The impact of remittances on financial development in selected asian countries

ABSTRACT Although the impact of remittances on economic growth and poverty has always been a controversial problem for researchers and policy makers as remittance inflow have been becomi

UNIVERSITY OF ECONOMICS ERASMUS UNVERSITY ROTTERDAM

HO CHI MINH CITY INSTITUTE OF SOCIAL STUDIES

VIETNAM THE NETHERLANDS

VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACT OF REMITTANCES ON

FINANCIAL DEVELOPMENT IN

SELECTED ASIAN COUNTRIES

BY HUYNH THI MY CHI

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, DECEMBER 2016

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACT OF REMITTANCES ON

FINANCIAL DEVELOPMENT IN

SELECTED ASIAN COUNTRIES

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By HUYNH THI MY CHI

Academic Supervisor:

DR NGUYEN VAN NGAI

DECLARATION

“This declaration is to certify that this thesis entitled “The Impact of Remittances

on Financial Development in Selected Asian Countries” which is conducted and submitted by me in partial fulfilment of the requirements for the degree of the Vietnam – The Netherlands Programme

The thesis constitutes only my original works and due supervision and acknowledgement have been made in the text to all materials used.”

Huynh Thi My Chi

I am also very obliged to Prof Nguyen Trong Hoai, Dr Pham Khanh Nam for their valuable comments and suggestions for my Concept Note and Thesis Research Design My special thanks to Dr Truong Dang Thuy for his encouragements, advices and enthusiasm to help me finish the thesis I would also like to thank all VNP staff for their diligent assistance

I am thankful to my friends from VNP who supported, encouraged and shared experiences for my thesis completion Besides, my sincere thankfulness also goes

to my company’s managers and colleagues who kindly and understandingly facilitated my master studying

Finally, I am most grateful to my family for their endless support and encouragements to me all the way through my journeys

ABBREVIATIONS

FDI : Foreign Direct Investment

FEM : Fixed Effect Model

GDP : Gross Domestic Product

GDPPC : Gross Domestic Product Per Capita

GMM : Generalized Method of Moments

ODA : Official Development Assistant

REM : Random Effect Model

ABSTRACT

Although the impact of remittances on economic growth and poverty has always been a controversial problem for researchers and policy makers as remittance inflow have been becoming one of the largest external capital sources for many countries, its direct effect on financial development merely attract more attention after the financial crisis of 2007-2008 In an effort to contribute to empirical studies on this issue, this study utilizes fixed effect, random effect and system Generalized Method of Moments (GMM) to investigate the direct impact of remittances on two dimensions of financial development comprising the percentage of domestic credit to private sector by banks and broad money to GDP

in thirty-seven Asian countries during the period 1990-2014 Furthermore, this study also examines whether there are different effects of remittance inflows in high, middle and low-income countries in this area The results show that an increase in remittances seems to have no impact on financial development in general while there are mix results regarding the different income groups of countries in Asia In particular, while no evidence on the impact of remittances on both measurements of financial development as the whole region are obtained in middle and low-income countries, there is a significant and positive effect of these flows on the ratio of domestic credit to private sector by banks to GDP despite an insignificant influence on broad money to GDP in high income countries

Keywords: Remittances, Financial development, Asia, Income Group

TABLE OF CONTENTS

LIST OF TABLES

LIST OF FIGURES

CHAPTER 1: INTRODUCTION 1

1.1 Problem statement 1

1.2 Research objectives 3

1.3 Scope and data of the study 3

1.4 Structure of the study 5

CHAPTER 2: LITERATURE REVIEWS 6

2.1 Theory of remittances and financial development 6

2.1.1 The concepts and channels of remittances 6

2.1.2 Definitions of financial development 7

2.1.3 The role of remittances in financial development 7

2.2 Empirical studies 10

2.3 Other determinants of financial development 15

CHAPTER 3: MODEL SPECIFICATION AND DATA 18

3.1 Model specification 18

3.2 Data sources 21

3.3 Estimation methods 23

3.3.1 Pooled OLS model 24

3.3.2 Fixed effect model 25

3.3.3 Random effect model 26

3.3.4 Tests for choosing sufficient model 26

3.3.5 The system generalized method of moment estimation 28

CHAPTER 4: THE IMPACT OF REMITTANCES ON FINANCIAL DEVELOPMENT IN ASIA 31

4.1 Overview of remittance inflows and financial development in Asia 31

4.1.1 Overview of remittance inflows to Asia from 1990 to 2014 31

4.1.2 Overview of financial development in Asia from 1990 to 2014 36

4.2 Empirical results 40

4.2.1 Descriptive statistic 40

4.2.2 Empirical results 45

CHAPTER 5: CONCLUSIONS AND POLICY IMLICATIONS 54

5.1 Conclusions 54

5.2 Policy implications 55

5.3 Limitations and further researches 56

REFERENCES

APPENDIX I

APPENDIX II: THE REGRESSION RESULTS

LIST OF TABLES

Table 3.1: The definition and expected sign of variables 22

Table 4.1: The summary statistics of variables 41

Table 4.2: The correlation between variables 44

Table 4.3: The results of tests for choosing models 45

Table 4.4: The results of FEM with robust 47

Table 4.5: The results of system GMM 49

Table 4.6: Summary of the impact of remittances on financial development in Asia and different income groups by FEM and system GMM 50

LIST OF FIGURES

Figure 4.1: Remittances received by areas in the world from 1990 to 2014 (US$

billion) 31

Figure 4.2: Top 10 remittance recipient countries in 2014 (US$ billion) 32

Figure 4.3: Top 10 remittance recipient countries in 2014 (% GDP) 33

Figure 4.4: Remittances to areas in Asia from 1990 to 2014 (US$ billion) 34

Figure 4.5: Remittances received by income groups in the world from 1990 to 2014 (US$ billion) 35

Figure 4.6: Remittances received by income groups in Asia from 1990 to 2014 ($US billion) 36

Figure 4.7: Domestic credit to private sector by banks (% of GDP) in Asia from 1990 to 2014 37

Figure 4.8: Broad money as % of GDP in Asia from 1990 to 2014 38

Figure 4.9: The average ratio of domestic credit to private sector by banks to GDP across income groups in Asia (%) 39

Figure 4.10: The average ratio of broad money as % of GDP across income groups in Asia 39

Figure 4.11: Correlation between domestic credit to private sector by banks (%GDP) and remittance inflows (%GDP) and other controlling variables 42

Figure 4.12: Correlation between broad money (%GDP) and remittance inflows (%GDP) and other controlling variables 43

CHAPTER 1: INTRODUCTION 1.1 Problem statement

Together with the augmentations of migration flows in recent decades, remittances - money sent by migrants to home countries - have grown rapidly and appeared to surpass main conventional channels like official development assistant (ODA), private capital (Dilshad, 2013) According to the data from World Bank, in 2014, personal remittances recorded worldwide are up to one-third of foreign direct investment (FDI) and more than three times as large as the sum of ODA and official aids, from US$ 67 billion in 1990 to over US$

533 billion Moreover, while foreign direct investment (FDI) fluctuates wildly during the period from 2000 to 2014, ODA and other external sources remain either unchanged or even decrease substantially; remittances keep its routine

to accelerate stably over time In particular, officially recorded remittances worldwide declined the first time in 2009 since 2000 Nevertheless, the decrease in remittance inflows by nearly 5 percent in 2009 compared to the remittance amount in 2008 due to global financial recession was trivial, in comparison with a 45 percent decrease in FDI in the same year After that, while remittances have been totally recovered and continued to rise, FDI already fell twice in 2012 by nearly 10 percent and in 2014 by 20 percent

As the stability and increment of remittance inflows has drawn enormous attention from researchers and policy makers in recent decades, a strong wave

of papers and studies have dug into links between these flows and various aspects of economic development However, while most investigations have attempted to figure out effects of remittances on growth, poverty, education, less effort has been spent for studying the linkage between remittance inward flows and financial development, which has been documented to foster economic growth and reduce poverty by literature extensively (Goldsmith, 1969; Bencivenga and Smith, 1991; King and Levine, 1993; Beck, Demirguc-

Kunt and Levine, 2004), across recipient countries despite their important contribution in total external financial sources

Moreover, various perspectives relating to this relationship argue different channels via which remittance flows may affect financial sectors, and empirical studies examining the impact of remittances on financial development also demonstrate inconsistent outcomes across countries and areas On the one view, these flows may enhance financial development if formal financial channels are utilized in order to conduct transactions relating

to remittances, recipients are acknowledged financial services; thereby permitting banks to get acquainted or approach unbanked recipients At the same time, that other financial products might be need if recipients prefer to store surplus income fosters the development of banking products and services (Orozco and Fedewa, 2006; Gupta, Pattillo and Wagh, 2009; Aggarwal et al., 2011; Demigüç-Kunt et al., 2011) Furthermore, playing as a collateral role, remittance flows may enlarge bank willingness to provide loans for families with stable remittances Even in the case remittances cannot become sufficient collateral, overall credit might still surge through recipient communities due to the incremental loanable funds as a result of remittances deposited to banks (Chami et al., 2009)

On the other view, remittances might impede the development of financial sectors if remittance inflows loosen recipients’ budget constraints and allow them to lower their demand for outside credit (Martínez, Mascaró and Moizeszowicz, 2008; Brown et al., 2011) Recipients might also consider remittances as additional income and utilize most of them for consumption, or their distrust of financial sectors might discourage them to deposit money to banks, therefore no need for financial products and no increase in bank deposits (Chami et al., 2009) As a result, whether, how and to what extent remittances impact financial developments in remittance recipient countries

are still complicated issues, hence the need for more studies to investigate these effects

In an effort to address the relationship between remittances and the development of financial sector in Asia, this study utilized a panel data from

1990 to 2014 for thirty-seven Asian countries and different econometric methods In particular, the linkage of personal remittances and financial development’s indicators comprising domestic credit to private sector provided by banking system and broad money are analyzed with fixed effect, random effect and system Generalized Method of Moments method Furthermore, based on the level of country’s income which is classified by World Bank, this study also examines whether there are different effects of remittance inflows in high, middle and low-income countries in this area

1.2 Research objectives

This study is conducted in an attempt to:

 Analyze the trend of remittance inflows and the situations of domestic credit to private sector provided by banks and broad money in Asia region,

 Access the impact of remittances on financial development in Asia in general,

 Evaluate different impacts of remittance flows on financial development in different income-groups of countries in Asia

From the findings, this study will propose recommendations in order to foster the effects of remittance inflows on financial development in Asian remittance recipient countries

1.3 Scope and data of the study

This research investigates whether remittances have significant influence on financial development for Asian countries due to many reasons First, remittances flowing to Asia have accelerated substantially in the recent decade

and captured nearly 50% total remittance inflows in the world Especially many middle and low income countries have taken large parts in both numerical value and percentage of Gross domestic product (GDP) in the amount of remittances flowing to this area; nonetheless, the development impact of remittances on financial sectors has not been commensurately analyzed in this area

Second, researches on studying the impact of remittances on financial development are solely officially conducted for separate country or a part of Asia For example, Chowdhury (2011) finds that there is a direct positive relationship between remittance flows and financial breadth and depth in Bangladesh while Noman and Uddin (2012) provides evidences of for an indirect impact of remittances on banking sector and economic growth in selected South Asia countries

Third, as previous studies have chosen sample basing on the division of developing and developed countries which may affect results when high tolerance among the income of countries may be occurred among those types

of countries Hence, it is necessary for studying the linkage of remittances and financial development in this area Specially, investigation on the impacts of these flows on different income groups will provide a better view for policy makers

Finally, from the impact of remittances on financial development in Asia, several recommendations may be suggested in the case of Vietnam, one of Asian middle-income countries whose remittance inflows have been accelerate from US$1.34 million in 2000 to over US$13 million and account for nearly 7% of GDP in 2015

Hence, there is a need for investigating the impact of remittances both in general and in separate income groups in Asia Data of selected Asian countries collected for the period from 1990 to 2014 are employed in this

study Except for financial openness indicator which is represented by The Chinn-Ito Index (Chinn and Ito, 2006), the remained data are extracted from the database of World Bank

1.4 Structure of the study

This thesis consists of five chapters Chapter 1 presents the motivation for scrutinizing the nexus between remittances and financial development in Asian countries Chapter 2 provides concepts of remittances and reviews vital literature relating to perspectives on the role of remittances to financial sectors and empirical studies considering the effects of remittances and other variables

on financial development Chapter 3 demonstrates the research methodology

in tandem with data utilized in this study Chapter 4 presents an overview of remittances and financial development in Asia during the period 1990-2014 and analyzes empirical results derived from regression The last chapter summarizes main findings, proposes policy recommendations; moreover, limitations and future researches are also mentioned in this chapter

CHAPTER 2: LITERATURE REVIEWS

This chapter comprises three parts First part presents concept and channels of remittances, definitions of financial development and main perspectives on the effect of remittances on financial development Previous empirical studies on the relationship between remittance inflows and financial development will be present in the second part The last part delivers former papers investigating the impact of main macroeconomic and openness factors to financial development

2.1 Theory of remittances and financial development

2.1.1 The concepts and channels of remittances

The term “Remittances” has been used commonly recently but it is rarely defined In many previous papers, remittances are defined generally as the cross-border money that migrants send back to their home countries Remittances may be transferred via either official or unofficial channels Official transfers refer to transactions utilizing the banking system or money transfer organizations Unofficial transfers are sent mainly in cash through friends, family members, migrants themselves or via traditional channels, called hawala in some countries, by which money may be deposited with an unlicensed organizations in one country and may be drew at their partners in the recipient country (Freund and Spatafora, 2008; Nyamongo, 2012; Giuliano and Ruiz-Arranz, 2005; Aggarwal et al., 2011)

As mentioned in literature, informal channels are utilized widely for transferring remittances in the world due to the accessibility, anonymity, low cost, reliability First, both the remittance senders and receivers do not need to have bank account or prepare complex procedures which are required at banks

or official organizations Second, the information relating to the transactions can be remained unknown with other people Third, the cost of these transfers

is lower than they should be when utilizing official channels Finally, that

remittances are delivered via the networks of family members or friends creates the reliability especially for people who seldom used official financial organizations

Nevertheless, utilizing informal channels induce some consequents First, official organizations may encounter difficulties in collecting data and make a miscalculation the volume of remittances Second, criminal organizations or individuals can use remittances for money laundering Finally, diminishes the financial development impact of remittances as envisaged by the proponents

of financial development (Nyamongo, 2012)

2.1.2 Definitions of financial development

According to the definitions of World Bank, financial sector is the combination of institutions, instruments, markets, and the legal and regulatory framework that permit transactions to be made by extending credit Primarily,

to develop the financial sector is to overwhelm “costs” arise in the financial system The process of cost reduction in obtaining information, enforcing contracts, and conducting transactions leads to the appearance of financial contracts, markets, and intermediaries Diverse kinds and conjunctions of information, enforcement, and transaction costs with various legal, regulatory, and tax systems have inspired distinctive financial contracts, markets, and intermediaries across nations and throughout history

Financial development appears when there are improvements in financial instruments, markets, and intermediaries although these improvements may or may not remove the burdens of information, enforcement, and transactions costs (Levine, 2005)

2.1.3 The role of remittances in financial development

Different perspectives on the impact of remittances on financial development

in recipient countries at the theoretical level have been mentioned in many previous studies The first argument is that remittance inflows foster financial

sector on both demand and supply aspects With regard to the demand side, remittances is assumed to enhance financial literacy within remittance recipient communities when migrants and remittance recipients adopt formal transfer channels, thereby accelerating requirements for and utilization of banking products and services (Orozco and Fedewa, 2006; Gupta, Pattillo and Wagh, 2009) For instance, the need for channels through with remittances can

be transferred or received can increase the opportunities of searching information related to products offered by banks; hence, stimulating the need and usage of various financial products and services and increasing the chances for banks to approach un-banked recipients, which permit for their outreach expansion.It is also argued that even if these flows of remittances are not transacted through banks, money surpluses created by additional income from remittances might potentially stimulate the acquisition of other banking services as people feel necessity for a means to store or invest the excess balances (Aggarwal et al., 2011; Demigüç-Kunt et al., 2011)

Regardless of supply side, remittances are also presumed to promote the development of breadth and depth of financial sectors For example, banks are encouraged to provide more products and services or even more branches to satisfy the growing requirement of remittance recipients Furthermore, banks might be obligingly permit or increase credit for remittance recipients with stable and considerable remittance receipts as they become more attractive and potential customers Additionally, augmentation in loanable fund deposited to banks by remittance recipients along with the costs of transactions related to sending, receiving or storing remittances may result in rise of bank credit to communities (Giuliano and Ruiz-Arranz, 2005; Toxopeus and Lensink, 2008; Aggarwal et al., 2011) Consequently, financial systems in recipient economies may be further widening and deepening, and it is essential to investigate the impact of remittances on financial development at the country level

In the second view, remittances may create deleterious effects on financial development since individuals with remittance receipts may relax their budget constraints and lower credit demand which may be needed from financial organizations otherwise (Caceres and Saca, 2006; Martínez, Mascaró and Moizeszowicz, 2008; Aggarwal et al., 2011) Moreover, it is worse in case a pattern of conspicuous consumption is developed along with the inability to promote a saving habit that can assist investments and economic growth.

In the third view, remittance inflows may have no impact on stimulating financial development in many countries, especially in countries with less developed financial systems due to many reasons (Brown et al., 2011) Above all, migrants prefer to transfer money to home countries through informal transfer ways rather than formal channels then there might be no need for recipients to be aware of or utilize bank transfer services As unbanked – receivers do not have acknowledge of banking products and services, namely financial literacy is not increased in the communities, the need for financial systems does not exist or rise Moreover, remittance recipients might store excess money at home or utilize them for other purposes as they might distrust banks and other financial institutions, or spend most of them for consumption; hence, there is no demand for saving products provided by banks or other formal financial products These behaviors of remittance recipients might result in neither growth nor harmfulness on financial sector performance Besides debates on the impact of remittances on financial development, the adverse causality is also argued from different level of financial sector performance (Brown et al., 2011) Lacking of development financial system and accessibility of commensurate quantity of banks and other formal financial institutions within the remittance recipient countries may lead to distrust of this sector among unbanked individuals or insufficient adaptation for the demand of financial products and services, hence driving individuals to rely more on informal channels for transaction related to remittances In

contrast, higher level of financial development might enhance the trust of individuals in financial sectors and stimulate the demand for financial products and services Furthermore, lower cost of transferring remittances as a result of financial development might foster utilization of these services of both remittance senders and receivers

2.2 Empirical studies

Various methods and datasets have been utilized to access the effects of steadily accelerating remittance inflows on financial development in the world

in recent decades; the approaches of the above relationship in those papers can

be categorized in two main strands comprising indirect and direct link For the indirect approach, researchers explore the nexus of remittances and financial development indirectly by analyzing whether remittances foster economic growth at given level of financial development With regard to the direct approach, the impact of remittances on financial development is investigated directly to evaluate the widening and deepening effect of remittances on financial sector performance

The first indirect group of studies focusing on the relationship of remittances and growth while considering interactions between remittances and financial development derives two main contrary aspects relating to whether country’s financial development is less developed or relatively developed On the one hand, in a country lacking in financial development, remittances are believed

to play an important role in providing additional sources for capital market, thereby promoting investment and economic growth For instance, by adding a representative variable for financial development in tandem with remittances

in growth equations while analyzing for sample of over 100 countries from

1975 – 2002 with GMM approach, Giuliano and Ruiz-Arranz (2009) find strong evidence that remittance inflows enhance economic growth by providing an alternative financial source for investment and mitigating credit

constraints for countries with less developed financial systems The findings remains unchanged for different measures of financial system development utilized in the paper after controlling for the problem of endogeneity emerged

by the causal relationship between remittance inflows and financial development This paper also provide proof that there may exist an investment channel via which inflows of remittances can boost economic growth, especially in case the credit offered by financial sector does not fulfill to the population demand The role of remittances in providing external sources for investment is weaker in countries with quite developed financial sectors as the availability of credit lowers the needs of remittances for investment intentions Ramirez and Sharma (2008) also acquires analogous outcome as Giuliano and Ruiz-Arranz (2009), indicating that remittances may boost economic growth more in country with weak financial development when utilizing unit root test, cointegration test and fully modified ordinary least square method for a dataset

of twenty-three upper and lower income countries in Latin American and Caribbean area for the period of 1990 – 2005 Nevertheless, this study shows supplementary outcome that impact of remittances on economic growth in the upper income group is stronger than in the lower income group Besides, the study also presents other channels through which remittances can positively influence economic growth such as the degree of education and economic liberalization

On the other hand, the impact of remittances on growth may be stronger in countries with more developed financial systems since the immense accessibility of financial products and services give assistance in orientating remittances to more effective usage or investment Mundaca (2009) shows this

by utilizing a cross-countries panel of Latin America and the Caribbean covering the period of 1970 – 2002 to analyze his theoretical model Utilizing First Difference GMM to solve the possible endogeneity, this paper concludes that remittances are appeared to boost further growth in countries with proper

developed financial system which can direct remittance inflows to invest in technology or other capital; besides, another important finding of this study is that when remittance proxy is added in growth equation, the impact of per capita investment on economic growth increases substantially The studies of Ojeda (2003), Terry and Wilson (2005), and World Bank (2006) also support for the above findings by presenting the similar results that channeling remittances for better profitable investments through the formal financial sector accelerates the development impacts of remittances

Bettin and Zazzaro (2011) also obtain similar results when investigating the relationship of remittance inflows and the level of financial development Utilizing a panel dataset of sixty-six developing countries over the period

1970 – 2005 with system GMM in tandem with adding a new representative of the development of financial system to gauge the banking performance efficiency in remittance-receiving countries, they find that remittance inflows contribute to the economic growth in countries whose banking systems operate well

In this first approach studies group, nevertheless, the financial development degree is given and the direct impact of remittance inflows on financial development in the recipient economy is neglected Hence, researches have been investigated influences of remittances on the development of financial sectors more directly as remittances have shown their gradually increasing important effects on the development of economic

Taking into account the limitations of indirect approach in the first group of studies, the second strand of empirical studies has been investigated more direct impact of remittances on financial development in the recipient country with mix results in the recent years The outcome that appears quite frequently

in recent papers is that remittances promote financial development in many countries For instance, Gupta et al (2009) shows this when examining the

remittances – financial development linkage and financial development – poverty nexus by employing a panel data of 44 Sub-Saharan Africa countries over the 1975-2004 periods with three stage least square, fixed effects and random effects models of regression along with six years period averages The results show that remittances in this area, which are still small in comparison with other aid flows, but with a stable and gradually increasing volume during the study period, have a significant positive impact on financial development and direct effect on poverty alleviation These findings remain unchanged after dealing with reverse causality which may exists when assessing the relationship between remittances and financial development or poverty in this area

Demirguc-Kunt et al (2010) present evidences of a direct positive impact of remittance inflows on the banking sector’s breadth and depth by analyzing county-level data for households and banking sectors comprising the number

of bank branches, the number of bank accounts and value of bank deposits and credit in Mexico in 2000 In detail, the study shows that the higher the proportion of the population has remittances in a county, the higher the number of bank branches, the number of bank accounts and value of bank deposits exist in that county after taking into consideration of the potential endogeneity When the portions of households who receive remittances grow

by one percentage, the proportion of households utilizing financial products and services will be increased by nearly 0.16 to over 0.19 percentages

Aggarwal et al (2011) obtain the analogous outcome when examining the nexus between remittance inflows and financial systems development in recipient economies by utilizing a large sample of 109 developing countries over the periods from 1975 to 2007 with various research methods comprising fixed effects estimations, dynamic system GMM, and instrumental variables (IV) estimations As bank credit and deposit to private sector expressed in proportion of GDP represented for the performance of financial sectors, this

study finds that worker remittances have a direct and positive significant influence on the aggregate bank credit and deposit to private sector in developing countries after considering for variable omission, reverse causality and measurement errors effects

Cooray (2012) also provide evidence for the association of remittances and financial sector when examining the annual dataset of 94 non-OECD countries over the period from 1990 to 2010 with pooled OLS and system GMM The study analyzed the effects of remittance inflows on the size and efficiency of financial systems, and the results show that remittances increase these two dimensions of financial systems The study, furthermore, examines the correlation of remittances on above two measurements of financial sectors via their interaction with the government ownership of remittance-receiving countries’ banks The outcomes indicate that the lower the government owner ship of bank a country has, the higher the impact of migrant remittances on the enlargement of the size of financial sector in countries Nevertheless, the higher increase in the efficiency of financial sectors required the higher government ownership of banks

With regard to Asia, Chowdhury (2011) investigates whether remittance flows have positive contribution to the development of the financial sector in Bangladesh with annual dataset from 1971 to 2008 and Cointegration and Vector Error Correction Model method The study provides evidence for significant and positive effects of remittance inflows on widening and deepening the financial system in this country The results also indicate that remittance inflows and indicators of financial development do not have reverse causation when applying test for endogeneity bias

Even though most of studies favor the association between remittances and financial development as presented in above studies, other researches still find evidences for different results as remittances appeared to have no or negative

effects on the development of financial sectors Brown et al (2011), for instance, show evidence that migrants’ remittances have no effect or impede financial development when examining this nexus on both macro as well as micro level On macro level, researchers collected a dataset of 138 countries of world for the period of 1970 to 2005 and incorporated fixed effects model of panel data and Probit model in exploring financial development and remittances On the other hand, at micro level, data are collected from 3,899 households from Azerbaijan and 3,995 households from Kyrgyzstan The study finds that remittances seem to have no effect or even have deleterious effect on financial development at macro level At micro level, the study find

an inverse impact of remittances from both perspectives households as well as community in Azerbaijan while there appears a direct impact of remittances with both sources households and community in Kyrgyzstan

2.3 Other determinants of financial development

Beside remittances, former papers have indicated main macroeconomic and openness variables which have effect on financial development comprising country size, GDP per capita, inflation, financial openness and trade openness With regard to country size, Goldsmith (1969) and Gurley and Shaw (1967) find that the growth of an economy leads to the increase in the needs for financial products and services; and financial sector accommodate itself to those growth requirements Such increment in demand will foster more sophisticated and advanced financial intermediaries in order to meet new need for their products and services (Yartey, 2008)

Concerning the economic development and quality of country legal institutions, it is supposed that higher income may encourage higher rate of savings leading to the increment of supplementary financial instruments which assists channeling these flows into better investment (Kamar and Ben Naceur, 2007; Yartey, 2008) On the other hand, it is wisely founded that bad

institutions is one of major hindrances to the development of an economy A country with low quality of institutions may induce an impediment of financial development due to fear increase in the stability of savings and investments in this sector Furthermore, as founded in the research of La Porta et al (1997), variations in preservations for the rights of investors and creditors or in the level of law and regulations enforcement may illuminate why financial systems in some countries are more advanced than others

With respect to inflation, that high inflation deteriorates financial properties and raise the encouragement to invest in other sectors rather deposit money in financial sector Consequently, high inflation may be harmful to the development of financial sectors The negative relationship of inflation and performance of financial sector have been evidenced by many recent studies, for instance, in the paper of Boyd et al (2001) and Naceur and Ghazouani (2008)

Regarding financial openness, according to the findings of Chinn and Ito (2002) and Baltagi et al (2009), the capital account openness enhances financial sector accountability and transparency, hence augmenting the access and utilization of financial products and services

Finally, as for trade openness, country with higher integration degree to world economy may have more incentives to push for the development of more advanced financial systems in order to assisting trade transactions Findings on the study of Rajan and Zingales (2003) indicate that in a country with low level of trade openness, industrial incumbents might hinder the growth of financial sector

In general, despite the positive impact of remittances on financial development appeared to overwhelm in previous studies, the inconsistent results are derived due to different dataset and approaches involve in this relationship Moreover, despite the positive impact of country size, GDP per capita, financial openness

and trade openness and negative impact of inflations on financial development

in most of former studies, the influences of these determinants on financial development in Asia and different income groups of countries in this area are still an open question Consequently, there is a need to examine separately the role of remittances and other factors on the development of financial sector in selected Asian countries in either general or in different income groups

CHAPTER 3: MODEL SPECIFICATION AND DATA

This chapter consists of three main parts The first part presents applied empirical model based on previous studies The second part introduces and discusses empirical models of the study in order to answer research questions The last part describes indicators for financial development, remittances and other determinants of financial development and data sources

3.1 Model specification

When analyzing the relationship between remittances and financial development, potential endogeneity due to measurement error, variable omissions and reverse causality should be taken in to account (Aggarwal et al., 2011) Remittances are believed to be recorded with measurement errors as informal transfer channels through friends, relatives and other Hawala-type organizations Causal relationship is the one of the most concerns in examining the impact of remittances on financial development since higher level of financial development might result in higher recorded remittances either since financial development stimulates remittance inflows or because a higher proportion of remittances are recorded as those remittance inflows are transferred via banks or other formal financial organizations Moreover, financial development might provide lower cost of transferring remittances, hence resulting in such inflows increment Finally, the omissions of essential factors which can affect either the growth of remittances or financial sector performance also lead to biases when estimating influences of remittances on the development of financial sectors

In an effort to construct a model to investigate the impact of remittances on financial development, this study relies on previous papers to select an appropriate model and various variables Following the papers of Aggarwal et

al (2006) and Gupta et al (2009), dynamic panel data model is applied in

order to address the problems mentioned above The general form of dynamic panel data model is demonstrated as below:

Yit=α+γYi,t-1+β1Xit+ni+ εt+uit (3.1) where i represents for individual 1,2,…,n and t represents for time 1,2, ,T; Yit

is the indicators of financial development; Yit-1 is the lagged values of indicators of financial development; Xit is a set of explanatory variables comprising remittances and other determinants of financial development.; ni is unobserved country specific effect; εt is a time – specific effect; uit is the error term

Basing on former studies concerning financial development, besides remittance indicators is the main explanatory proxy, other factors which are evidenced to have influence on financial development are also comprised in the model as follows:

FDi,t = β1FDi,t-1 + β2REMITi,t + β3GDPPCi,t + β4LNGDPi,t + β5INFi,t +

β6TRADEOPENNESSi,t + β7FINANCIALOPPENNESSi,t + β0 +

as a share of GDP (CREDIT) and the ratio of broad money to GDP (M2) Domestic credit to private sector by banks measured as a share of GDP is adopted in order to measure the development and the efficiency in allocating resources of banking sector (Beck et al., 2000; Aggarwal et al., 2006) As this indicator represents for the amount of money transfer to private sector, the higher this ratio is, the higher the domestic investment in economy is, thereby the higher the development of financial sector Besides, King and Levie (1993), Beck et al (2000) utilize broad money to GDP to access the size of

financial system Aggarwa et al (2006) made argument that the growth of private financial assets, applying broad money (represented by M2 or M3), shows the liquidity position of the financial system and analyzes the degree of monetization and the development of financial market On the other hand, broad money expressed in percentage of GDP (M2/GDP) was considered as

an indicator of financial deepening (Brown et al., 2013)

REMIT is personal remittances expressed in proportion of GDP, which comprises of two parts: personal transfers and compensation of employees according to the new definition in the sixth edition of the IMF Balance of Payments and International Investment Position Manual (BPM6) In particular, personal remittances comprise two parts: personal transfers and compensation of employees Personal transfers is broader than worker’s remittances which is utilized in many previous studies when representing for remittances as personal transfers are independent with the source of earnings

of migrants and the relationship between the recipients Compensation of employees comprise three part: wages and salaries in cash, in kind and social contributions by the employers involving border, seasonal, and other short-term workers who are employed in an economy where they are not resident and of residents employed by nonresident entities (World Bank, 2016)

In all models, this study controls for macroeconomic and openness variables which have been indicated by literature to have effect on financial development GDPPC representing for economic development and the quality

of institutions is GDP per capita in thousands of constant 2010 US$ LNGDP presents for country size by taking log of GDP while GDP’s data are in constant 2010 U.S dollars INF is inflation as measured by the annual growth rate of the GDP implicit deflator shows the rate of price change in the economy as a whole TRADEOPENESS is trade openness presented by the sum of exports and imports of goods and services measured as a share of gross domestic product FINANCIALOPENNESS is financial openness represented

by KAOPEN index calculated by Chinn and Ito (2006) This index is constructed from four binary dummy variables that codify restrictions on cross-border financial transactions that are reported in the IMF's Annual Report on Exchange Arrangements and Exchange Restrictions These variables indicate:

 the existence of multiple exchange rates;

 restrictions on current account transactions;

 restrictions on capital account transactions; and

 the requirement of the surrender of export proceeds

Chinn and Ito reverse these binary variables—so that they are equal to unity when capital account restrictions are non-existent—and derive the first principal component, which is their summary measure (KAOPEN)

3.2 Data sources

In an effort to identify how remittances impact financial development, this study utilizes eight variables comprising two financial development measures, personal remittances, GDP in thousands of constant 2010 US$, GDP per capita in thousands of constant 2010 US$, trade openness and financial openness

Most of data except for financial openness were gathered from World Development Indicators (WDI) Financial openness is presented by KAOPEN index, which is calculated by Chinn and Ito (2006)

This study originally intended to cover the data for all countries in Asia; nevertheless, many countries do not have commensurate data for all variables, leading to examinations on unbalanced dataset Hence, this study includes data

of thirty-seven Asian countries covering the period 1990-2014, based on the availability of data

Table 3.1: Definition and expected sign of variables

Relationship

Financial

development

indicators

CREDIT Domestic credit to private

sector by banks expressed as

a percentage of GDP M2 Broad money measured as a

proportion of GDP

comprising personal transfers and compensation of employees expressed as a percentage of GDP

Trade Openness TRADE

-OPENESS

Sum of exports and imports

of goods and services expressed as a share of GDP

Positive

Financial

Openness

OPENNESS

FINANCIAL-KAOPEN Index calculated

by Chinn and Ito

Positive

Moreover, in order to estimate impact of remittance inflows in high, middle and low income groups of countries, countries are defined as high, middle or low income countries according to the income classifications of World Bank

in each year Next, this study utilizes two dummy variables HIGH and MIDDLE, where:

 HIGH equal 1 if that country is classified as high income country while HIGH equal 0 if that country is classified as middle or low income country

 MIDDLE equal 1 if that country is classified as middle income country while MIDDLE equal 0 if that country is classified as high or low income country

In total of 704 observations, 121 observations are classified as high income country, 365 observations are classified as middle income country and the remaining are classified as low income country

3.3 Estimation methods

In an effort to address the problems mentioned above, this paper utilizes several empirical models to investigate the impact of remittances on financial development First, Pooled OLS model, fixed effects model (FEM) and random effects model (REM) are applied to estimate panel data for a overlook

of remittances and financial development relationship Second, system General Method of Moments (GMM) is conducted in order to solve the problems of causal relationship

As the lagged dependent variable added in dynamic panel data model as an explanatory variable leads to biased in the results of Pooled OLS model, FEM and REM, models which are excluded lagged dependent variable are applied

in order to analyze these above regressions Moreover, in order to estimate impact of remittance inflows in different income groups of countries, the interactive terms of remittance and dummy variable of income group are

included in the model Separate equations for two indicators of financial development are depicted as follows:

CREDITi,t = β1REMITi,t + β2GDPPCi,t + β3LNGDPi,t + β4INFi,t +

β5TRADEOPENNESSi,t + β6FINANCIALOPPENNESSi,t + β0 +

CREDITi,t = β1REMITi,t + β2REMIT_HIGHi,t + β3REMIT_MIDDLEi,t +

β4GDPPCi,t + β5LNGDPi,t + β6INFi,t + β7TRADEOPENNESSi,t +

β8FINANCIALOPPENNESSi,t + β0 + ui,t (2) M2i,t = β1REMITi,t + β2GDPPCi,t + β3LNGDPi,t + β4INFi,t +

β5TRADEOPENNESSi,t + β6FINANCIALOPPENNESSi,t + β0 +

M2i,t = β1REMITi,t + β2REMIT_HIGHi,t + β3REMIT_MIDDLEi,t +

β4GDPPCi,t + β5LNGDPi,t + β6INFi,t + β7TRADEOPENNESSi,t +

β8FINANCIALOPPENNESSi,t + β0 + ui,t (4)

3.3.1 Pooled OLS model

Pooled OLS model is one of the most common employed methods with general form as below:

Yit=β0+β1Xit+uit (3.3) where i represents for individual 1,2,…,n and t represents for time 1,2, ,T 𝑌 is dependent variable X is independent variable β1 is coefficient for Xit, β0 is constant intercept, and uit is the error term With the assumption that there are

no differences among individuals in estimated cross-section, the Pooled OLS method predicts common constant β for all individuals in cross-section

However, in order to adopt this method, many strict assumptions must be satisfied such as the parameters in model must be linear, and the error term 𝑢𝑖𝑡

is assumed to be independently and identically distributed (iid), 𝑢 ~ iid(0,σ2) Moreover, for each individual, the error term must have no correlation with

explanatory variables for all the time In addition, the variance of uit must be homoscedastic, and there is no autocorrelation between ui and uj (i ≠ j)

In comparison with FEM and REM, the results derived from the regression of the Pool OLS the constant intercept and slope coefficients

3.3.2 Fixed effect model

Fixed effects regression is utilized to estimate the effects of the explanatory variables on explained variable depending on the changes in the variables over time with general form as below:

Yit=αi+βXit+εit (3.4) Where i represents for individual 1,2,…,N and t represents for time 1,2, ,T; αi

is the specific intercept for individual i; Y is explained variable; 𝑋 is explanatory variable; β is coefficient for Xit,; εit is error component

Fixed effects model expresses that the coefficient for explanatory variables are constant and the individual specific effects do not change over time but varied among individuals As FEM addresses individual specific effects through intercept, the model permits for the existence of correlation between time-invariant individual specific effects and explanatory variables while idiosyncratic error (εit) is still not allowed to have correlation with explanatory variables

As individual characteristics are assumed to have relationship with independent variables or dependent variable, FEM can remove the influence

of those time-invariant characteristics and evaluate the net impact of the predictor variables on the predicted variable However, those time-invariant characteristics must be peculiar to individual and do not related to characteristics of other individuals and the same requirement for the correlation among the error terms of individual If those conditions are not satisfied, FEM will be inappropriate and other model like random effect model should be applied

3.3.3 Random effect model

In contrast with FEM, REM allows for variation among individual characteristics and assumes that those characteristics are random and do not have impact on input variables or output variable consisted in the model The common form of REM is:

Yit=β0+β1Xit+uit where uit=εit+vit (3.5) Where i represents for individual 1,2,…,N and t represents for time 1,2, ,T; 𝑌

is regressand; X is regressor; is coefficient for Xit; β0 , β1are intercepts; uit is error term which comprises two components, 𝜀𝑖𝑡 referring to error component

of cross-section, and vit, referring to error component for cross-section and time series combination

In this model, country specific effect is a random variable and it is assumed not to correlate with regressors Compared with fixed effect model, invariant variables can be added into random effect model However, if invariant variables which are omitted correlate with regressors, estimators will be bias and inconsistent

3.3.4 Tests for choosing sufficient model

In an attempt to figure out the adequate model among three above model, this study adopt three tests consist of F-test, Breusch–Pagan LM test, Hausman Specification test The F – test is utilized to choose better model between FEM and Pooled OLS model while Breusch–Pagan LM test is applied to find more appropriate model between REM and Pooled OLS model The Hausman Specification test is employed to compare FEM and REM and choose more sufficient model between them

3.3.4.1 The F – test

Basing on goodness of fit, the F-test is applied to choose an appropriate technique between fixed effects method and Pooled OLS The regression

model of fix effect method is given as Yit=α+ μi+βXit+εit to test the hypothesis

H0: μ1 = μ2=… = μn-1 = 0 F-test is calculated as follows:

F= (RSS-URSS)/(N-1)URSS/(NT-N-K) ~ FN-1,N(T-1)-KWhere RSS is the restricted residual sum of squares obtained from the Pooled OLS model; URSS is the unrestricted residual sum of squares of FEM

If the hypothesis H0 is rejected, this means that at least one μi is different from zero Consequently we can conclude that fixed effect model is favored over the pooled OLS

3.3.4.2 Breusch – Pagan LM Test

Breusch – Pagan LM test is utilized to determine REM or the pooled OLS should be employed in this study The regression model of random effect method is given as Yit=β0+β1Xit+uit where uit=εit+vit to test the hypothesis

H0: var(u)=0 The LM test is computed as:

2(𝑇 − 1)[

∑ 𝑁(∑ 𝜀𝑇 𝑖𝑡2)2

∑ 𝑁 ∑ 𝜀𝑖𝑡2 𝑇

− 1] ~ 𝜒12

If the hypothesis H0 is rejected, this means that at least one variance component is different from zero or REM is better than the pool OLS

3.3.4.3 The Hausman Specification Test

The Hausman Specification Test is applied to choose the sufficient model between FEM and REM by considering whether the time – invariant individual effects ui are correlated with the regressors xit If ui are correlated with xi,t, FEM is consistent and efficient while REM is not consistent On the contrary, if ui are uncorrelated with xi,t, REM will be consistent and efficient while FEM is inefficient

The Hausman Test statistic is computed as:

(𝛽𝐹𝐸 − 𝛽𝑅𝐸)′[𝑉𝑎𝑟(𝛽𝐹𝐸) − 𝑉𝑎𝑟(𝛽𝑅𝐸)]-1(𝛽𝐹𝐸 − 𝛽𝑅𝐸)~χ2

The null hypothesis Ho: ui is not correlated with the xit or the REM should be employed

H1: ui is correlated with xit or the FEM should be employed

In summary, in order to choose the most sufficient model, this study utilized several tests including F-test, LM test and Hausman test First, the F test is used for determined FEM or the pooled OLS Second, LM test is conducted to choose between REM and the pooled OLS Finally, the Hausman test is applied to decide the sufficient model between FEM and REM

3.3.5 The system generalized method of moment estimation

In attempt to investigating the nexus between remittance inflows and financial development with panel dataset, the positive impact of the past financial development on the current financial development should be put into consideration (Chinn and Ito, 2006, Baltagi et al., 2009) This mean that the lag values of financial development must be comprised in the model or a dynamic model should be utilized

Yit=α+γYi,t-1+β1Xit+ni+ εt+uit (3.1) where i represents for individual 1,2,…,n and t represents for time 1,2, ,T; 𝑌𝑖𝑡

is the indicators of financial development; Yit-1 is the lagged values of indicators of financial development; Xit is a set of explanatory variables comprising remittances and other determinants of financial development.; ni is unobserved country specific effect; εt is a time – specific effectuit; is the error term

To resolve the potential endogeneity due to reverse causality between remittances and financial development, relevant omitted factors and measurement errors, the study utilizes the Arrelano-Bover/Blundell-Bond system GMM estimation technique

Three vital assumptions should be taken into account when employing GMM technique First, the error terms are not serially correlated Second, the explanatory variables are weakly exogenous Third, there is no correlation between the changes in explanatory variables and the country specific effects,

β0, then the following moment conditions can be applied to obtain unbiased estimates of the regressors:

E [(Yi,t-s-Yi,t-s-1)(εt + ui,t)] =0 for s=1

E [(Xi,t-s-Xi,t-s-1)(εt + ui,t)] =0 for s=1 The dynamic regression model utilized for examining the impact of remittance inflows on financial development can be written as follows:

CREDITi,t = β1CREDITi,t-1 + β2REMITi,t + β3GDPPCi,t + β4LNGDPi,t +

β7FINANCIALOPPENNESSi,t + β0 + ui,t (5) CREDITi,t = β1CREDITi,t-1 + β2REMITi,t + β3REMIT_HIGHi,t +

β4REMIT_MIDDLEi,t + β5GDPPCi,t + β6LNGDPi,t + β7INFi,t +

β8TRADEOPENNESSi,t + β9FINANCIALOPPENNESSi,t + β0 +

M2i,t = β1M2i,t-1 + β2REMITi,t + β3GDPPCi,t + β4LNGDPi,t + β5INFi,t +

β6TRADEOPENNESSi,t + β7FINANCIALOPPENNESSi,t + β0 +

M2i,t = β1M2i,t-1 + β2REMITi,t + β3REMIT_HIGHi,t +

β4REMIT_MIDDLEi,t + β5GDPPCi,t + β6LNGDPi,t + β7INFi,t + +β8TRADEOPENNESSi,t + β9FINANCIALOPPENNESSi,t + β0 +

Despite the potential endogeneity due to measurement error, variable omissions and reverse causality which is mentioned in previous studies (Aggarwal et al., 2011), it is necessary to utilize various methods to analyze the relationship between remittances and financial development Pooled OLS method, FEM and REM are employed together with the system GMM in this study in attempt to figure more accurate on the impact of remittances on financial development in selected Asian countries