This effect has been fully realized in academic work from the IMF.

Another problem is that remittances wax and wane with the global economy, though often they can be less volatile than local wages. According to the World Bank, remittance inflows globally dropped by 6% during the recent financial crisis. Dependency on remittances inhibits normal development and can actually mask deep structural deficiencies in local economies like underemployment. Remittances can also undermine policy decisions as their inflow can shift the existing money supply within an economy, making it more difficult for a local government to efficiently allocate capital.

In the end, there can be no doubt about the positive role remittances play. They outweigh Official Development Assistance (ODA) by almost three times globally and often match or exceed private capital flows to developing countries. The world is better off with remittances, but policymakers in countries that are heavily reliant on them should remain vigilant of the negative side effects they can have.

The views expressed in this article are the author’s own and do not necessarily reflect Fair Observer’s editorial policy.

Photo Credit: Thinglass / Ken Wolter / Shutterstock.com


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