Chapter 2 Literature Review
2.19 Remittance Volatility
Remittance flows are regarded as a stable source of foreign funding for both developed and less developed countries. Given the trends and potential impacts of foreign remittance flows, recent studies have focused on the factors that significantly contribute to remittance behavior. The main motives that have been identified to explain the behavior of remittances at micro level are altruism, self-interest and insurance (Chami et al., 2008, Ratha, 2005a, Lucas and Stark, 1985). There has been also a gradual increase in the number of studies focusing on the macro-economic drivers of remittance flows as well as remittance volatility. Macro-economic drivers of remittance behavior include the economic performance of the receiving country (Moore and Greenidge, 2008, Singh et al., 2010); interest rates (Chami et al., 2009b); exchange rates (Craigwell et al., 2010); inflation (Chami et al., 2008); and the age dependency ratio (Buch and Kuchulenz, 2010). However, remittance volatility and its dynamic impacts on low-income countries have received limited attention (Jackman, 2013). The lack of research in this area could be explained by generally accepted wisdom that remittances are a steadier source of finance than other global financial flows
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(Ratha, 2005a). In contrast, Jackman (2013) stresses that the magnitude of the volatility of remittances cannot be ignored, and that there is a need to identify the main driver of remittance volatility among global and domestic macro-economic and financial variables.
Following Ratha (2005a), the magnitude of remittance variability is dependent on the targeted use of remittances, that is, are they meant for altruistic purposes, insurance or portfolio investment?
There is general consensus among scholars that profit driven remittances are more volatile than remittances meant for other uses (Jackman, 2013). However, Ghosh (2006) argues that even if remittances are meant for insurance or altruistic purposes, their magnitude and variability are expected to increase during times of hardship. Accordingly, such remittances have a downside risk because the more they move counter-cyclically, the more they gain in potential variability.
Although the counter-cyclical behavior of remittances is a desirable characteristic, it has negative effects on the level of remittance volatility as it rises during severe shocks or natural disasters and declines as the shock dissipates (Ghosh, 2006).
Furthermore, Jackman (2013) and Craigwell et al. (2010) suggest that irrespective of the intended use of remittances, economic volatility tends to drive remittance variability. They found a significant and desirable relationship between economic volatility and remittance volatility. A positive link was also found between a natural disaster and remittance volatility, implying that remittance volatility is bound to increase in the event of a natural disaster and decline as the natural phenomenon dies down.
Empirical evidence has also revealed the significant role played by interest rates and exchange rates in the variability of foreign remittance flows (Jackman, Craigwell, and Moore, 2009). As a result, the existing literature concurs with the hypothesis that remittance flows comprise an investment component (Jackman, 2013). Regarding remittance flows to meet portfolio objectives, uncertainty in exchange rates and interest rates significantly influences remittance volatility, that is, the more volatile exchange and interest rates are, the higher the volatility in remittance flows.
On the other hand, fluctuations in the remitting country’s income increase remittance flow volatility, while countries with more educated migrants receive a stable flow of remittances (Jackman, 2013, Jackman et al., 2013). This finding implies that there is a trade-off between brain drain and the stability of remittance flows (Craigwell et al., 2010, Jackman, 2013) as countries
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exporting highly skilled labor receive more stable inflows of remittances compared to those exporting a largely unskilled labor force.
Makhlouf and Mughal (2011) investigate the variability of remittance flows to Pakistan by employing the Autoregressive Conditional Heteroscedasticity (ARCH) model. They find that remittances to Pakistan are fairly stable while those to the Middle East and North America are relatively volatile as a result of the variability in output of recipient economies and the migrant’s profile. The study also demonstrated that foreign remittance flows from Europe are least volatile and are not affected by shocks to the host economy; hence, they can be used as a steady origin of foreign exchange (Makhlouf and Mughal, 2011). Furthermore, foreign remittance flows have overtaken other foreign financial flows and have become a key source of external finance and foreign currency for emerging countries such as Pakistan. Foreign remittances to Pakistan form the largest international financial flows and are very crucial to the country such that sudden fluctuations in remittances can pose serious risks to the macro-financial system and serious challenges to the country’s policymakers (Makhlouf and Mughal, 2011). This is despite the fact that the literature regards remittances as a stable source of foreign exchange flows that is less affected by economic shocks and business cycles than FDI and foreign portfolio flows (Chami et al., 2009c, Ratha and Mohapatra, 2007). Based on Grabel (2008), such low variability is crucial in promoting monetary and fiscal stability which in turn can improve citizens’ welfare. Overall, remittance volatility is influenced by various macro-economic factors such as variations in output and exchange rate fluctuations. However, Singh et al. (2011) argue that investigations of the nature of correlations between the magnitude of foreign remittances and the level of economic performance in the recipient economy have not produced conclusive answers. For instance, Yang and Choi (2007) show that income and remittances in the host economy are negatively correlated.
Finally, cyclicality is an important but debatable characteristic of remittances. Several scholars stress that remittances are counter-cyclical and supply a steady flow of external funding to developing economies. However, Sayan (2006) disputes the counter-cyclicality of remittances on the basis that it lacks empirical support. Sayan uses de-trended remittances and de-trended real GDP to compute unconditional correlations for 12 nations and finds that remittances are a-cyclical in most cases or even pro-cyclical at times. Similarly, Yang (2008) finds that Filipino migrants remitted little when the peso lost value due to the Asian financial crisis. An earlier study by
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Straubhaar (1986) finds that total foreign remittance flows to Turkey are not influenced by exchange rate fluctuations.
2.20 FOREIGN PORTFOLIO INVESTMENT VOLATILITY: EMPIRICAL STUDIES