- Workers' Remittances and the Equilibrium Real Exchange Rate:Theory and Evidence
International economic integration in the early twenty-first century is conventionally thought of in terms of increased openness to trade in goods and services, as well as a dramatic increase in the volume of capital flows. The twenty-first-century experience is sometimes contrasted with that of the last wave of globalization at the end of the nineteenth century, when increased integration in both of those dimensions was also accompanied by large waves of international migration. However, this contrast is probably overdrawn, as increases in international flows of labor services have also been characteristic of the current wave of globalization, and the impact of these factor movements is increasingly being felt in the international economy.
A particularly dramatic manifestation of this fact is the sharp recorded increase in flows of worker remittances to the large number of developing countries that have been the source of these flows of labor services. In recent years, many such countries have witnessed significant increases in remittance flows, to the point that their scale has come to dwarf that of other types of resource inflows, whether development assistance, foreign direct investment, or other types of capital flows. In 2007 remittance flows to sub-Saharan Africa were equal in magnitude to flows of official development assistance, for example. Remittance flows now account for some 17 percent of GDP and 77 percent of exports in El Salvador, and over 20 percent of GDP and nearly 50 percent of exports in Honduras. In these countries, remittance flows are more than five times larger than foreign direct investment flows.
Unlike capital flows, remittances do not entail the creation of external debt with future repayment obligations; unlike foreign development assistance, they do not come encumbered with a variety of political and economic conditions with which the recipient country must comply. Despite these virtues, however, large inflows of worker remittances have been perceived as posing [End Page 45] macroeconomic challenges for the recipient countries.1 One specific challenge is that large inflows of worker remittances could lead to the emergence of "Dutch disease," that is, remittance inflows could result in an appreciation of the equilibrium real exchange rate that would tend to undermine the international competitiveness of domestic production, particularly that of nontraditional exports.
Accordingly, the purpose of this paper is to analyze the effect of worker remittances on the equilibrium real exchange rate in recipient countries. Our specific concerns are to investigate analytically the conditions under which an increase in worker remittances would indeed tend to appreciate the equilibrium real exchange rate, and to bring some empirical evidence to bear on this issue. For the analytical component, our strategy is to use a simple "workhorse" model of a small open economy to derive the standard result that an increase in remittance inflows results in an equilibrium real appreciation, and then investigate the conditions under which this conclusion could be reversed.2 Our main conclusion is that the "benchmark" case, in which a permanent increase in the flow of worker remittances results in an appreciation of the long-run equilibrium real exchange rate comparable to what would result from a similar permanent increase in the receipt of exogenous international transfers, is a rather special one: reasonable modifications in the modeling of the factors driving remittances, or in the various macroeconomic roles that remittances may play, could moderate or even reverse the expected impact of remittance flows on the equilibrium value of the real exchange rate. The implication is that the presumption that a permanent increase in workers' remittances causes an appreciation in the long-run equilibrium real exchange rate is too facile: the complicated macroeconomic roles that remittances play in recipient economies allow for a multiplicity of possible outcomes, and the issue is therefore an empirical one. We investigate this issue empirically by applying panel cointegration techniques, employing the largest set of countries for which remittance data are available. After controlling for a large number of fundamental determinants of the equilibrium real exchange rate, we find that despite the theoretical ambiguities, the empirical evidence is indeed consistent with an appreciation of...