THE EFFECT OF REMITTANCES AND FINANCIAL DEVELOPMENT ON PRIVATE INVESTMENT IN KENYA PRESENTED BY MOSES ROTICH CHERONO X50/73245/2012

Transcription

1 THE EFFECT OF REMITTANCES AND FINANCIAL DEVELOPMENT ON PRIVATE INVESTMENT IN KENYA PRESENTED BY MOSES ROTICH CHERONO X50/73245/2012 SUPERVISORS: DR. MARTINE OLECHE DR. SULE FREDRICK E. ODHIAMBO NOVEMBER, 2013 A RESEARCH STUDY SUBMITTED IN PARTIAL FULLFILLMENT OF THE REQUIREMENTS FOR AWARD OF THE DEGREE OF MASTER OF ARTS IN ECONOMICS, SCHOOL OF ECONOMICS, UNIVERSITY OF NAIROBI

2 DECLARATION This Research project is my original work and has not been submitted for examination in any other University. Signed Date MOSES ROTICH CHERONO X50/73245/2012 This Research project has been submitted for examination with my approval as University supervisor. Signed.. Supervisor: DR. MARTINE OLECHE Date Signed.. Date Supervisor: DR. SULE FREDRICK E. ODHIAMBO ii

3 ACKNOWLEDGEMENTS I would like to express my sincere gratitude to the following people: my supervisors Dr. Martine Oleche and Dr. Fredrick Odhiambo Sule for their invaluable advice and assistance in making this project a success. I would also like to thank the African Economic Research Consortium for providing financial support to undertake my masters program as well as this project. I would also like to acknowledge the contribution of Dr. Anthony Wambugu for his invaluable advice in designing the topic this research project. Finally, special thanks go to my parents for having supported my educational journey since childhood to this day. iii

4 TABLE OF CONTENTS BACKGROUND OF THE STUDY... 1 CHAPTER ONE Introduction Remittances in Kenya Statement of the Problem Objectives of the Study Significance of the Study Organization of the paper...11 CHAPTER TWO LITERATURE REVIEW Theoretical Literature Empirical Literature Overview of the Literature...20 CHAPTER THREE METHODOLOGY Theoretical Models Empirical Specification Estimation Method A priori Expectations about the Variables Data...28 CHAPTER FOUR EMPIRICAL RESULTS Stationarity tests Jarque Berra Test for Variables Error Correction Model Long-run (cointegrating) regression Granger Causality test Ramsey Reset test Breusch-Godfrey LM test for autocorrelation Breusch-Pagan / Cook-Weisberg test for heteroscedasticity Jarque Berra Test for Residuals...40 iv

5 CHAPTER FIVE CONCLUSION AND POLICY RECOMMENDATIONS Conclusion Policy recommendation Areas for further research...42 REFERENCES v

6 LIST OF TABLES Table 1: Table 2: Table 3: Table 4: Table 5: Table 6: Table 7: Table 8: Table 9: Table 10: Table 11: Abridged Summary of Remittances Inflows to sub Regions in Africa Uses of Remittances in Kenya and other sub-saharan countries Jarque Berra Test Stationarity tests Error Correction Model Results from the long run regression model Results from the long run regression model Ramsey Test Breusch-Godfrey LM test for autocorrelation Breusch-Pagan / Cook-Weisberg test for heteroscedasticity Jarque Berra Normality Test for Residuals vi

7 LIST OF FIGURES Figure 1: Remittances and Other Resource Flows to Africa, Figure 2: Figure 3: Composition of Emigrants from Kenya by Country and Region Remittances to Kenya vii

8 LIST OF ACRONYMS ECT EG ADF CPI GDP OLS DOLS VAR VECM ECM GMM FDI MEC Error Correction Term Engle and Granger Augmented Dickey Fuller Consumer Price Index Gross Domestic Product Ordinary Least Square Dynamic Linear Ordinary Least Squares Vector Autoregressive Model Vector Error Correction Model Error Correction Model Generalized Method of Moments Foreign Direct Investment Marginal Efficiency of Capital viii

9 ABSTRACT In the recent past, remittances have grown rapidly to form a significant component of foreign inflows to Kenya. Concurrently, there has been a prolific increase in the number of studies analyzing the behavioral patterns of remittances in Kenya. However, very limited work has been devoted to analyzing the impact of remittances on investment in Kenya. This study therefore sought to establish the impact of remittances on private investment in Kenya. Further, the study attempted to establish how financial sector development influences the effect of remittances on private investment in Kenya. The paper found a positive and statistically significant relationship between remittances and investment in Kenya. Moreover, the coefficient on the interaction coefficient between remittances and financial sector development was found to be positive and statistically significant. This result suggests that remittances can complement the allocation of capital by credit markets to private investment activities in Kenya. ix

10 BACKGROUND OF THE STUDY CHAPTER ONE 1.1. Introduction Remittances from emigrant workers have grown significantly over the last two decades to become a primary source of foreign inflows in Africa. From a paltry 9.1 billion dollars in 1990, remittances have grown more than three-fold to reach US $40 billion in 2010, up from US$ 38 billion in 2009 (Ratha et al., 2011). This exponential growth in remittance flows reflects an increase in emigration from Africa as well as increasing incomes of migrant African workers driven by the robust growth experienced in the developed economies in the run up to the 2007/2008 financial crisis. In 2009, remittance inflows comprised 2.6 per cent of GDP in Africa. This was higher compared to remittances to the developing world which on average formed about 1.9 per cent of GDP (Ratha et al., 2011). Unlike other sources of external finance, remittances tend to be more stable making them a reliable source of financing for developing countries (Biller, 2007). Remittances are often more effective than development aid since they are sent directly to the recipient thus making them less susceptible to bureaucratic bottlenecks and corruption. Remittance inflows to Africa on average are now roughly equal to official development assistance. The turning point occurred in 2007 when remittances officially exceeded development aid in Africa on average. In North Africa, remittances are now larger than official development aid forming roughly 3.3 per cent of GDP and 0.6 per cent of GDP, respectively. However, in sub-saharan Africa, remittances are somewhat lower than development aid comprising 2.2 per cent and 3.7 per cent of GDP, respectively. Only foreign direct investments are currently larger than remittances as a per cent of GDP. This is because some African countries like South Africa, Angola and Botswana are richly endowed with natural resources (minerals and oil) which attract substantial foreign direct investments. However, for those countries that are not richly endowed in natural resources, remittances exceed foreign direct investments by a significant margin and are increasingly an important source of foreign inflows. 1

11 According to the World Bank, the total remittances could in fact be higher by as much as 50 per cent (World Bank, 2010). This is mainly because the precise estimation of total remittance flows is fraught with difficulties. Countries and international organizations such the international Monetary Fund and the World Bank differ on their understanding of the specific components of remittance flows; they often overestimate or underestimate remittances by including or excluding other types of transfers such as transfers to NGOs and embassies. Moreover, a large share of remittance inflows are sent through informal channels and are therefore not captured in official tabulations. For example, a survey by the World Bank using informal sources reported a US$ 1.9 billion inflow to Kenya in 2010, compared to CBK figure of US$ 609 million during the same year (Central Bank of Kenya, 2012). Similarly, in Ghana, the central bank estimated remittances in 2010 to be US $1.6 billion, a figure fourteen times higher than the US $114 million estimated by the International Monetary Fund (Ratha et al., 2011). Figure 1: Remittances and Other Resource Flows to Africa, Source: Leveraging Migration for Africa: Remittances, Skills, and Investments 2

12 Table 1: Abridged Summary of Remittances Inflows to sub Regions in Africa (in millions of dollars) Region/Flows e %GDP Sub-Saharan Africa Migrant Remittances Official Aid Foreign Direct Investments Private debt and equity portfolio flows North Africa Migrant Remittances Official aid Foreign Direct Investments Private debt and portfolio equity flows All Africa Migrant Remittances Official Aid Foreign Direct Investments Private debt and portfolio equity flows Source: Leveraging Migration for Africa: Remittances, Skills, and Investments 3

13 The growth of remittance inflows in developing countries has generated intense debate and controversy among academics and policy makers studying the contribution of remittances on the economic welfare of recipient economies (Adams and Cuecuecha, 2010). The controversy revolves around the issue of how the remittances are spent. Burnside and Dollar (2000) argues that the effect of remittance inflows on the economic development of recipient countries hinges on whether they are invested or consumed. If invested, remittances will generate a positive impact on growth and if consumed, there will either be no impact on growth or there will be a reduction in growth if remittances cause households to substitute labor for leisure. Three propositions have thus been put forth to explain how remittance expenditure might impact economic development. The first view advanced by some studies is that remittances are spent just like any other income at the margin. This means that households spend remittances just like a dollar of income from any other source. Adams et al. (2008) corroborated this view in a study of how households spend remittances at the margin in Ghana. The paper found that households are indifferent at the margin on the expenditure of remittance on either consumption or investment. The significance of this view is that remittances will have no impact on economic development. The second proposition is that remittances cause behavioral changes on household expenditure. Specifically, it is argued that households use remittances on consumption goods at the expense of investment goods. Chami et al (2003, pp ) in a review of the literature on the subject find that households spend a significant amount of remittances on consumption goods. The implication of this finding is that remittances have no effect on investment and consequently economic growth. The third premise builds on the concept of permanent income hypothesis. The permanent income hypothesis argues that households spend their income at a level consistent with their average long term income. Therefore, since remittances tend to be transient, households will spend it more on investment goods like physical and human capital than on consumption goods at the margin. This hypothesis is important to the research on the impact of remittances on economic development since investment contributes to capital formation which is a necessary precondition for economic growth and development. For example, expenditures on education creates human capital which is an important component of economic growth. Similarly, expenditures on investment goods like housing, machinery, equipment and infrastructure creates physical 4

14 capital which generates new income and new employment opportunities for communities. Empirical literature corroborates this viewpoint. Edwards and Ureta (2003) in a study on El Salvador found that households receiving remittances do spend more on education at the margin. The study attempted to establish a comparison between the effect of remittances on education and the effect of income from other sources on education. Unlike income from other sources, remittance income was found to have a more significant impact on retention rates in schools. Remittances were found to lower the chances of school drop out by 54% Remittances in Kenya Following independence, emigration from Kenya was largely minimal. While many people of Asian and European descent emigrated from Kenya for socio-political reasons, Kenyan ethnic groups largely avoided emigrating from the country. This desire to shun emigration was largely driven by opportunities arising out of the strong economic performance witnessed in the country in the first two decades. However, over the last 25 years, emigration from the country has increased in tandem with the deterioration of economic performance especially in the 1990s as well as social upheavals such as high population growth, and political instability. Data by the Centre on Migration, Globalization and Poverty from Sussex University suggest that the largest numbers of migrants from Kenya are resident in the United Kingdom reflecting not only the colonial heritage of the United Kingdom with Kenya but also the economic opportunities existent in the United Kingdom given its status as a first world country. However, Africa as a whole hosts the largest contingent of migrants from Kenya. Elimination of travel restrictions and growth of multilateral trade within the East African Community largely accounts for this scenario. The pie chart on the next page shows the composition of emigrants from Kenya by country and region in which they reside. 5

15 Figure 2: Composition of Emigrants from Kenya by Country and Region Canada 6% Uganda 9% USA 13% Remittances by Country United Kingdom 37% Tanzania 35% North America 15% Asia 4% Remittances by Region Europe 39% Africa 42% Latin America 0% Source: Census data from the Centre on Migration, Globalization and Poverty from Sussex University, Remittances from these emigrant workers have been on an upward trend in Kenya. In the last five years, remittances have increased by 55% from US$ 574 million in 2007 to US$ 891 million in 2011 (Central Bank of Kenya). North America and Europe remain the primary sources of these remittances reflecting the number of Kenyans resident there with gainful employment. Within the last 5 years, North America contributed an average of 51% in total remittance while Europe contributed 28%. Kenya now ranks among the highest recipients of remittances in Sub-Saharan Africa. In 2011, the estimated share of remittances as a percentage of GDP was 5.4 per cent. The increased use of money transfer services 6

16 contributed to the rapid growth of remittances to Kenya. For example, Safaricom partnered with Western Union in July 2009 to facilitate Diaspora remittance from the UK to Kenya. This arrangement saw a total of US$18.4 million remitted to Kenya in two years with the figure rapidly increasing on a monthly basis. The decline of the local currency in 2011 also created a temporary surge in remittances inflows to Kenya. Depreciation of the Kenyan currency increased the purchasing power of foreign currency which induced emigrant workers to increase the amount of remittance inflows. The increase in remittance inflows can also been attributed to aggressive government efforts to draw Kenyans living in the Diaspora to invest in government securities. The government is increasingly becoming aware of the contribution remittance inflows are playing in promoting economic development in the country. As such, the government has deepened the financial sector by creating innovative investment instruments targeted at the Diaspora including: Infrastructure bonds, Diaspora Investment Funds, and Diaspora Investment bonds. There has also been an attempt by the government to improve the overall macroeconomic policy and business environment (World Bank Doing Business Indicators, 2011). The latest Country Policies and Institutional Assessment (CPIA) rating by the World Bank, places Kenya fourth in Sub-Saharan Africa in terms of policy reform and institutional quality. Further, Kenya is now among a number of Sub-Saharan Africa countries enacting commercial laws to improve corporate governance. The figure in the next page shows the annual trend of Diaspora remittances to Kenya. 7

17 Figure 3: Remittances to Kenya Remittances to Kenya (Millions of Dollars) 1,400,000 1,200,000 1,000, , ,000 Remittances 400, , Source: Authors own computation based on data from Central Bank Database In spite of the upward surge in the amount of remittances to Kenya, there are number factors that impede their flow. The first is transaction costs. Presently, the cost of sending money to Kenya is very high. This high cost is mainly contributed by the exclusive arrangements between banks and international money transfer institutions as well as stringent regulations related to money laundering and terrorist financing (World Bank, 2011). Poor access to formal financial institutions, and high interest rate spread also plays a significant part in contributing to the low mobilization of Diaspora remittances. In recent times, advanced economies where a majority of emigrants are resident have experienced economic challenges which has led to persistent unemployment. The reduced employment prospects for emigrants from Kenya have slowed down the rate of remittance inflows. Remittances from the Diaspora to Kenya are used for a number of purposes. At the macro-level, they help support the capital account of the balance of payments account which enables the country to maintain capacity to purchase imports as well as maintain adequate foreign exchange reserves to stabilize the domestic currency. Remittances also help support domestic investment and consumption in the country. At the household level, remittances play an important role in smoothing out consumption alongside financing development projects both in the short and long run. A survey revealed that 8

18 households have been making productive investments in land, housing, agricultural equipments, and farm improvements accounting for 65% of total remittances. This can be compared to remittances spending on consumption activities like food, clothing, marriage, funerals, rent, and cars, which account for 35% of total remittances (Central Bank of Kenya). The table below shows the uses of remittances in Kenya and other Sub-Saharan countries. Table 2: Uses of Remittances in Kenya and other sub-saharan countries (%) USES Bukina Faso Kenya Uganda Nigeria Senegal Construction of new house Food Education Health Business Clothing Marriage/Funeral Rent (house,land) Rebuilding of House Cars/Trucks Purchase of land Improvement of Farm Investment Other Source: Central Bank of Kenya 1.3. Statement of the Problem Investment expenditure is one of the key components of total expenditure in an economy. The Keynesian expenditure equation states that total expenditure is a function of aggregate investment and aggregate consumption. Unlike other components of total expenditure in an economy like consumption expenditure in food, clothing, and entertainment, investment expenditure directly contributes to capital formation which is a precondition for economic growth. The rapid growth of remittances in Kenya raises the question of whether these monies are used towards investment and thus expansion of the productive 9

19 capacity of the economy. Despite the significant flow of remittances into the country in the recent past, not much is known about the impact of these remittances on private investment levels in the country. Empirical research from other countries has produced mixed results. Some studies suggest that remittances are primarily used for consumption purposes while other studies are of the view that remittances are used for investment rather than for consumption. Many of these studies used crosscountry data where the behavioral pattern of remittances was analyzed by combining data from several countries. The result of this approach was that country specific dynamics were lost in the process. Furthermore, these studies merely established correlations which do not necessarily imply causation. This study therefore seeks to empirically test the link between remittances and private investment in Kenya by attempting to resolve these shortcomings in the existing in the literature Objectives of the Study The primary objective of this study is to evaluate how the rapid growth in remittances in the recent past has affected private investment rates in Kenya as well as to examine the role played by financial sector development in facilitating the contribution of remittances towards private investment in Kenya during that period. The specific objectives of the study are as follows: i) Investigate the impact of remittances on private investment in Kenya. ii) Examine how financial sector development affects the impact of remittances on private investment in Kenya. iii) To suggest policy recommendations based on the result Significance of the Study Over the past few years, there has been a prolific increase in the number of studies analyzing the behavioral patterns of remittances in Africa. Most of these studies have focused on the influence of remittances on economic growth and welfare (Adam and Page, 2005 and Kiiru, 2010). Very limited work has been done on the impact of remittances on investment in Africa and specifically in Kenya. This study will therefore contribute to the existing body of knowledge on the subject in Africa and Kenya in particular. Depending on the findings, the study will make recommendations to policy makers on how 10

20 remittances could be harnessed effectively to facilitate economic development. The study will also suggest areas for further research for future researchers to investigate. As mentioned previously, very few country specific studies on the remittances-investment relationship have been conducted in Africa. However, there exist studies that have investigated the subject in Africa from a cross-country perspective where the behavioral patterns of remittances is analyzed using an aggregate of selected countries, for example, sub-saharan Africa. The result has been that country specific dynamics that affect the remittance-investment nexus have been lost in the process. This study departs from that approach by investigating the remittance-investment relationship focusing on one country, Kenya. The paper therefore compliments those studies with a cross-country focus by establishing the impact of remittances on private investment at a country specific macroeconomic level. Also, the regression models used in many of the studies have merely established correlations between the variables. However, correlation does not necessarily imply causation. Granger causality test will therefore be conducted to determine whether remittances are in fact useful in forecasting investment. The granger causality test will also assist determine whether the model suffers from endogeneity resulting from bidirectional causality. Ordinary Least Squares Regression of a model containing endogeneity gives biased estimates, a problem that is prominent in the literature on the subject under study Organization of the paper The study is divided into five chapters. Chapter 2 explores the theoretical literature as well as the empirical evidence surrounding the relationship between remittances and private investment. Chapter 3 discusses the methodology to be employed in the study and the empirical specification of the model. Chapter 4 discusses the empirical results from the study. Chapter 5 summarizes the results and gives policy recommendation based on the results. Thereafter, the chapter suggests potential areas for further research. 11

21 CHAPTER TWO LITERATURE REVIEW 2.1. Theoretical Literature According to Chami et al. (2003) remittances may affect the rate of private investment in an economy. However, whether remittances affect the rate of private investment in a country depends on how remittances are spent. How remittances are spent depends in turn on the motives driving the remittance flows. The literature identifies the following two main theories for analyzing remittance flows (See IMF World Economic Outlook, 2005, pp. 78). The two theories are critical in providing a conceptual framework for understanding the relationship between remittances and private investment Theory of Altruism According to this theory, the decision to remit is based on the income needs of the relatives of the emigrant worker. Emigrant workers send money to their relatives in the country of origin in order to improve their welfare. There is no expectation of reciprocation on the part of the migrant worker. The migrant worker remits the money because his utility is derived from that of his family members (Chami et al., 2003). In other words, the migrant worker gets satisfaction if the welfare of the family left back home improves. As a result, the motivation for the migrant worker to remit increases when his family is facing economic constraints. Remittances are therefore a form of compensatory transfers which compensate households faced by economic disruptions thus enabling them smoothen their consumption. As such remittances tend to be countercyclical; increasing during periods of economic downturns and decreasing during periods of robust economic growth. Therefore, according to this theory, remittances do not have a positive relationship with private investment since they are primarily spent on consumption activities. 12

22 Portfolio Approach In this theory, remittances are viewed as a strategy by an emigrant worker to diversify his or her savings. Accordingly, the decision to remit is based on the risk return differential of assets in both the host and recipient country. As such, the main determinants of the decision to remit include interest rate differential on deposit accounts in the host and recipient country, real estate return, inflation rate, and black exchange rate premium among others. Apart from these economic determinants, the desire to invest may also be driven by the desire of the emigrant worker to return back home with dignity in the event that the emigrant worker chooses to return home (OECD, 2006). Since the desire to remit is purely motivated by investment opportunities, the correlation between remittances and GDP tends to be positive unlike in the previous case of altruism. Similarly, according to this theory, the correlation between remittances and private investment is positive since remittances are principally spent on investment activities Empirical Literature The remittance-investment nexus is ambiguous in the literature. Some studies have argued that remittance have no impact on private investment levels. In fact before 1990, no positive correlation between remittances and economic development had been established. The prevailing view in the literature was that remittances were primarily spent on consumption goods and repayment of debts. As a result remittances were thought to have insignificant effects on economic growth. Rempel and Lobdell (1978) reported that remittances were primarily used for consumption purposes. Lipton (1980) estimates that 90 percent of remittances were spent on consumption expenditures. Massey et al. (1987) found that between 68 percent and 86 percent of remittances from Mexican immigrants to the United States were spent on consumption goods. Carletto et al. (2004) reported that a meager one per cent of households used remittances on investment activities with the rest going to consumption activities. The author further argues that these low levels investment were contributed by poor rural infrastructure, and low public investment. Chami et al. (2005) cast doubt on the assumption that remittance can be viewed as a source of capital in the same way as foreign direct investment. The paper constructed an econometric model in 13

23 which remittances were presumed not to be motivated by profit but rather as a form of compensation. As such, the model differentiated between treating remittance as a function of capital inflows or as compensation. The paper found the remittance-gdp growth nexus to be negative. This indicates that remittances may not be a form of external finance like foreign direct investment, but rather of form of compensatory transfers. Hrushikesh Mallick (2012) utilizes an error correction model and the Dynamic Ordinary Least Squares procedure (DOLS) developed by Stock Watson (1998) to investigate the impact of remittances on private investment in India. The paper finds that remittances crowds out private investment in India with the majority of income including remittances going towards consumption expenditure. In other words, remittance inflows led to a decline in the rate of private investment. As a result, the author suggests that the government should formulate policy to encourage the allocation of remittances towards private investment. Okuda Henry (2010) also established a similar result to Hrushikesh Mallick (2012), finding that remittances crowd out domestic investment sub-saharan Africa. The paper utilized a Generalized Method of Moments (GMM) estimation model to estimate the impacts of remittance inflows on domestic investment in sub-saharan Africa. The author found that remittances negatively affect domestic investment in sub-saharan Africa. A 10% rise in remittances from emigrant workers led to a 20.9 percent decrease in domestic investment in sub-saharan Africa. Current research particularly from Latin America and Asia suggest that households spend remittances on investment goods such as housing, education, and microenterprises. As such, these expenditures on investment goods promote both human and physical capital accumulation in developing economies. Mishra (2005), while investigating the impact of remittances in 13 Caribbean countries found that a 1 percent increase in remittances contributed to a 0.6 percent increase in domestic investment. According to Rather (2003) remittance inflows compliment investment resources from other sources both domestic and foreign in sub-saharan Africa. Adams (2002) is of a similar view arguing that remittances are used for investment rather than for consumption. In a household survey in Pakistan in late 1980s, the paper found that the marginal 14

24 propensity to save was higher for households with remittance than for households receiving other forms of domestic income. Specifically, for households receiving remittances, the marginal propensit y to save was 0.71 compared to rental incomes where the marginal propensity to save was The author argues that remittance flows were viewed as transient in nature and thus people saved them more than they consumed. The author believes that the increased savings from remittances contributes positively to investment. Adams (2005) investigated the household expenditure patterns in rural and urban areas of Guatemala. The study used data from a survey in 2000 of 7,276 households and did a comparison of the share of investment and consumption on households budgets of remittance receiving and non-remittance receiving households. Their finding was in line with the permanent income hypothesis which suggests that households are likely to invest if they perceive their income to be transient or uncertain. In particular, households receiving remittances were found utilize 58.1 percent of their remittance on education at the margin than households that did not receive remittances. This, according to the author underscores the way that households prefer to invest rather than spend their remittance earnings. Adams and Cuecuecha (2010) using panel data for the period between 2000 and 2007 from the Indonesia Family Life Survey, analyzed the effects of remittances on consumption and investment. The study established three significant findings. First, by employing instrumental variables to control for endogeneity and selection bias, the paper finds that remittances have the capacity of alleviate poverty in Indonesia. Second, the study found that households receiving remittances spent more only on food-a consumption item- at the margin than would be the case without remittances. Third and most significant, the study found that households receiving remittances spent more on housing - investment goods- at the margin than would be the case without remittances. These findings, according to the authors, lend credence to the view that remittances have the capacity to increase human and capital investments levels in the recipient economies. Adams and Cuecuecha (2010) also established a similar result in Guatemala. Yang (2005) investigated the same issue by examining whether exchange rates shocks affected expenditure patterns of remittances in Philippines during the Asian financia l crisis of The paper used data from both before and after the crisis. This allowed the study to investigate the impact of both 15

25 negative and positive exchange rate shocks on remittance expenditure. The study found that a one per cent increase in exchange rate contributed to a 0.4 per cent increase in remittance expenditure on education. Therefore, exchange rates shocks increase the expenditure of remittances on education. This increase in remittance expenditure on education, as argued earlier, helps to develop human capital and consequently expand the productive capacity of the economy. Similarly, Osili (2004) in a study on how migrants spend their income in Nigeria found that migrants are more likely to spend their income on investment than on consumption. Specifically, migrants with higher incomes tend to invest in housing. Remittance expenditure therefore is an important part of private investment in Nigeria. Woodruff and Zenteno (2007) in a study on emigration from Mexico to the United States also found that remittance from migrants in the United States of America form a significant segment of capital investment in Mexico. The paper found that remittance from the United States to Mexico lead to between 35 and 40 per cent increase in capital investment level in Mexico. The remittances were, in particular, an important source of capital for small enterprises. Cristian ÎNCALŢĂRĂU and Liviu-George MAHA (2008) construct an econometric model to ascertain the impact of remittances on investment and consumption in Romania. The paper focused on the effects of remittances on consumption and investment at the macro-level. This was a unique departure from other studies which have mainly analyzed the impact of remittances on socio-economic variables at the household level. The results from the study showed that remittances contributed significantly more to investment than to consumption. Ronnie Griffith et al. (2008) used Dynamic Ordinary Least Squares (DOLS) model to analyze the impact of remittances on investment in Barbados in the period between 1970 and The results from the study suggest that remittances have a significant effect on investment both in the short run and in the long run. The paper also provides some evidence to show that the housing sector has benefitted immensely from Diaspora remittances. As a consequence of remittance inflows many wooden houses have been converted to concrete structures in Barbados. Further, the author argues that applications for 16

26 savings bonds have increased since 1970 in Barbados suggesting that remittances have been used to invest in these bonds. Balde (2010) employed Ordinary Least squares (OLS) and instrumental variables (2SLS) estimation methods to investigate the macroeconomic impact of remittances on savings and investment in Sub-Saharan Africa (SSA). Specifically, the paper compared the effectiveness of remittances and foreign aid (official development assistance) in promoting savings and investment. The study found that remittances are more effective than foreign aid in promoting savings and investment in SSA. The coefficients on the remittances variable were found to be 6 to 7 times higher than those on the foreign aid variable. Glytsos (2001) utilized a simple dynamic, simultaneous model to analyze the impact of remittance on investment, consumption and imports and their consequent impact on GDP growth for seven Mediterranean countries in the period between 1969 and Results from the study suggest that remittances have a positive impact on investment. Specifically, the paper found that remittances were positively correlated with investment in six of the seven countries used in the study. Leon-Ledesma and Piracha (2004) found a similar result. The paper indirectly investigated the performance of employment in 11 transition economies in Central and East Europe through the impact of remittance on productivity growth and investment covering the period between 1990 and The results from the study indicated that remittances have a positive impact on employment and productivity through its effects on investment. Taiwo V. Ojapinwa and Lateef A. Odekunle (2013) investigated the link between remittances and fixed capital formation in Nigeria. The paper was particularly interested in establishing how a country s capacity to utilize remittances was influenced by financial sector development. The study used time series data between 1977 and 2010 and employed the Dynamic Ordinary Least Squares model to study the subject. This model allowed the study to control for endogeneity occasioned by the use of a lag in the independent variables. The study found a positive correlation between remittances and physical investment. Moreover, the relationship between remittances and financial depth was found to be positive and significant. This, according to the author, suggests that financial development compliments 17

27 remittances in enhancing investment. Therefore, as a policy recommendation, the author argues that for Nigeria to benefit from remittances from emigrants, the government should focus on improving financial development in order to enhance the effect of remittances on capital formation. Lucas (2005) in a review of empirical literature split the analysis of the impact of remittances into two: First, he discussed their effect on poverty and inequality and secondly, he investigated the remittance-investment and savings nexus. The author was able to identify a positive correlation between remittance and investment. Specifically, he pointed out that remittances may have accelerated the level of investment in Pakistan, India and Morocco. Aitymbetov (2006) found that approximately 10 percent of remittances were used as some form of investment in Kyrgyzstan, and thus had a positive impact on the economy. The paper constructed a dynamic demand model to assess the macroeconomic implications of remittances in Kyrgyzstan. The model goes through consecutive phases where the impact of remittance on investment, consumption and imports respectively is analyzed. This culminates in the eventual regression of the impact of remittance on GDP growth in Kyrgyzstan. Remittances are found to produce a multiplier effect. A $100 increase in income is found to lead to a $230 increase in income. The multiplier effect is determined by the marginal propensity to consume and the marginal propensity to invest. Therefore, the results support the hypothesis that remittances positively influence the economy through its impact on aggregate investment in the economy. Calderon et al. (2010) investigate whether investment could benefit from remittances if the government legislate a series of policy improvements. The study employs a regression model based on the simple accelerator model relating investment to output growth. The model is augmented with a series of variables meant to capture variables unique to the investment climate. Human capital is found to be complimentary to remittances in the process of capital accumulation. Remittances are found to increase with the level of high school enrollment (a proxy for human capital).similarly, the effect of remittances on investment is found to be positively correlated with institutional quality and policy environment as proxied by a policy variable. However, remittances and financial depth were found to be inversely related suggesting that remittances and financial development are substitutes. 18

28 Ziesemer (2006) developed an open economy model to analyze the impact of remittance on economic growth through two channels: physical capital channel and the human capital channel. The paper estimated two variants of an open economy model for the two channels using the general method of moments with heteroscedasticity and autocorrelation correction (GMM-HAC). Data consisted of pooled data from four countries that received remittance in The study established the following results: First, remittances had the largest impact on savings in countries with low per capita income; Second, remittances was found to have a positive relationship with steady-state level of GDP; Third, human capital variables were found to have a positive correlation with GDP. The implication of these results, according to the author, is that remittances will increase growth not only through increase in investment but also through increase in literacy levels. Paulson and Towsend (2000) posit that entrepreneurs in many developing countries suffer from lack access to credit since many developing countries suffer from underdeveloped financial systems and therefore face liquidity constraints. In the absence of credit, entrepreneurs will not be able to pursue profitable opportunities. Remittance inflows can therefore alleviate such credit constraints in economies where there is limited access to credit. Dustmann and Kirchamp, (2001) argues that relaxation of credit constraints would lead to higher levels of investment and thus economic growth. Paolo Giuliano and Ruiz-Arranz (2005) used a Generalized Method of Moments (GMM) approach to investigate whether remittances could bridge the gap caused by the lack of access to credit. In particular, the paper examined the relationship between remittances and economic growth focusing on how the interaction between remittances and financial development can influence a country s capacity to utilize remittances as well as the effectiveness of remittances. Data comprised of cross-country data of 73 developing countries receiving remittances in the period between 1975 and The empirical results suggest that remittance can promote investment and thus economic growth in countries with underdeveloped financial markets. Anupam Das (2009) compares the impact of remittance inflows and grants on capital formation and economic growth. Data consisted of four countries receiving remittances from emigrant guest 19

29 workers in oil-rich Arab states. The study estimated investment, consumption and income equations using time series analysis and panel data methods. The impact of remittance on capital formation and of grants on capital formation was at found to be at variant. The results indicated no relationship between remittances and investment in all countries except Bangladesh. Grants on the other hand had a positive relationship with investment in Pakistan and Syria, a negative correlation with investment in Egypt and no effect in Bangladesh. Since both remittances and grants are transfers from abroad, a similar impact on capital formation was expected. The author postulates that the private characteristic of remittance explains this variance Overview of the Literature Empirical evidence on the impact of international remittances on investment is mixed. While some studies argue that remittances have a negative or no impact on investment, others contend the contrary view that remittances contribute positively to investment. Very few of these studies have analyzed the relationship in Africa. This is because a huge portion of remittances has been flowing to Latin America and Asia with Africa only getting a significant chunk of the pie recently. Those studies that investigated the subject in Africa have done so primarily from a cross country perspective where the behavioral pattern of remittances is analyzed using data from several countries. The result is that country specific dynamics that affect the remittance-investment nexus are ignored or assumed away. The mixed results obtained by empirical literature also raise the question of whether endogeneity is a problem in the literature. Many of the studies assumed remittances to be an exogenous variable and investment to be endogenous thus ignoring the problem of causality. Theoretically, bidirectional causality between remittances and investment is possible. 20

30 CHAPTER THREE METHODOLOGY 3.1. Theoretical Models Several models have been employed in the literature to analyze the determinants of investment. These models include: the neoclassical model of investment, the accelerator investment model and the Q- model of investment. The neoclassical model is based on the work of Jorgenson (1970). According to the theory, the desired level of capital stock is influenced by the output level and the relative price between capital services and output. Capital services refer to the flow of productive services provided by an asset that is employed in production. The price of capital services is in turn a function of price of capital goods, interest rate, and taxes. Therefore, the desired capital stock (investment) depends on changes in output, and the relative price between capital services and output price. Reaction lags are also included in the model to capture expectations. Three main criticisms have been adduced against the neoclassical model. The first criticism revolves around the impact of the user cost of capital on investment. Empirical evidence is mixed on the impact of user cost of capital on investment. This relationship is core to the neoclassical model theory. For example, Chirinko (1993) finds that output is the main determinant of investment. The second criticism is that the lag coefficients are difficult to interpret because the effect of expectations cannot be distinguished from other factors captured by the lag variable such as adjustment costs. The third criticism is the lack of measures of capital stock (Blejer and Khan, 1984). According to Ramirez (1994), many developing countries do not have published records of capital stock or estimates of depreciation rates; and even more importantly, the financial sector in many developing countries has been subject to significant government intervention so that investment reflects available quantity of resources rather than market determined quantity where the marginal product of capital is equal to its rental price. 21

31 The Q-theory of investment is based on the work of James Tobin (1978). According to the Q- theory, the desired level of capital stock (investment) is correlated positively with ratio of the market value of the firm to the replacement cost of the firm s capital. Tobin writes it is common sense that the incentive to make new capital investments is high when the securities giving title to their future earnings can be sold for more than the investments cost. Mathematically; Market value of capital Q Replacement cost of firm' s capital Therefore, according to the model, the market value of the firm s stock is a proxy for the gap between the existing capital stock and future capital stock. The model is suited for analyzing investment in countries with more developed financial markets like the advanced economies of the west. Developing economies are characterized by underdeveloped financial markets which are inefficient thus making the model unsuitable. Another major shortcoming of the model is its assumption that financial markets are efficient meaning that financial markets will capture the fundamental value of assets. Literature suggests that this may not be the case. The occurrence of speculative bubbles demonstrates that financial markets even in developed economies may not be efficient thus share prices may not reflect the true value of a firm s assets. The accelerator model is mostly used to analyze the determinants of investment. The idea behind the accelerator model is that investment is determined by the gap between the desired level of capital stock and the existing or actual level of capital stock. Firms continuously attempt to bridge this difference between the desired capital stock, K*, and existing capital stock (proxied by last period s capital stock), K, through investment. This hypothesis gives rise to the following investment function: I = δ (K* - K t ) Where I = net investment, K* = desired capital stock, K t = last period s capital stock, and δ = partial adjustment coefficient. The accelerator model further hypothesizes that the level of capital is proportional to the expected level of output. Thus, capital stock is a function of output level so that investment is a function of output 22

32 growth. Furthermore, adjustment to the desired level of capital stock is assumed to take place over many periods. Therefore, reaction lags are incorporated into the model to reflect the time it takes for new investments to be made in response to changes in demand. The inclusion of reaction lags also helps to incorporate expectations into the model. Other variables may be augmented with the accelerator model as determinants of capital stock, K. The other variables to be included are selective reflecting the socioeconomic environment of the country or region being studied. Although the accelerator model suffers from problems similar to those experienced with the neo classical model particularly with regard to the specification of expectations, empirical evidence suggests that the accelerator model outperforms the neoclassical model empirically (Baddeley, 2002) Empirical Specification The empirical specification for the investment function in this paper is derived from the flexible accelerator model of investment. The variables augmented in the model for this study include the following: initial level of investment, gross domestic product, inflation rate, remittances, nominal exchange rate, nominal interest rate, foreign direct investment and private sector credit. The functional form of the equation is given below. (PINV)=f{(INV) -1,(INF),(REM),(INTR),(GDP),(FDI),(PCREDIT),(EXCH)}.... (2) Where: PINV = Private Investment (INV) -1 = Lagged private investment (INTR) = Interest rate (EXCH) = Real exchange rate (INF) = Inflation rate (REM) = Remittances 23