Migrants Remittances and Financial Development: Macro- and Micro-level Evidence of a Perverse Relationship

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1 Migrants Remittances and Financial Development: Macro- and Micro-level Evidence of a Perverse Relationship Richard P.C. Brown and Fabrizio Carmignani School of Economics, University of Queensland Ghada Fayad Oxcarre, Department of Economics, Oxford University Abstract Financial development and financial literacy in developing countries are commonly identified as important conditions for attaining higher rates of investment and economic growth. It has also been argued that migrants remittances stimulate financial development in the receiving economy, contributing indirectly to economic growth. Past research has been based almost exclusively on the macro-level relationship between remittances and financial depth. To explore this relationship further, we combine macroeconomic analysis using a cross-country panel dataset with micro-level analysis of households uses of financial sector services. From the macroeconomic analysis we find evidence of a negative relationship between remittances and financial deepening in developing countries, once we control for the countries legal origin. At the microeconomic level we use household survey data from a recent study of migrants remittances in two transition economies, Azerbaijan and Kyrgyzstan, to test the relationship between remittances and financial literacy among remittance-receiving households. While we find some supportive evidence, albeit weak, for Kyrgyzstan, in Azerbaijan, the relatively more financially-developed economy, we uncover a strong perverse relationship. Remittances appear to deter the use of formal banking services. Possible reasons are explored and areas for further investigation identified. Key Words: Remittances, Financial Development, Financial Literacy, Azerbaijan, Kyrgyzstan The authors acknowledge and thank the Asian Development Bank for permission to use their dataset for the household-level analysis. We also thank Eliana Jimenez, Elizabeth Kenny and Xinran Liu for their invaluable assistance in preparing this paper.

2 1. Introduction In 2009 the estimated value of international migrants remittances was around US$420bn, of which approximately US$316bn was sent to developing countries (Ratha et al., 2010). Two points about these numbers are noteworthy. First is their magnitude compared with other international financial flows. Remittances are greater than the total value of foreign direct investment (FDI) and more than double the total value of foreign aid or, Official Development Assistance (ODA). Second, remittances are considerably more stable than other international financial flows (Ratha, 2004). This was particularly noticeable during the global financial crisis, when, contrary to expectation, remittances declined by only 6.2% in comparison with their peak levels of 2008 and are expected to increase by 6% to 7% in 2010 and 2011 (Ratha et al., 2010). In two large and highly remittance-dependent countries, Bangladesh and Pakistan, the total value of remittances was actually higher in 2009 than in 2008 despite the major recessions experienced in most migrant destination countries. From a global and macroeconomic perspective remittances have consequently come to be recognized as a very important and stable source of development finance for poor, labour-exporting countries to be harnessed for economic growth and development (Djajic 1986,1998; Kireyev, 2006; Nikas and King, 2005; Vargas-Silva and Huang, 2006). The assessment of the contribution of migration and remittances from this perspective has been mixed, and often negative (Chami, et al., 2003). Remittances have often been blamed for encouraging wasteful (and in some cases even unhealthy ) consumption by the recipients and impacting negatively on output by raising the reservation wage and discouraging work effort among recipient communities, and/or fuelling unproductive and inflationary speculative expenditure on real estate. Policy analysis has correspondingly addressed measures necessary to encourage the more productive use of remittances (Djajic, 1998). Another distinguishing characteristic of remittances is that migrants have tended to rely heavily on informal transfer channels rather than through formal bank transfers (see for example Adams and Page, 2005; Brown, 1992; 1997). Reasons for this are various, including: the availability of more favourable exchange rates in informal, parallel foreign exchange markets, or through sending relatively cheap commodities (eg. second-hand clothing) for sale at higher prices in informal markets in the recipient economies; the lack of financial development and availability of adequate numbers of banks or other financial institutions in the remittance-receiving communities; the relatively lower transactions costs and greater efficiency of alternative, largely informal transfer methods such as transfers by 1

3 hand of the returning migrant him- or herself, or returning or visiting friends and relatives, or by paid informal sector money couriers; and, an underlying distrust of banks and the associated financial authorities, including taxation departments, in the recipient countries. Informal money transfer systems are variously described in the literature, the most commonly used term being the hawala system used extensively in the Middle-East and South Asian context (El Qorchi, et al., 2003). Through these transactions foreign exchange controls are evaded and the migrant receives a more favourable exchange rate. Informal remittance transfers thereby provide those engaged in informal and often illegal international financial transactions with an important transfer mechanism for their activities. That remittances have provided an important conduit for unrecorded capital export ( capital flight ), from the migrant-sending countries has been recognised for some time (Choucri, 1986; Brown, 1992). The heavy reliance by migrants on unofficial forms of money transfer and the associated perception of the billions of dollars circulating around the international financial system on an informal, unrecorded basis has also come to be perceived as a key area of policy concern on the part of financial authorities in both remittance-sending and remittancereceiving countries. Increasing attention is therefore being given to what measures need to be introduced, including anti-money-laundering interventions, to channel migrants remittances through the banks and other money transfer organizations and agencies on a formal, recorded basis. Harnessing remittances for development has effectively become synonymous with channelling remittance transfers through the formal banking system, in the belief that this will foster financial development and with it enhanced opportunities for bank-financed credit for investment in productive, development projects. In recent years there has been mounting concern on the part of major international financial institutions including the IMF, World Bank, BIS, and ADB that measures need to be implemented to bring remittance flows into the formal banking sector (see for example El Qorchi, et al. 2003, Gupta, et al., 2009; BIS and World Bank, 2007). Associated with this growing concern over the formalisation of remittance flows has been an increased interest in the previously neglected relationship between remittances, financial development and economic growth in the remittance-receiving economies. From this literature a particular view that can be described as the induced financial literacy hypothesis has emerged. Underlying this is the notion that the receipt of remittances exposes households increasingly to the formal financial sector about which they become better educated, which in turn induces households to make more use of formal bank services for their transfers and other financial transactions. This induced financial literacy brings with it 2

4 both financial widening and financial deepening as the banking sector responds to growing consumer demand by creating more branches (widening) and extending more credit (deepening). Without household level data on remittances and use of financial services it cannot be concluded that the presence of un-banked households is due to financial illiteracy, or whether they consciously choose not to use formal bank channels and other bank services in spite of being financially literate. If migrants and remittance recipients are inherently distrustful of banks and other formal, financial institutions for reasons other than lack of information/education ( financial illiteracy ), such as deliberate avoidance of recorded income flows, there will be no direct relationship between remittances and financial development as posited by the induced financial literacy hypothesis. For instance, the recently introduced anti-money laundering regulations usually require banks to report to the country s financial authorities, any bank transfers in excess of a certain amount. For this reason migrant households, despite being financially literate, may choose not to use banks for remittances, nor any other financial transactions. To our knowledge there is only one study that analyses the relationship between remittances and use of financial services at the household level. Demirgüç-Kunt and Peria (2006) analyse data from a household survey in El Salvador and find a strong positive relationship between remittances and the households use of financial services. In this study we examine the relationship between remittances and financial development at two levels. First, we use cross-sectional panel data at the country level to analyse the relationship between remittances and financial depth. Second, we test for the presence of a direct relationship between remittances and the recipient households use of formal bank services in two developing countries, Azerbaijan and Kyrgyzstan, for which we have a unique micro-level data from a large household survey undertaken for the Asian Development Bank (ADB) in 2007, involving one of the authors (ADB, 2008). This dataset includes responses to detailed questions about the households migration history, remittances, and use of formal bank and other informal financial channels for transferring their remittances and other transactions such as saving, borrowing and lending. We analyse the relationship between remittances and the recipient households financial literacy as indicated by presence in the household of at least one member who has at least one form of bank account; i.e. current account, savings account, debit/atm card, or credit card. The rest of the paper is structured as follows. Section 2 reviews the existing literature on remittances and financial development with a particular focus on the induced financial 3

5 literacy hypothesis. Section 3 analyses the relationship between remittances and financial development at the macroeconomic level. In section 4 the methodology, modelling and econometric analysis of the household survey data from Azerbaijan and Kyrgyzstan are presented. Section 5 discusses the findings, draws conclusions, and points to areas for further investigation. 2. Remittances and Financial Development The relatively small and quite recent literature on remittances, financial development and economic growth can be categorised under two main lines of enquiry. One set of studies explores the remittances-financial-development relationship indirectly by investigating how the given level of financial development in a country affects the impact of remittances on growth. The other set of studies examines the relationship between remittances and financial development, with a view to assessing their impacts on financial widening (outreach) and financial deepening. The indirect, growth-focussed approach allows for possible interactions between remittances and financial development in estimating economic growth equations for recipient countries. Within this set of studies two opposing positions have emerged. One view contends that where an economy has experienced relatively less financial development, remittances contribute to investment and growth by substituting for inefficiencies in credit and capital markets. By alleviating credit constraints, remittances help provide an alternative source of funding for profitable investments, even in the presence of inhibiting liquidity constraints. In this case, remittances promote growth more in less financially developed countries. Giuliano and Ruiz-Arranz (2009), for instance, show this by interacting remittances with a measure of financial development in standard growth equations for a large sample of 73 countries over the period. Ramirez and Sharma (2009) obtain similar results using panel data from 23 Latin American countries over the period, again linking remittances to growth through financial development. The other, opposing position within the indirect growth-focussed approach hypothesizes that where the recipient economy is relatively more financially developed, there is greater potential for remittances to promote economic growth. The hypothesis here is that the greater availability of financial services helps channel remittances to better use, thus boosting their overall growth effect. In this respect, remittances are viewed as "financial flows in search of good investment projects and good financial institutions that together can 4

6 meet the investment needs of households with family members living abroad." Enhanced growth can then only occur when the channelling of remittances to such investments is facilitated by formal financial sector intermediaries. In support of this argument, Mundaca (2009) finds that financial development tends to increase the responsiveness of growth to remittances in Latin America and the Caribbean over the period. This finding is supported by a few other studies which argue that channelling remittances through the formal banking sector enhances their developmental impacts (Hinojosa-Ojeda, 2003; Terry and Wilson, 2005, and World Bank, 2006). In the indirect growth-focussed studies, the country s degree of financial development is taken as given in the sense that no allowance is made for the possible impact of remittances on the breadth (outreach) or depth of financial development in the recipient economy. In this regard, another very recent strand of the remittances-financial development literature explores evidence of more direct linkages between remittances and the level of financial development in the recipient economy. 1 Here, the underlying argument is that remittances contribute to financial development through both demand- and supply-side effects: (i) by fostering financial literacy among the remittance-receiving communities, thereby increasing households demand for and use of banking services; and, (ii) by increasing the availability of loanable funds to the financial sector thereby promoting greater financial depth. In relation to the financial literacy argument, the assumption, usually implicit, is that informal money transfer systems are used by migrants and their recipient households on account of a simple lack of financial literacy and trust in financial and government institutions (Desai, et al., 2004). The prevalence of un-banked remittancereceiving households is purported to be a function largely of ignorance, or financial illiteracy, and that this behaviour is amenable to corrective intervention in the form of appropriately targeted financial literacy educational programs. For instance, it is believed that without a certain level of financial literacy, households are more likely to make sub-optimal decisions and face excessive costs increasing, and that promoting financial literacy can reduce information asymmetries in the financial sector, leading to more efficient and better quality financial institutions (World Bank, 2009). It has also been argued that financial literacy and education can lower the mistrust between consumers and financial intermediaries, and help the consumers understand the true costs and benefits of financial intermediation (Cirasino, et al., 2008). Orozco (2009) found, for instance, that 80% of those 1 Almost all the work done in this area has been in relation to Latin America. For a good overview of these studies see Peria et al. (2008). 5

7 receiving financial education indicated an interest in utilising and acquiring other financial services. As a result of increased financial education, the likelihood of a household head opening a bank account was 5% and this increased to 12% if they were also illiterate (Kefela 2010). In an effort to increase the financial literacy of Latin American migrants in the US, a telenova was developed to reach those unwilling or unable to seek information elsewhere. It has been suggested that this program was effective at educating viewers, raising their awareness of financial services and significantly decreases migrants mistrust of formal financial intermediaries (Spader, et al., 2009). Increased literacy has been linked to more usage and comfort of low-cost financial services (financial widening), which has a key implication for economic growth (Amuedo-Dorantes and Bansak, 2006). It also help drive the demand and use of different financial services (financial widening), which is found to contribute to market stability and general economic growth (Demirgüç-Kunt et al., 2010). Apart from the use of targeted financial literacy programs, it is also believed that the flow of remittances in itself can induce greater financial literacy among the recipient communities. We refer to this as the induced financial literacy hypothesis. An example is Orozco and Fedewa (2005) who argue that remittances, by fostering financial literacy, stimulate demand by the recipient households for access to other financial products and services provided by banks. Others similarly hypothesize that remittance transfer services offered to migrant households bring banks into contact with un-banked remittance recipients, allowing for extension of their outreach (Aggarwal, et al., 2010); Demirgüç-Kunt et al. (2010); Gupta et al., 2009). They also argue that the relatively high fixed costs of sending remittances results in irregular or lumpy flows, the resulting excess cash balances held by recipient households might potentially increase their demand for other banking services and, hence, foster banking outreach and depth. On the supply side, remittances are also believed to play a positive role in the widening and deepening of the financial sector. It has been argued for instance that banks might be more willing to extend credit to remittance-receiving households, given that remittances are perceived to be a significant and stable income source. Moreover, the increased loanable funds created by the banked remittance transfers can lead to an increase in overall credit to other, non-remittance receiving households in the community (Aggarwal, et al., 2010). It is therefore important to analyse the impacts of remittances on financial development not only in terms of at the direct effects on the remittance-receiving households but also in terms of the indirect effects at the community level. 6

8 In one of the very few empirical studies on the relationship between remittances and financial development Demirgüç-Kunt et al. (2010) use municipality-level data for Mexico for 2000 to show that remittances are strongly associated with greater banking breadth (measured by number of branches and deposit accounts per capita) and depth (measured by the volume of deposits and credit to GDP). These effects are found to be statistically significant and robust to the potential endogeneity of remittances. The most conservative estimate suggests that a one-standard deviation change in the percentage of households receiving remittances roughly a doubling of the mean remittance rate leads to an increase of one branch per 100,000 inhabitants (against a mean of 1.79), 31 accounts per one thousand residents (relative to a mean of 42 accounts), and an increase of 3.4 percentage points in the deposit/gdp ratio (compared to a mean of 4.2). The induced financial literacy hypothesis thus rests to a large extent on the assumption that once educated about and exposed to the various services provided by the formal financial sector, the greater the likelihood that a remittance-receiving household will use formal bank services for their transfers and other financial transactions. However, as Demirgüç-Kunt et al. (2010) acknowledge, they were not able to provide direct evidence, at the household level, of increased financial literacy due to the lack of appropriate data on the banking behaviour of remittance-receiving households. It was therefore not possible for them to ascertain whether households that were un-banked were indeed financially illiterate, or whether they had consciously chosen not to use formal bank channels and other bank services in spite of being financially literate. If migrants and the recipients are inherently distrustful of banks and other formal, financial institutions for reasons other than financial illiteracy, such as deliberate avoidance of formal recording of income flows, there will not necessarily be any relationship between remittances and financial development. It is conceivable that with the recent introduction of anti-money laundering legislation that usually requires banks to report to the country s financial authorities any bank transfers in excess of a certain amount, migrant households, despite being financially literate in the sense of possessing the relative knowledge about banks and the types of services offered, may choose not use banks for remittances, nor possibly, for any other financial transactions. In this study we are able to test more directly, the relationship between remittances and the recipient households use of formal bank services. We use data from a unique household survey undertaken in Central Asia and the South Caucasus compiled by the ADB in The survey instrument, modelled on the World Bank s Living Standards Surveys, included the usual questions on the household s demographic composition, income, assets, 7

9 education, etc. but also some modules containing detailed questions about the households migration history, remittances, and use of formal bank and other informal financial channels for transferring their remittances and other financial transactions such as saving, borrowing and lending. In section 4 we analyse the relationship between remittances and the recipient households use of bank services as indicated by there being anyone in the household having one or more types of bank account, such as a current account, savings account, debit card/atm, or credit card. The two case study countries are Azerbaijan and Kyrgyzstan. By way of background and complementary to this analysis, the next section presents the results of our analysis of the relationship between remittances and financial development at the macroeconomic level. 3. Macroeconomic Analysis of Remittances and Financial Development In order to set the context for the miro-level econometric analysis in Section 4, it is useful to look at the aggregate macro-evidence on the relationship between remittances and financial development. For this purpose, we use annual data for 138 countries over the period to estimate the following model: (1), =, +, + + +, where f is domestic credit to the private sector in percent of GDP, r is the volume of remittances (in percent of GDP) received by country i in year t, X is a vector of controls, γ is a country fixed effect, δ is a time fixed effect, and ε is a noise. Both domestic credit to the private sector and remittances are obtained from the World Development Indicators of the World Bank. 2 Table 1 reports our baseline results. We start in column 1 with a parsimonious specification of model (1) which only includes the log of per-capita GDP as a regressor in addition to remittances and the time and country fixed effects. As can be seen, the estimated coefficient of remittances is positive, but largely not significant (the p-value of the t-test is 0.48). 2 The panel is however unbalanced as some of the variables are not available for several countries at the beginning of the sample period. From a preliminary inspection of the domestic credit indicate the presence of some outliers. We restrict our sample for estimation to observations that are associated with a value of domestic credit smaller or equal to 250% of GDP. 8

10 Table 1 Baseline Macro Panel Estimates 1 Panel LS 2 Panel LS 3 Panel LS 4 2SLS 5 2SLS Remittances (% GDP) * ** * Log GDP per capita *** *** *** *** *** Inflation (%) Financial openness *** 6.355*** Trade openness (% of GDP) *** Legal origin UK *** *** Legal origin Scandinavia Legal origin Socialist *** *** Legal origin Germany *** *** Observations in the panel Notes: All regressions include time dummies. Regressions in columns 1, 2, and 4 also include country dummies. Estimates of the constant term in each regression are not reported. *, **, *** denote statistical coefficients at the 10%, 5%, and 1% confidence level respectively. This suggests that a higher inflow of remittances is not associated with any relevant increase in our indicator of financial development. In fact, this result can be rationalized in a number of ways (see again Aggarwal et al., 2010). First, if remittances lift individuals financing constraints, then they might lower their demand for credit and therefore resulting in a lower level of credit to the private sector. Second, remittances might be immediately consumed or used to finance government. In both cases, there is no positive effect on credit to the private sector. Third, recipients might deposit remittances into banks, but if banks are unwilling to lend and prefer to hold liquid assets, again credit to the private sector will not increase. The coefficient of per-capita GDP is instead positive and strongly significant, consistently with the idea that economic development facilitates financial development. A first obvious concern with the parsimonious specification estimated in column 1 is that it does not account for various other macroeconomic factors that the previous literature has employed to explain financial development (see inter alia Aggarwal et al., 2010 and Chinn and Ito, 2006). Therefore, we expand the set of regressors to include: the rate of inflation, a measure of capital account liberalization (which we label financial openness ), and country s openness to international trade. Inflation is simply measured by the annual rate of change of the consumer price index (data are taken from the World Development Indicators of the World Bank) and it is meant to account for macroeconomic instability. Intuitively, inflation discourages financial intermediation and therefore should result in lower financial development (see Boyd et al., 2001 for discussion and previous evidence of this effect). Capital account liberalization is measured by Chinn and Ito s (2008) measure of financial openness. The relevant theoretical argument for including this variable is that, especially in capital-poor countries, the liberalization of international capital flows deepens 9

11 domestic financial intermediation and provides the necessary conditions for the expansion of the domestic banking sector. Finally, openness to international trade is measured by the sum of exports plus imports in percent of GDP (data are again taken from the World Development Indicators of the World Bank). We include it in order to account for possible interactions between trade and domestic financial liberalization (see for instance Edwards, 2008).The estimated coefficients of the extended specification are reported in column 2 of Table 1. None of the three additional macro variables seem to matter much for financial development after controlling for variation in per-capita GDP. More importantly, the estimated coefficient on remittances remains non-significant. In column 3 we consider a further extension of our model by adding a set of dummy variables which capture a country s legal origins. 3 As a matter of fact, there is now quite a voluminous literature discussing the crucial role of legal origins in determining the quality of governance and institutions that are necessary for financial development. 4 Our estimates seem to confirm this point, with three of the four legal origin dummies being highly significant. Countries whose legal system originates from the UK common law tend to have higher financial development. This is because the UK common law was designed as a tool to protect the parliament and the citizens against the interference of the Crown and therefore facilitated the emergence of institutions for the protection of property and creditor s rights and the enforcement of contracts. On the contrary, the French civil code was established to allow the State to interfere in the economy. The resulting institutions are therefore less strongly supportive of creditor s rights and this in turn discourages financial intermediation. Countries with socialist legal origin also have a disadvantage in terms of financial development as they have developed legal systems that are clearly against the protection of private property and all of the associated economic rights. The inclusion of the legal origin dummies produces some interesting changes with respect to the other control variables. First of all, most of the other coefficients are now much more precisely estimated. This suggests that, at least to some extent, the macro variables mainly capture cross-country variation in financial development rather than variation over time. Second, remittances turn out to be negatively associated with financial development, and the estimated coefficient passes the zero restriction test, albeit at the 10% confidence level only. The rationale for this result can be found in the micro-econometric evidence we 3 Because the dummies are time invariant, we have to drop the country fixed effects. The model however does include the time fixed effects. 4 Two seminal references in this are La Porta et al. (1999) and Beck et al. (2000) 10

12 discuss in Section 4: remittances can actually discourage recipients from opening a bank account. If this is the case, then more remittances reduce the ability of the banking sector to mobilize domestic resources and hence to allocate credit to the private sector. The second major econometric concern in estimating model (1) is the potential endogeneity between remittances (and/or other controls) and financial development. To address this issue we provide panel 2SLS-instrumental variables estimates in columns 4 and 5 of Table 1. To the extent that our instruments are valid, the estimated coefficients can then be taken to represent a causality effect and not just a correlation (see footnote 5 for a discussion of instrument diagnostics). In applying the 2SLS estimator, the legal origin dummies are treated as exogenous while all of the macro variables are instrumented by their five year lagged value. 5 It appears that instrumental variable estimates are not qualitatively different from the panel least squares estimates shown in columns 2 and 3. In particular, we note that the coefficient of remittances remains negative and significant, thus confirming that remittances weaken financial development. The third complication associated with estimating model (1) arises from the diversity of the countries included in the sample: do the slope coefficients reported in Table 1 equally apply to such heterogeneous countries like the United States and Zimbabwe? In fact, parameter heterogeneity is a common problem in applied work when estimation is based on large cross-sections of countries. While several advanced methods to deal with heterogeneity have been identified in the literature (see for instance Pesaran et al and Durlauf et al. 2005), in this section we take a rather crude, but intuitive, approach: we split the sample into two more homogeneous sub-samples of countries and re-run 2SLS estimates on each subsample. The criterion for splitting the sample can be rather easily identified by looking at the data on remittances. Within the group of 137 economies which constitute the full sample, there are 21 that receive close to zero remittances. These are the Western European and North American economies, Japan, Australia, and New Zealand. It seems obvious to analyse them separately from the others. This will shed light on possible differences between developed and developing countries in the effect of remittances on financial development. Results by subsamples are reported in Table 2. 5 The five-year lagged values are positively correlated with the contemporaneous values and are therefore likely to be valid instruments. As a matter of fact, the partial R 2 and the Shea s R 2 of the first stage regressions are above 0.5. The Cragg- Donald Wald test indicates that lagged values are not weak instruments. However, because we use only one instrument for each endogenous regressor, we are not able to test for overidentfying restrictions. All of the first stage diagnostics are available from the authors upon request. 11

13 Table 2 Macro Panel Estimates for Different Country Subsamples 1 2SLS (developing countries) 2 2SLS (developed countries) 3 2SLS (full sample) 4 2SLS (developing countries) 5 2SLS (developed countries) Remittances (% GDP) ** * *** Log GDP per capita *** ** *** *** *** Inflation (%) Financial openness *** *** Trade openness (% of GDP) ** * *** Legal origin UK *** 7.237*** *** Number of observations in the panel Notes: All regressions include time dummies. Regressions in columns 1 and 2, also include country dummies. Estimates of the constant term in each regression are not reported. *, **, *** denote statistical coefficients at the 10%, 5%, and 1% confidence level respectively To begin with, we consider the specification of the model without legal origin dummies. Column 1 reports estimated coefficients for the subsample of developing countries and column 2 the estimates for the subsample of developed countries. Some differences between the two subsamples emerge with respect to (i) the sign and statistical significance of the coefficient of the trade openness variable and (ii) the size of the coefficient of the log of per-capita GDP. However, the most striking and, for our purpose, interesting difference concerns the role of remittances. In developing economies remittances appear to have a negative, albeit statistically negligible effect on financial development. Conversely, in developed countries the effect is positive and highly significant. One possible way to look at this result is to argue that remittances contribute to financial development in countries that have already achieved a certain stage of economic and, presumably, financial development. Alternatively, it could be that remittances positively affect financial development only if received in small amounts (as it is the case for developed countries). This would imply a nonlinearity in the relationship between financial development and remittances. To allow for such a possibility, we have re-estimated the model on the full sample of countries including both remittances and remittances squared. 6 The square term turns out to be of the same sign as the linear term and neither is significant. We take this as evidence that the relationship is not U (or inverted-u) shaped. We can now turn to the specification which includes legal origin dummies. A problem that emerges in this case is that in the subsample of developed economies there are no 6 Results are available from the authors upon request. 12

14 countries with socialist legal origins, while in the subsample of developing countries there are no countries with German or Scandinavian legal origins. So, we have to simplify our specification and include only the dummy for UK legal origins, leaving French legal origin as the base scenario. To see how the exclusion of the other three legal origin dummies affects our baseline results, in column 3 we re-estimate the model with UK legal origin only on the full sample of all countries. Results confirm the basic findings from Table 1. In particular the coefficient of remittances is still negative and significant (even if we note that its p-value is very close to 0.1). Columns 4 and 5 show the estimated coefficients for the two subsamples. Again the evidence indicates that remittances promote financial development in developed countries while they seem to be irrelevant in developing countries. Interestingly, UK legal origins strengthen financial development in developing countries, but not in developed countries. This differential effect of legal origins in the two sub-samples is certainly an interesting avenue of future research. To sum up, our macro-estimates provide an interesting picture. There is little evidence that remittances promote financial development in the full sample of all countries. In fact, if anything, the effect seems to be negative. This is consistent with the micro-econometric evidence that we present in Section 4 for Azerbaijan. However, when we restrict the analysis to the sample of developed economies, the effect turns from negative to positive. 4. Micro-level Analysis of Remittances and Financial Literacy 4.1 Country background In this section we analyse the relationship between remittances and households financial literacy for two countries, Azerbaijan and Kyrgyzstan. The two countries have similar economic histories in the sense that both were formerly part of the Soviet Union until its dissolution in 1991, and both countries have witnessed substantial international migration (primarily to Russia) and receive substantial remittance inflows. Both countries are also members of the CIS-7 group of former Soviet states, all low-income and IDA eligible. After independence Azerbaijan s GDP declined significantly from approximately US$8.9 billion in 1990 to just over US$3.3 billion in Its vast reserves of oil and natural gas and consistent efforts at structural reforms have however contributed towards Azerbaijan s recent recovery. Economic growth has been strong in recent years, reaching 25 per cent in

15 Despite this the Human Development Index (HDI) has remained relatively constant: 0.77 in 1990 and in Kyrgyzstan is classified as a low-income country by the World Bank but has shown some signs of recovery. Between 1990 and 2007, the annual growth in GDP increased from 5.7 per cent to 8.2 per cent and per capita gross national income increased from US$1,810 to US$1,980. The HDI has shown an improvement in the country s development between 1990 and 2007, increasing from 0.68 to The two countries differ quite substantially with respect to their level of financial development. This is not immediately apparent from observation of conventional measures of financial depth such as M2/GDP, or Bank Assets/GDP as shown in Table 3. Table 3 Comparative Financial Data, 2006 Azerbaijan Kyrgyzstan Population (mn) GDP/Capita (US$) M2/GDP (%) Bank Assets/GDP (%) Banks and Branches (per mn. pop.) 420 (49.5) 171 (32.9) Mean Distance from Bank (mins)* Households with Bank A/C (%)* Households Receiving Remittances (%)* Sources: * Compiled from ADB (2008) survey data (see also Table 5). All other: Key Indicators for Asia and the Pacific, Asian Development Bank, Azerbaijan s M2/GDP and Bank Assets/GDP ratios were lower than Kyrgyzstan s suggesting that the latter is more financially developed. However, our survey data indicate the opposite. In Azerbaijan over 36% of the surveyed households held a bank account, in comparison only 1% of households in Kyrgyzstan. The number of banks or bank branches per million population was also much higher for Azerbaijan (49.5) in comparison with Kyrgyzstan (32.9), and, from the survey data, we also find that the mean travel time to the nearest bank was much lower for Azerbaijan (approximately 20 minutes) compared with Kyrgyzstan (approximately 31 minutes). The survey data also show that households in Azerbaijan enjoy a much closer physical proximity to a bank, where the average distance in time from the nearest bank is around 20 minutes in in comparison with 30 minutes for households in Kyrgyzstan. 14

16 How can we account for this apparent inconsistency between the macro- and household level measures of financial development? We suggest that the conventional M2/GDP measure is unsatisfactory in that it ignores differences between countries in how much of M2 consists of bank deposits as opposed to notes and coins in circulation outside the banking system. The more developed a country s financial system, the less reliant it is on currency in circulation. Given the enormous differences among countries in the proportion of currency in total money supply a more appropriate measure of financial depth is given by (M2-C)/M2, where C is the amount of currency held outside the banks. This measure has been referred to as contract-intensive money (CIM) and has been used in the macroeconomic growth literature as a broad measure of the general security of contracts and property rights in a country (Clague, et al., 1999). Here, we use it as an alternative measure of financial literacy given our interest in the relationship between remittances and the receiving households access to and use of banking services. The more financially developed the country, the higher would be the expected CIM ratio. Table 4 compares M2 and CIM ratios for the CIS-7 and a selection of other Asian countries including our two countries of interest. 7 Table 4 Comparative Measures of Financial Depth (2006) M2/GDP (%) (M2-C)/M2 (%) CIS-7 Countries (mean) Armenia Azerbaijan Georgia Kyrgyzstan Moldovia Tazikistan Uzbekistan Other Asia Korea Malaysia Singapore Taiwan Source: Authors calculations based on data from Key Indicators for Asia and the Pacific, Asian Development Bank, Applying this measure we find that while Kyrgyzstan had a higher M2/GDP ratio than Azerbaijan, and well above the average for the CIS-7 group, its CIM ratio of 39.9% was very much lower than Azerbaijan s 61.9%. Compared with other CIS-7 countries, Azerbaijan had 7 In both countries, as discussed later, a large share of migrants remittances are in the form of hand-carried cash in foreign currency, mainly Russian roubles and US dollars, which are openly used and exchanged in the informal market. As these components of cash in circulation are not captured by the official measures of money supply, the M2/GDP ratio will accordingly be underestimated while the CIM ratio will be overestimated. 15

17 one of the highest CIM ratios and Kyrgyzstan the lowest, where the CIS-7 average in the same year was 56.6%. The relative underdevelopment of the financial sector in the CIS-7 group generally is brought out by the comparison with the other more developed Asian economies. For these countries the M2/GDP ratio was well over 100% (over 200% for Taiwan) and the CIM ratio was between 94% and 98%. 4.2 Household Survey Data The Asian Development Bank (ADB) through a household survey compiled the dataset used in this study in early 2007 (ADB, 2008). This project included one of the authors of this study. The design of the questionnaire was based on the living standard surveys of the World Bank, consisting of 207 questions grouped into 19 sections, and including standard modules for household income and expenditure, asset ownership, socio-economic-demographic characteristics of households and each of their members, as well as some additional, smaller modules on various elements of well-being including health. 8 The recall period for most questions was for the calendar year The survey also collected data on community-level variables including geographic distance and travel time to key amenities and facilities, such as main roads, railway stations, community centres, shops, hospitals as well as bank and postoffice. A stratified two-stage random sampling procedure was used, with households divided into the three strata: the capital city; other urban areas; and, rural areas. Survey interviews were conducted face-to-face between trained interviewers and the nominated household head in the residence of the respondent. The interviews were conducted in the principal language of the respective country. For the purpose of this study a hierarchical dataset at two levels was compiled for each country, resulting in a final dataset of 3,899 households for Azerbaijan and 3,995 households for Kyrgyzstan. The household is defined as a group of people who live together, usually pool their income, and eat at least one meal together a day when they are at home. The household does not include people who have migrated permanently or are considered visitors. For the purpose of this study we take the household as the unit of analysis but we include some individual-level and community-level variables in our analysis. Both Azerbaijan and Kyrgyzstan have become increasingly reliant on migration and remittances, mainly from temporary and seasonal migrants to Russia and Khazakstan. From 8 For further details of the study see ADB (2008). 16

18 Table 5 it can be seen that in % of households in Azerbaijan and 15.8% in Kyrgyzstan received remittances, the mean values of which were $ and $ respectively. We also have information on the main transfer channels used. In Azerbaijan households relied heavily on informal channels, with 71.5% of remittances being handcarried, either by the migrant or a friend or relative of the migrant. Only 28.2% were sent through official money transfer organisations (MTOs), banks or post-offices. In the case of Kyrgyzstan there was much greater reliance on formal channels with only 19.8% of remittances being informally, hand-carried and 80.2% being sent through formal channels. These findings are somewhat unexpected given that Azerbaijan is far more financially developed than Kyrgyzstan, and yet relies much more on informal transfer channels. However, it is worth noting that of the formal channels used, MTOs were by far the most important. Only 4% of recipients in Kyrgyzstan actually deposited their remittances in a bank once they had been received, even though, in most instances, they need to enter a bank to collect the money sent through an MTO (ADB, 2007). 9 Table 5 Remittances and Channels Used Azerbaijan (n=3899) Kyrgyzstan (n = 3995) Number remittance receiving HHs (%) 436 (12.70) 595 (15.84) Mean remittances (per HH) $ $ Mean remittances (per receiving HH) $ $ Use of formal channels (% remittances) Use of informal channels (% remittances) Source: Compiled from ADB dataset (2008). If the induced financial literacy hypothesis holds, one would expect a higher proportion of remittance-receiving households to hold a bank account. The data from our survey are not supportive of this. They indicate that in Azerbaijan the opposite seems to hold; a larger proportion of non-remittance-receiving households held a bank account (37.1%) in comparison with those that received remittances (32.5%). In poorer, and less financially developed Kyrgyzstan there is very little difference; 0.95% of households without remittances held a bank account in comparison with 1.13% of those receiving remittances. These preliminary comparisons suggest little support for the induced financial literacy hypothesis. Indeed, they seem to suggest that in Azerbaijan, remitters prefer to avoid the use 9 It needs to be noted that MTOs such as Western Union have an arrangement with banks through which their transfers are made and from which the remittances are collected by the recipient. But, these transactions remain anonymous and do not constitute transfers to a bank account (ADB, 2007). 17

19 of banks and other formal financial sector transfer channels, and, if they do receive remittances they are less likely to hold a bank account. To test this more formally we apply appropriate multivariate analysis using household survey data from the two countries. 4.3 Regression model and variables We test the hypothesis that remittances increase the likelihood of a household having a bank account. We allow for remittances to influence our variable of interest at two levels: at the household level as measured by the value of cash remittances it received, and at the community level in terms of the proportion of households in the community receiving remittances. Including the community level variable allows us to capture the possible external effects that remittances could have on the banks provision of services to the wider community, including households that receive little or no remittances. Our baseline specification is a probit model where the dependent variable is a dummy variable indicating whether or not any individual in the household held a bank account in one form or another in the survey year (2006): Prob (Bank i ) = f [HH Remittances i + Community Remittances i + Location i + Household Demographic Characteristics i + Household Income and Wealth i + Community Characteristics i ] Remittances at the household level are measured in terms of the absolute level of cash remittances received in the 12 months preceding the survey, measured in US$ thousands (HH Remittances). 10 Remittances at the community level are captured by a variable which measures the proportion of households in the community (defined as the Primary Sampling Unit or PSU) that received cash remittances in the survey year (Community Remittances). The expected sign on both remittances variables is positive if the induced financial literacy hypothesis holds. Apart from the variable capturing the proportion of households receiving remittances (Community Remittances), we have a variable capturing the outreach (or accessibility) of banks as measured by the mean distance in minutes to the nearest bank (Distance to Bank) and, as a bank substitute, the mean distance in minutes to a post office (Distance to Post Office). Geographic location is captured by a dummy variable Rural. We expect the sign on 10 We also used a variable measuring the proportion of cash remittances in total household income from all sources as an alternative measure of household remittances. The results using this measure are very similar to those reported here and are available from the authors on request. 18

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