Remittances and economic growth in developing Asia and the Pacific countries

UNIVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

INSTITUTE OF SOCIAL STUDIES
THE HAGUE
THE NETHERLANDS

VIETNAM – NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

REMITTANCES AND ECONOMIC GROWTH
IN DEVELOPING ASIA AND THE PACIFIC
COUNTRIES
A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By
PHAM THI HANG

Academic Supervisor:
Dr. PHAM KHANH NAM

HO CHI MINH CITY, December 2014

1


Table of Contents
List of Figures ........................................................................................................................ 3
CHAPTER I: INTRODUCTION........................................................................................... 5

1.

Introduction ................................................................................................................. 5

2.

Research objectives..................................................................................................... 7

CHAPTER II: LITERATURE REVIEW .............................................................................. 8
1.

Remittance definition .................................................................................................. 8

2.

Remittance in Growth model .................................................................................... 10

3.

Consequence of remittances ..................................................................................... 12

4.

3.1

Remittances and capital accumulation .............................................................. 12

3.2

Remittance and labor force growth ................................................................... 13

3.3

Remittance and total factor productivity growth ............................................... 14

Factors effect economic growth ................................................................................ 15
4.1

Remittances ....................................................................................................... 15

4.2

Investment ......................................................................................................... 20

4.3

Fiscal balance .................................................................................................... 22

4.4

Trade openness .................................................................................................. 25

4.5

Inflation ............................................................................................................. 27

4.6

Population growth ............................................................................................. 30

4.7

Human capital formation ................................................................................... 32

CHAPTER III: METHODOLOGY ..................................................................................... 35
1.

Analytical framework ............................................................................................... 35

2.

Estimation technique................................................................................................. 39

3.

Data source ............................................................................................................... 41

CHAPTER IV: EMPIRICAL RESULTS ............................................................................ 42
1.

Overview of remittances in developing Asia and the Pacific countries ................... 42

2.

Remittances and growth............................................................................................ 46
2.1

Non-parametric analysis .................................................................................... 46

2.2

Parametric analysis ............................................................................................ 48

CHAPTER V: CONCLUSION ........................................................................................... 53
References ............................................................................................................................ 57
Appendix .............................................................................................................................. 66

2


List of Tables
Table 1: Data description ..........................................................................................37
Table 2: Remittances to developing countries, 2010 -2013 (US$ billion) ...............42
Table 3: Summary statistics of variables ..................................................................46
Table 4: Correlation matrix .......................................................................................46
Table 5: Estimation results ........................................................................................52
Table 6: List of countries and remittances (share of GDP, 2000-2012) ...................66

List of Figures
Figure 1: Remittances and other resource flows to developing countries ..................5
Figure 2: Share of remittances by region in Asia and the Pacific countries, 2013 ...43
Figure 3: Growth rate of remittances by region in Asia and the Pacific countries ...43
Figure 4: Top 10 remittance-receiving developing countries in Asia and the Pacific,
2013 ...........................................................................................................................44
Figure 5: Scatter plot of growth and remittances ......................................................47

3


ABSTRACT

Over the past three decades, remittance inflows have increasing dramatically and
become the main source of foreign exchange both in absolute terms and as a
percentage of GDP in many developing countries. However, the growth effect of
remittance is still not well understood. This study attempts to investigate the impact
of remittance inflows on economic growth in developing Asia and the Pacific
countries. Moreover, it examines whether remittances can effect on the impact of
labor and capital on growth in remittance-receiving countries. The study uses a
balanced panel data on remittance flows to 25 developing countries in Asia and the
Pacific for the period 2000-2012. Endogeneity problem is controlled by system
GMM estimator. The results find no evidence suggesting the significant relationship
between remittances and growth when remittance is considered as an explanatory
variable in a standard growth regression. Taking into account interaction terms, this
paper comes to conclusion while population growth and remittances is
complementary, human capital development and remittances are used as substitutes
to promote growth.

4


CHAPTER I: INTRODUCTION
1. Introduction
Remittance is one of the most crucial parts of total international capital flows. It is
transferred through official and unofficial channels. For instance, in 2013, official
recorded worldwide remittance flows reached nearly $550 billion (World Bank,
2013). The unrecorded remittance flows is believed to be as large as 20 to 200
percent of total official remittance flows (Aggarwal et al., 2006; World Bank,
2006). International remittance inflows to developing countries are expected to
increase to 8.4 percent in 2014-2016 and can reach to $516 billion in 2016 (World
Bank, 2013). This forecast is calculated according to the outlook for GDP growth
rate in key remittance-sending countries and remittance growth rate in the past. In

other words, the outlook for remittances remains optimistically. Moreover, these
flows are expected to get three times larger than official development assistance and
become more stable than private debt and portfolio equity.

Figure 1: Remittances and other resource flows to developing countries
Sources: Migration and Development Brief 22, World Bank

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Because of the dramatic increase in size, remittance flow has attracted scrupulous
attention of academics and policy makers. They have believed that the money the
migrants send back to their relatives and friends in home country may impact that
country macroeconomics conditions in many aspects. For example, on the one hand,
the migrants of skilled and educated labor raise serious doubts about the brain drain
and effect on sustained economic growth of migrant-sending countries (Docquire &
Schiff, 2009). On the other hand, the academic and policy circles believe that
remittances can be seen not only as the main income for the low and middle-income
households in developing countries but also as the crucial financial supply for
domestic investment. Another advantage of remittances is that it is sent directly to
family and friends without government intervention, thus, it seems to be less
volatile than other nontrade foreign currency inflows. Moreover, remittances also
expected to promote consumption and reduce cost of capital in recipients’ country.
Therefore, remittance inflows can have important implications for economic growth
of recipient’s countries.
While there is vast literature on the effect of remittances on the development
prospect in migrant-sending countries, empirical studies on this issue have been
done at the worldwide level or for developing countries as a whole with mixed
result. For example, the study was done by Vargas-Silva, Jha and Sugiyarto (2009)
pointed out that a 10 percent higher in remittances as a share of GDP leaded to a

0.9-1.2 percent higher in GDP growth. Some other researchers argued that even
though the impact of remittances on growth of receiving countries still depended on
how this money was spent, and even when the households do not use remittances
for investment, remittances may have an important multiplier effect. Lowell and De
La Garza (2000) investigated that each one remittance dollar spent on additional
consumption could encourage retail sales and further goods and services demand,
and then helped to greatly stimulate growth and employment. However, Straibhaar
and Wolburg (1999) discovered that strongly dependence on remittance can
encourage continuing migration of the working-age population, especially high-

6


skilled. Then, the welfare loss due to emigration cannot be compensated by.
Besides, if remittances provoke goods and services demand higher than the
economy’s capacity, especially on non-tradable goods, remittances may cause
inflation. In Egypt, because of the massive rise in remittances, agriculture land price
had increased by 600% between 1980 and 1986 (Adams, 1991). Finally, remittances
may create negative impact on growth by existing significant moral hazard
problems. In particular, with additional income by remittances, people tends to
work less and to diminish labor supply (Chami, Fullenkamp & Jashjah, 2003).
This study addresses the question whether remittance inflows promote economic
growth in developing countries in Asia and the Pacific. It differs from previous
studies in that it examines whether remittances can effect on the impact of labor and
capital on growth in developing Asia and the Pacific countries. The study uses a
balanced panel data on remittance flows to 25 countries in Asia and the Pacific for
the period 2000-2012. The results show that while population growth and
remittances is complementary, human capital development and remittances are used
as substitutes to promote growth.
The structure of the paper is as follows. Chapter 2 provides an overview of existing

theories and previous empirical studies. Chapter 3 presents the analytical
framework, estimation technique and data descriptive. Empirical results are
described in chapter 4. The last chapter will conclude and provides some policy
recommendations.
2. Research objectives
 To evaluate the impact of remittances inflows on economic growth in
developing Asia and the Pacific countries.
 To examine how remittances affect the impact of investment, population
growth and human capital formation on growth in developing Asia and the
Pacific countries.

7


CHAPTER II: LITERATURE REVIEW
Remittance flows are expected to have potential effect on economic growth due to
its considerable increase. This chapter provides theoretical framework along with
empirical studies of the impact of remittances on growth. First, remittance
definition and remittance in growth model are discussed. Then, section 3 examines
the channel through which remittances may effect on economic growth. In the last
section, empirical studies on the factors effect economic growth including
remittances, investment, fiscal balance, trade openness, inflation, population growth
and human capital formation are reviewed, respectively.
1. Remittance definition
Remittances take place when one or more family members live and work abroad
send money back to their remaining family in the home country (Chami, Cosimano
& Gapen, 2006). IMF defined remittances in the fifth edition of Balance of
Payments Manual (BPM5) as the sum of three items including worker’s
remittances, compensation of employees and migrants’ transfer.
 Worker’s remittance is the current transfer by a migrant worker, a resident of

another country or a worker who stays or expects to stay abroad for more
than one year to their home country. According to BPM5, it is recorded
under current transfer.
 Compensation of employees is gross earnings of nonresident workers who
live abroad for less than one year like border, seasonal worker or local
embassy staff…. It is included under income in the current account (BPM5).
 Migrants’ transfer represents the capital transfer of financial assets by
individuals who have a change of residence from one country to another
country. According to BPM5, it is documented in the capital account of the
balance of payments.

8


However, it has been argued that the inclusion of migrants’ transfers on remittance
calculation is misspecification because of two underlying reasons. Firstly, since
remittance refers to change in wealth transfer, migrants’ transfers involve assets
remain in the same hands of people who have moved their accumulated assets from
one country to another country. Secondly, there is no special need for any actual
flows because of a change in residence status. The certain transaction is
reclassification of assets. Therefore, in the third annual meeting in July 2005, the
UN Advisory Experts Group in National Accounts particularly recommended to
remove migrants’ transfers from capital account because of no change on
ownership.
Because of the demand on the accuracy of measuring remittance flows, a working
group composed of the World Bank, IMF and other international financial
institutions was established in order to clarify remittance definition as well as
provide guidance for collecting and estimating remittance statistics. This technical
group made recommendations to the IMF Committee on Balance of Payments
Statistics and the Advisory Experts Group in National Accounts with the following

items:
 Replacing workers’ remittances by personal transfers which focus on
household transfer.
 A new item, personal remittances, is created. They will be measured as the
sum of personal transfers and net compensation of employees.
 Migrants’ transfer is removed from the balance of payments framework. The
assets’ transactions related to changes in individual’s residence will be
recorded under other changes of assets and liabilities.


The concept of migrant is eliminated in the balance of payments because
personal transfers’ definition is based on the residency rather than migration
status.

9


2. Remittance in Growth model
Economic growth is defined as an increasing not only in actual output over time but
also the capacity of the economy to produce goods and services. The economists
have devoted special attention on the importance of economic growth centuries ago
in the attempt to find the way nations become healthier and how to increase the
standard of living. There are numerous macroeconomists who have contributed
significantly to the development of the study of economic growth both in theoretical
and empirical. However, this part will concentrate on the model that closely
relevant to the study.
The direct and permanent growth effects of enhancing variables like remittances,
reforms or globalizations have been captured by using production function.
However, empirical studies found that in annual data or even with short panel, these
effects could not be estimated by regressing the growth rate of output on these

enhance variables. These effects will be capture through the impact of remittances
on total factor productivity (Rao & Hassan, 2011).
The model based on the augmented Solow framework, where per worker output y
was defined as a function of stock of technology A and capital per worker k. The
production function takes Cobb-Douglas form with the constant returns:
𝑦𝑡 = 𝐴𝑡 𝑘𝑡𝛼 where 0 < α < 1

(1)

The evolution of technology, as assumption of Solow model, is given by:
𝐴𝑡 = 𝐴0 𝑒 𝑔𝑇

(2)

A0 is the initial stock of knowledge, T is time and g is the steady state growth of
output per worker. Thus, the production function for estimation will be modified as:
𝑙𝑛𝑦𝑖𝑡 = 𝑙𝑛𝐴0 + 𝑔𝑇 + 𝑙𝑛𝑘𝑖𝑡

(3)

It is also plausible to assume that:

10


𝐴𝑡 = 𝑓(𝑇, 𝑋𝑡 ) 𝑓𝑇 and 𝑓𝑋 ≤ 0 or ≥ 0

(4)

X is a vector of growing variable, which is remittances in this study, and a set of

control variables for growth such as investment, labor, and human capital. Besides,
trade openness is used as an indicator of an economy’s external orientation and
inflation and fiscal balance are used to capture the macroeconomic environments.
The production function captures the effect of remittances and other variables on
TFP are extended as:
𝑦𝑡 = 𝐴0 𝑒 (𝑔1+𝑔2𝑋𝑡) 𝑘𝑡𝛼

(5)

The Solow model defined steady state level of income per worker (𝑦 ∗ ) as a function
of saving rate s, growth rate g, employment rate n and depreciation rate d. The
production function in equation (1) is extended as:
∗

𝑦 =(

𝑠
𝑛+𝑔+𝑑

)

𝛼
1−𝛼

𝐴

(6)

In this equation, by making assumption on g and d, using data on s and n, and given
α, the steady state growth rate can be:

∆𝑙𝑛𝑦 ∗ = ∆𝑙𝑛𝐴

(7)

With the assumption that the evolution of the stock of knowledge grows as constant
rate, then:
∆𝑙𝑛𝑦 ∗ = 𝑔

(8)

However, the steady state will be extended as the assumption in equation (5):
∆𝑙𝑛𝑦 ∗ = 𝑔1 + 𝑔2 𝑋

(9)

In this equation, the growth effects trend and ignored variables are illustrated by
𝑔1 and growth effects of the variables in vector X are captured by 𝑔2 .

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3. Consequence of remittances
In principal, remittances can effect growth through three channels including capital
accumulation, labor force growth and total factor productivity (TFP) (Chami, Dalia,
& Peter, 2009).
3.1 Remittances and capital accumulation
Remittances may affect the rate of capital accumulation in the various ways. The
most importance mechanism is directly financing for capital accumulation in the
countries that rely heavily on domestic funds for investment. For instance, if a
country has enormous difficulties in accessing foreign sources, remittances may

become the valuable funds to finance for domestic investment. Besides, from a
microeconomic perspective, remittances reduce some financial restrictions that the
household may face in their investment activities (Barajas et al., 2009). In other
words, remittances increase the rate of accumulation not only physical but also
human capital.
However, remittance flows not only impact on domestic investment through supply
funds but also effectively augment household collateral. In fact, remittance inflows
are expected to increase creditworthiness of domestic investors, and then, reduce
cost of capital in recipient country. To be more precise, people who receive
remittances frequently may have more trust from the financial institutions;
therefore, additional borrowing to finance for their investment during any given
period of time may exceed the magnitude of remittance flows during that period.
The forthcoming remittance flows can be one of the main sources to service for
outstanding debts. As the consequence, remittance flows may increase the size of
household collateral.
Beside two mechanisms that list above, domestic capital accumulation could be
effected by remittance inflow through reducing output volatility (Chami, Dalia &
Peter, 2009). The fact is the risk premium in undertaking investment may definitely

12


reduce when the domestic macroeconomic become stable. Therefore, domestic
investment becomes more attractive.
Although the impact of remittances on capital accumulation definitely exists, it
seems not to be positive in every case. To be more precise, with the compensation
nature, a family with a high marginal propensity to consume may not use significant
quantities of remittances for investment. Particularly, in the case of permanently
remittance flows, the households tend to spend money for additional consumption.
As the result, it will be beneficial to household welfare rather than aggregate

economic growth. Finally, remittance flows seem to have low impact on an
economy with highly integrated with world financial market and highly developed
in financial system.
To summarize, remittance flows directly effect on human capital accumulation
through financing the cost of investment as well as increasing the likelihood of
staying in school for the children of recipient households (Cox-Edwards & Ureta,
2003). For instance, it is not necessary for a young member of a high income family
to abandon school in order to working for a living. However, the effect on domestic
economic growth depends on whether the person receive this extra education will
participate in the domestic labor force or migrate to another country.
3.2 Remittance and labor force growth
Remittance flow may influence growth by effecting on the growth of labor input;
for instance, labor force participant, when level of human capital remains
unchanged. In particular, the labor force participant is expected to have reverse
direction with remittance receipts. This means that the higher remittance flows the
economy receives, the lower labor force participant they have (Kozelt & Harold,
1990). In other words, the household will substitute remittance income for labor
income. Furthermore, it is said that remittance flows may face with severe moral
hazard problems (Chami, Fullenkamp & Jashjah, 2003). In fact, because of the

13


asymmetric information and the distance between the remitter and recipient, it
seems extremely difficult to monitoring and enforcing the remittance spending. As a
result, moral hazard problems may happen when the recipients divert resources to
the consumption of leisure, so that, they tend to lower their job search and reduce
labor market effort.
3.3 Remittance and total factor productivity growth
Remittances can influence TFP growth through impact on two main components

including the efficiency of domestic investment and the size of domestic productive
sector. However, how these effects can happen in the recipients’ countries depend
on a wide range of factors that may vary from one economy to another.
In the former, as the remittances flow into an economy, they can boost domestic
investment by improving the quality of domestic intermediation. If the recipient
makes an investment instead of the remitter, the domestic investment effectiveness
may depend on the agent making investment decision (Barajas et al, 2009). For
instance, if the family members, who have less skilled in allocating capital, instead
of making investment decision, they leave money for the domestic financial
intermediary. Then, remittance flows become capital inflows rather than remittance
receipt. Consequently, the efficiency of domestic investment may be higher. In
addition, remittance flows improve not only the quality of domestic investment but
also the ability of financial system to allocate capital in recipients’ countries. It is
clear that formal remittances are transferred through banking system. This
mechanism may enhance financial development as well as economic growth
through increasing economies of scale in financial intermediation or a political
economy effect when the receivers put pressure on the government to do the
financial reforms (Barajas et al, 2009).
In the later, remittances can effect TFP growth through Dutch disease; that means
the effect operates through the influence of remittances on real exchange rate.

14


Empirical evidence show that a large and sustained remittance flows can lead to an
increase in the demand for domestic currency which may result in currency
appreciation, and thus lower export competiveness in the international economy
(Amuedo-Dorantes and Pozo, 2004). However, this mechanism does not happen in
every case. It existence depends on two factors including whether the real exchange
rate is actual appreciate, and whether the traded good production in recipients’

countries can generate dynamic production externalities.
On the whole, this discussion show that remittance flows may effect on economic
growth in many aspects. However, these effects seem to be uncertain and take the
opposite direction. The effects of remittances on economic growth are ambiguous
from the theoretical perspective. In the next section, empirical researches on
remittance- growth nexus will be reviewed in order to illustrate for this relationship.
4. Factors effect economic growth
4.1 Remittances
Plenty researchers had pay attention to the influence of remittances on growth in
recipient countries but reached different conclusions, for instance, positive effect,
negative effect, conditional effect or even no significant effect. Since, the difference
in the result comes from a lot of reasons; the endogeneity is one of the serious
problems for the researchers.
There are two possible reasons for two-way causality between remittances and
economic growth. The first one is that whether the remittance flows are high or low
depend on the domestic growth in recipient’s countries. For example, a low
economic growth country may have higher outward migrants, thus, remittance
flows also become higher. The remaining reason is that both growth and remittances
may be effected by independent causes which can be poor domestic governance,
motivating higher education or high economic growth in major destination countries

15


of migrants. In fact, due to larger migrant incomes in high growth countries, the
remittances increase as well.
Although endogeneity problem becomes the extremely importance in testing the
impact of remittance on economic growth, solving this problem seems to be
primary challenge for the researchers because there is no consensus regarding to
endogeneity in the literature on remittances. To date, three main tools for mitigating

endogeneity problem was used by researchers including choosing a set of
instrument variables, a set of conditioning variables or the estimation technique.
The first attempt to use these tools was Chami, Fullenkamp and Jahjah (2003). For
instance, they used two instruments variables for the remittances received including
the ratios of a country’s income to United State income and country’s real interest
rate to the United State real interest rate. By using panel date of 113 countries over
1970 – 1988 periods with some other control variables including investment rate,
inflation rate, the ratio of net private capital flows to GDP and regional dummies,
the authors estimated the ratio of worker remittances over GDP and the change in
this ratio. The result showed that although domestic investment and private capital
flows related positively to growth, the worker remittances over GDP was the
reverse. Because of moral hazard problem, remittances differed from private capital
flows in terms of motivate and effect; therefore, they failed to be the significant
source of capital for economic development. The authors tried other instrument
variables by using lagged right-hand-side variables but reached the same result.
The distance between home country of the migrants and their main destination
country was the other instrument that was used by the IMF (2005) and Faini (2006).
The IMF (2005) chose a dummy variable, whether home country and the
destination country shared the same language, and found no evidence for the effect
of remittances on economic growth. Similarly, Faini (2006) run the regression by
using a sample of 68 countries over 1980 – 2004 periods. The study differed from
previous researches because it did not take into account domestic investment in the

16


set of control variables. Whereas OLS regression showed the positive and
significant of the coefficient of the total remittances-to-GDP, the regression with
instrument variables revealed that the coefficient remained positive but
insignificant.

The World Bank (2006) used time-varying instrument by multiply the inverse of the
distance between OECD countries (migrants’ destination country) and the
recipients’ country to the GDP per capita, the GDP growth rate and the
unemployment rate of OECD countries. The study run the cross-country growth
regression on the data set of 67 countries over 1991 - 2005 periods with a set of
control variables including initial GDP per capita, the secondary school enrollment
ratio, the inflation rate, the ratio of real imports and exports to GDP, a measure of
real exchange rate overvaluation, the ratio of government consumption to GDP, the
ratio of domestic credit to GDP, political risk index from the International Country
Risk Guide and the time dummies. The result revealed that the remittances-to-GDP
created a positive impact on economic growth even though the specification
included or excluded investment variable. However, without investment, the
coefficients lost their significance. The contribution of remittances to economic
growth was also measured, however, it was small.
The study was done by Giuliano and Ruiz-Arranz in 2005 used lagged explanatory
variables with the SGMM technique along with OLS and fixed effects panel
regression to solve the endogeneity problem. They run the regression on a data set
of 73 countries with all variables measured in 5 years averages, over the 1975-2002
periods. The authors first regressed per capita GDP growth on the total remittancesto-GDP ratio with a set of explanatory variables including initial level of GDP per
capita, the investment rate, population growth, the fiscal balance as a percentage of
GDP, years of education, openness and inflation. The result showed no evidence for
the impact of remittances on economic growth. On the second regression, the
authors tested whether remittances might enhance growth by relaxing credit

17


constraints by adding more variables like loans-to-GDP ratio, credit-to-GDP ratio,
M2-to-GDP ratio and deposits-to-GDP ratio. They investigated that whereas the
remittances promote economic growth in a countries with small financial sectors,

the reverse was true in high financial developed countries. Besides, instead of using
instrument variables, Ramirez and Sharma (2009) mitigated endogeneity problem
by using the fully modified OLS. With the annual panel data of 23 Latin American
countries over 1990 – 2005 periods, they received the same result as Giuliano and
Ruiz-Arranz.
Just like Giuliano and Ruiz-Arranz, Catrinescu et al (2009) used an internal
instrument, lagged remittances, to test remittances-growth relationship on a data set
of 114 countries over the 1991 – 2003 periods. The authors not only used dynamic
panel method but also extended previous researches by making slight modifications
and adding institutional variables into the analysis. The study took into account a set
of control variables including initial GDP per capita, gross capital formation as
share of GDP, net private capital inflows as share of GDP, United Nations Human
Development Index, six governance indicators as in Kaufmann, Kraay and
Mastruzzi, and political risk rating from the International Country Risk Guide. The
result showed that although the relationship between remittances and economic
growth was positive, it was relatively mild.
The recently research was done by Barajas et al. (2009) revealed another instrument
to correct the endogeneity problem. They argued that the transaction cost associated
with making a remittance transfer should be the best choice because it was
negatively correlated with remittances and uncorrelated with the error term in the
growth equations. However, it was unable to observe such costs directly.
Consequently, they introduced a new instrument called the ratio of remittances to
GDP of all other recipient countries, which captured not only the effects of global
reductions in transaction costs but also the other systematic changes in the
microeconomic determinants of remittance flows. Additionally, the authors also

18


added a new control variable which was the trade-weighted average growth rate of

real per capita GDP of the top 20 trading partners to recipient’s country. The other
variables used in the regression included the initial GDP-per-capita, the ratio of
trade-to-GDP, the inflation rate, foreign direct investment ratio, the fiscal balance,
population growth to GDP , International Country Risk Guide political risk
indicator. By using a data set of 84 countries over the 1970 – 2004 periods, the
study found a little evidence for the contribution of remittance flows on economic
growth.
As the results discussed above suggest, due to the difference on solving endogeneity
problem, the impact of remittance flows on economic growth is inconclusive.
However, the diversity of results in testing remittances-growth nexus also comes
from other sources. The first one is the difference in measuring remittance data. As
mentioned above, while some researchers used three components of remittances in
order to investigating the problem, Chami et al. (2008) claimed that the balance of
payments categories of compensation of employee and migrants transfer captured
different behavioral characteristics as workers’ remittances. Moreover, the
correlations between workers’ remittances and compensation of employee within a
country are usually small, or even negative in some cases. Therefore, workers’
remittances seem to be narrower and precise definition which the most researchers
referred.
The other sources are the difference in choosing control variables included in
growth regression, the type of variation relied upon to investigate the growth effects
of remittance flows as well as the time periods or the sets of countries included. For
example, whereas researchers argued that investment variable played important role
in growth, the others did not share the same ideal; therefore, some important
conditioning variables that effect both on remittances and economic growth may be
omitted. Besides, remittance flows did not have the same impact on economic

19

growth when included and excluded financial development variables in the
specification.
In conclusion, this section briefly discuss in the previous researches which
investigated the impact of remittance flows on economic growth. Besides frequent
problems like other research topics, mitigating endogeneity problem is the most
challenge for the researchers. Based on the argument of the researchers as well as
the available of the data, some instrument variables has been used such as the ratios
of a country’s income to United State income and country’s real interest rate to the
United State real interest rate, the distance between home country of the migrants
and their main destination country, internal instrument and the ratio of remittances
to GDP of all other recipient countries. There were some complaints that since the
distance instruments were exogenous but time invariant, it must be multiplied by
the GDP of recipients’ country in order to change into time-varying instruments;
therefore, it may be too strongly correlated with the growth rate in the host country.
However, because there is no consensus on the endogeneity problem up to now,
choosing an appropriate instrument variable to control this problem is still in
research.
4.2 Investment
The investment is defined as the source of production of good that is used to
produce other goods. From theoretical perspective, it is obviously accepted that
investment is the key determinant of economic growth. The countries that invest a
substantial fraction of their GDP usually grow fast, and the reverse is true. In fact,
not only neo-classical but also Marxist economists confirmed that capital
accumulation could be seen as the engine of the economic growth. The most
primary purpose of capital is to boost the production of capital intensive goods.
Through consuming these goods, the growth of income will be increased (Sundrun,
1983). For this reason, the researchers used investment as one of the most
parameters when investigating the rate of economic growth.

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Since investment relates to all economic activities that using resources to produce
goods and services, it contains a lot of aspects like infrastructure, education,
agricultural or even human capital. To be more precise, infrastructure investment
can be considered as the most importance in less developed countries where lacking
of modern technology. Infrastructure may introduce modern technology to the
producers, teach them how to use it, thus, productive activities may be effectively
stimulated. Similarly, investment in education is extremely beneficial the society in
many aspects, for instance, making labors work more productive or creating more
knowledge, ideas, and technology innovation. Investment in agricultural research
increases the ability to disseminate the results of scientific researches, thus raising
the production. Since there is a highly correlated between the level of agricultural
investment and the food security and poverty reduction, the investment in
agricultural plays an important role in reducing hunger and promoting sustainable
agricultural production. Additionally, investment on human capital will increase the
cost of raising children which will lower the fertility and rise desired saving per
person, thus increasing per capita growth rate (Barro, 1991).
From practical perspective, many empirical researches had showed the significant
impact of investment on growth. For instance, Khan and Reinhart (1990) conducted
a researcher to test investment – growth nexus in 24 developing countries for the
period 1970 -1979. The authors used a set of variables such as private investment,
public investment, growth of labor, growth of exports and growth of imports. The
result showed that there was a difference in the marginal productive of private and
public investment in developing countries. In other words, private investment had a
larger effect on growth than public investment. Thus, the governments should pay
more attention to private investment in development. However, the authors argued
that the result was just show the direct effect of private and public investment. In
the indirect side, public investment played extremely role in increasing the
productivity of private capital formation because it provided the primary

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infrastructure for development like roads, electricity, telecommunications and
schools.
Also, Maqbool, Maaida and Sofia (2010) used vector autoregressive approach to
test determine the relationship between investment and economic growth in
Pakistan over the 1973 – 2008 periods. With a set of variables including public
investment, private investment, public consumption, GDP, macroeconomic
uncertainty and the dummy of political shocks, the authors found that both public
investment and private investment had a positive relationship on economic growth.
However, the private investment was strong influence on growth rather than public
investment. In the short run, whereas there was a positive relationship between
private investment on growth, public investment created a negative and insignificant
effect on economic growth.
The relationship between investment and economic growth was investigated by
other researchers with the same results. To illustrate, it is argued that higher
investment may add more investable resources and capital formation to the
economy, and thus promote economic growth (Mallampally & Sauvant, 1999).
Other researchers pointed out that foreign direct investment interacted closely with
domestic investment by complementary relationship, and then supported for
economic growth through introducing new technology and machinery (Sun, 1998);
generating new local input demands (Cardoso & Dornbusch, 1989); and proposing
new industries to the economy. Another research which was done by Khan and
Reinhart (1990) formulated a growth model that distinction between the impact of
public investment and private investment on growth. It revealed that private sector
has a considerably higher effect on growth than public sector.
4.3 Fiscal balance
The fiscal balance is the difference between total general government revenues and

total general government expenditures. When total revenues exceed total

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expenditures, fiscal deficit occurs. The reverse case is fiscal surplus. Recently, a
great deal of attention has been paid to fiscal deficit due to the increasing of
instability and financial crisis in the world. The government needs to suffer deficit
to finance for the mismatch in revenue and expenditure as well as for investment. It
is argued that the intervention of government in economic activity may boost
growth in long term because it can ensure efficient development in important
sectors including resource allocation, the economy stabilization, market regulation
as well as social conflict harmonization. However, In the case of persistent and high
deficit level, the problem become seriously. In fact, in order to finance for deficit,
the government can borrow from domestic, foreign or print money. These modes of
financing may lead to adverse macroeconomic consequence, for example, inflation
pressure, high interest rate, lower private investment, balance of payment crisis and
exchange rate appreciation. Moreover, high fiscal deficit may put pressure on the
governments to cut back their spending on primary sectors, which play important
role in long term growth, like health, education and infrastructure.
Because of the difference in result of financial status, a question on which fiscal
magnitude is good for the economy has become the big issue for the economists.
There were three controversial thoughts in this problem. For instance, whereas
Keynesian economies claimed that there was a positive relationship between fiscal
deficit and growth, the neo-classical economies claim the reverse. The Ricardian
equivalence hypothesis revealed that there was not a significant correlation between
fiscal deficit and growth. One possible reason is the difference on time dimension,
types of countries, degree of budget deficit as well as the estimation methodology.
While the relationship between fiscal deficit and economic growth has been still in
debate among economists, empirical research has showed the mixed results. For

example, Okelo et al (2013) took into account this relationship in Kenya with time
series data for a period of 1970 – 2007. The study added more macroeconomic
factors including labor force, capital, private investment, saving, national income,

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exchange rate and inflation. With the OLS technique, the study showed the same
conclusion as Keynesian economies. That was a positive impact of fiscal deficit on
growth due to providing public utilities like education, infrastructure, and health
and neutralizes public and private interest.
However, it is argued that whether the impact of fiscal deficit on growth is good or
not also depends on the “third” factors. In fact, Christopher and David (2005) set up
a simple Overlapping Generations model of saving behavior to examine fiscal
deficit – growth nexus. A set of data of 45 developing countries over 1970 – 1999
periods was used. The authors found that the impact of fiscal deficit on economic
growth varied according to the financing mix and the outstanding debt stocks. To be
more precise, it was the positive effect if the deficit was financed by limited
seigniorage. The negative effect occurred if the deficit was financed by domestic
debt. Besides, the authors investigated that the correlation between deficit and debt
stocks actually existed, for instance, the higher debt stocks was, the more adverse
consequences of high deficit exacerbated.
The research conducted by Mohanty (2013) agreed with the neo-classical
economies. The study examined both short run and long run impact of budget
deficit on growth in India from 1970-71 to 2011-12. The author adopted three
difference technique to test this relationship, for instance, Johansen Cointegration
test in the long run and Granger Causality test and Vector Error correction model
test in the short run. All three techniques revealed the same conclusion, which was
the negative relationship of budget deficit and growth. Instead of using money for
subsidies, the author recommended to spend more for health, education and

infrastructural sectors in order to enhancing the productivity of human capital as
well as physical capital, thus rising percapita income of people.
Similarly, Goher, Mehboob and Wali (2012) investigated the impact of budget
deficit on economic growth in Pakistan by unit root test and OLS application over
the period of 1978 – 2009. The other variables included in the model were inflation,

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real exchange rate, real interest rate and gross investment. The result showed that
there was a negative and significant effect of budget deficit on growth because the
government was lack of resources to finance for expenses in the long run.
4.4 Trade openness
Trade openness refers to the effort that makes the process of exchanging goods and
services and other fundamental factors like capital, labor, information as well as
ideals across the borders easily. The relationship between trade openness and
growth was first introduced by Ricardo. He stated that international trade helped the
countries to use their comparative advantages, thus profiting both statically and
dynamically from international exchange of goods. Certainly, an open economy
seemed to growth faster than a closed economy. Therefore, a lot of international
organizations like World Bank, International Monetary Fund and the World Trade
Organization usually recommend countries to liberalize their foreign trade and
investment.
In general, openness can boost economic growth through some aspects. Firstly,
international trade makes it easier to transfer resources, especially technology
advancement, from developed to developing economies. It is widely except that
technology is the engine for the sustainable growth in the long run. Therefore, the
diffusion and absorption of technology may definitely increase productivity, thus
enhancing economic growth. Also, openness allows to transmits ideals licensing,
exchange goods and services or foreign direct investment. The FDI inflows are

important for the economy directly through adding more investable resources and
capital formation, or indirectly through labor training and skill acquisition.
Consequently, trade openness impacts on the economy on a large scale. It is
possible to achieve a sustainable growth if the government manages trade
liberalization carefully and reasonably.

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