Remittances and economic growth in developing Asia and the Pacific countries

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.. In the las

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

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

3.1 Remittances and capital accumulation 12

3.2 Remittance and labor force growth 13

3.3 Remittance and total factor productivity growth 14

4 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

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

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

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

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-

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

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

 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

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

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:

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:

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

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:

In this equation, the growth effects trend and ignored variables are illustrated by

𝑔1and growth effects of the variables in vector X are captured by 𝑔2

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

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

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

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

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

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 remittances-to-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

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

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

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

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

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

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,

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,

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

Due to the importance of international trade to growth, a lot of researchers have paid attention to this issue Recent studies have focused on two serious problems: causality between trade and growth and endogeneity The most common approach

to solve these problems is instrument variables The researchers have to find the variables that meet two important requirements: play no role in explaining dependent variable and uncorrelated with the error term in the equation The first exogenous instrument that satisfied these conditions was geography For example, Frankel and Romer (1999) used gravity model with the instrument variables that impact on openness and uncorrelated with the growth That was geographical factors like population, land area, borders and the distances They concluded that trade was likely to promoted economic growth

However, geographical variables are time-invariant, thus precluding researchers from using panel data in the regression This is a weakness because using time-variant variables seems to less prone to confounding by omitted variables To be more precise, between the changes in openness through time and the differences in the level of openness across countries, the first factor tends to have less correlated with the unobserved determinants of income than the second one To avoid this problem, US tariff rates were used as an exogenous time-variant instrument (Romalis, 2007) The author assumed that the willingness to trade of other countries

to developing countries would show their openness To be more precise, the higher share of exports of country fell into particular US tariff bands, the lower openness the country was The result showed a positive relationship between openness and growth

The different between “before” and “after” liberalization was the other approach to deal with causality problem (Kneller, 2006; Wacziarg & Welch, 2008) Kneller investigated GDP growth rate with five year period from 1970 – 1974 to 1995 –

1999 by using the Sachs and Warner index of trade liberalization The author found that growth increased average both after a liberalization and ‘similar” non-

liberalizers Therefore, he concluded this method may just pick up general trends Similarly, Wacziarg and Welch conducted “before and after” study with a conclusion that liberalization was the result of development in openness, investment and growth

Billmeier and Nannicini (2007) tested the relationship between trade openness and growth by doing difference-in-difference exercise on data from 1963 to 2005 They separated the sample into two different groups: treated and control countries The difference in GDP per capita between these two countries would be the effect of liberalization The paper found that trade liberalization created a positive impact on per capita income growth in most cases Slaughter (2001) also applied difference-in-differences approach to investigating the effect of trade liberalization on income growth dispersion However, the author did not find any significant link between them

Apart from the positive relationship between trade openness and growth, some researchers also confirmed a reserve effect of trade-growth nexus To illustrate, it is stated that whether openness brought real benefit for the economy depended on their comparative advantages with the rest of the word (Grossman & Helpman, 1991), and the structural characteristics of the economy (Buffie, 1992) For example, because of the inverse effect of financial market over macroeconomic performance, the openness to trade leads to negative impact on economic growth (Jin, 2006) Also, Simorangkir (2006) analyzed the openness-growth nexus in Indonesia and found the same result due to the decrease on domestic production

4.5 Inflation

The causality between inflation and economic growth has long been the macroeconomics theory debates since 1960s In the one hand, Keynesian perspective and the early Phillips curve models suggested that the inflation – growth nexus actually existed This relationship could be positive if pressure from inflation

increased aggregate demand, and negative if the inflation come from monopolistic pricing practices, exchange rate volatility or supply shocks On the other hand, new classical economics claimed that it was not positive benefit for the economy in term

of growth and unemployment if the inflation was higher than the minimum band in the range of 2 -3 percent

Besides, it is believed that whether inflation is benefit for the economy or not depends on the way the money is introduced in the models Specifically, when introduced money in the utility function as well as considered cash-in-advance economy with an explicit credit sector, Tobin (1965) concluded that if money was being a substitute for capital, which meant that an increasing in monetary growth may strengthen capital accumulation, thus, inflation had positive impact on long-run growth The reverse happened when money was spent for purchasing capital goods, higher estimated inflation was likely to reduce steady-state real balances and capital stock (Stockman, 1981)

In endogenous growth models, the connection between inflation and growth is expressed through the rate of return to physical capital or human capital, or both The former, inflation can be seen as a tax on physical capital This tax will reduce the rate of return to capital, thus decreasing the economic growth The latter is a tax

on human capital which will decrease the rate of return to capital as well as growth because of the substituting between goods and leisure (Antonia & Valérie, 2011) In the general monetary endogenous growth model, inflation may influence the economic growth by effecting on money demand elasticity (Gillman & Kejak, 2005) In the case of rising in elasticity and inflation, the substitution away from inflation will arise easily, thus causing non-linearity On the contrary, it tends to be

a near linear response in the case of constant elasticity Therefore, it is expected that the impact of inflation on growth would be small at higher inflation rates

Furthermore, the connection between inflation and economic growth varies depending on country-specific characteristics To be more precise, the characteristic

of the relationship as well as the level of sensitivity will be determined by the degree of economic development among countries (Khan & Senhadji, 2001) It can

be some features like the level of financial deepening, trade openness, public expenditure and capital accumulation For example, inflation seems to increase the volatility in price of goods and money market, thus raising the costs of hedging financial assets in financial developed economies Therefore, inflation exacerbates the adverse effect on growth on higher level of financial development economies Barnes and Duquette (2006) investigated causal link among inflation, growth and the level of financial deepening revealed that the inflation thresholds for the relationship between financial and growth was 14% Eggoh (2012) concluded the growth would enhance financial development if the inflation rate was below 10% Considering trade openness factor, it seems that the more degree of trade openness

is, the higher exchange rate volatility and export competitiveness are, thus increasing cost of inflation Likewise, a massive public expenditure which is the consequence of seigniorage tax and cost overruns on public projects will exacerbate the negative relationship between inflation and growth Empirical finding showed that the influence of inflation on economic growth through the proportion of public expenditure is bi-directional Due to the high level of public expenditure, inflation arises On the contrary, public expenditure is getting worse by cost escalation because of inflation (Barro, 1991) Finally, the capital accumulation is also influenced by reducing real interest rate, saving rate and capital-labor ratio (Gillman

& Kejak, 2005)

In conclusion, the relationship between inflation and growth has a long and illustrious debate both in theoretical and empirical However, the question on whether inflation is beneficial or harmful for the economy remains unsolved because the effects of inflation on growth varies across countries due to the difference in the level of inflation, the way money is introduced to the models and the country – specific characteristics

4.6 Population growth

The question on whether the country gains from population growth is debated for a long time From the theoretical perspective, there has been no clear consensus to this relationship Up to now, there are three different viewpoints on this problem The optimists’ viewpoint believed that population growth might promote economic growth because it was easier for the larger economies to build on, exploit and disseminate the flows knowledge they produce In other words, continued increase

in population may create innovation for technological advancement, which is one of the crucial engines for economic development According to pessimists’ viewpoint, population growth was harmful for the economy in the long run due to the scarcity

of resources and the decreasing in aggregate output, holding other complementary economic factors constant Instead of using surplus resources for saving and investment, they are spent for feeding growth population As the result, the economy carried the great burden due to high unemployment, high unrest and instability (Bollag, 2002) The remaining argument belongs to the neutralists’ viewpoint, which explains that there is no significant relationship between population growth and economic growth

A large number of researchers have paid attention on the nexus of population growth and economic growth by using cross-country data since the 1960s The results are mixture For example, Kelley and Schmidt (1995) accessed economic-demographic study approach to investigating population – economic growth nexus

By using panel data set of 89 countries in three growth periods including 1960 –

1970, 1970 – 1980, 1980 – 1990, they showed the result that appeared to support the pessimists’ viewpoint To be more precise, in the 1960s and 1970s, the costs come from high birth rate were balanced by the mortality reduction, and then the net impact of population growth on the economy was neutral However, in the 1980s, because of the increasing in short term costs of high birth rate, the current forgone growth-rate costs of birth could not be offset by the raising in labor force participant

that resulted from the birth rate in the past Therefore, population growth caused negative impact on economic growth Also, Ukpolo (2002), by using Granger-causality model, concluded that the casual link between population growth and economic growth was positive in the short run and negative in the long run

However, it seemed not reliable for the studies that used cross-country data to test this relationship Indeed, with cross-country data, the researchers suggested that the effects of population growth on economic growth in all countries were the same in magnitude They did not take into account the differences in social, ethnic, cultural, religious value and other non-economic factors (Ukpopo, 2002) Therefore, other authors used time-series analysis to investigate the relationship between population growth and economic growth For instance, Vibha (1995) evaluated the short run relationship in 15 low and middle income countries The author hypothesized that there was a two-way causality between population growth and economic growth

He used Granger causality test to check for this hypothesis The result showed that whereas the null hypothesis of no causality from population to growth was rejected for 8 of 15 countries, the hypothesis of no causality from growth to population was rejected for 7 countries In particular, population growth did not create any impact on economic growth in the Ghana, Sri Lanka, Bolivia, Philippines, Syria, Thailand and Argentina And higher economic growth did not influence on population growth rates in the Nepal, Bolivia, Philippines, Guatemala, Peru, Thailand, Argentina and Mexico

Instead of focusing on short term relationship, Payne and Ewing (1996) considered the long run relationship between two variables by residual-based cointegration and error correction models With the sample of 15 countries, there was only three countries existed long run relationship: Argentina, Peru and Sri Lanka This relationship was negative in Argentina and Sri Lanka, and bi-direction in Peru

4.7 Human capital formation

Human capital plays an important role in determining economic growth According

to Schultz (1961), human capital is defined as a collection of resources like knowledge, skills, competences and abilities that are inherent in an individual or acquired from education, training, medical care or migration Among these factors, education seems to be the primary source in human capital investment, which is the most importance in economic growth

In general, education may effect on economic growth through different mechanisms Firstly, through education, the human capital inherent in the labor force can achieve a significant increase, and then the productivity will increase as well Thus, the economy will be transitional to a higher equilibrium level of output (Mankiw, Romer & Weil, 1992) Secondly, in theories of endogenous growth, the innovative capacity of the economy will definitely improve by receiving education The knowledge on technologies and products which are absorbed from education will play a significant role in promoting economic growth (Aghion & Howitt, 1998) Lastly, it is obvious that the diffusion and transmission of knowledge will be broadened by continuing education; therefore people may have ability to understand and process information as well as to exploit new technologies devised by others, thus promoting economic growth (Benhabib & Spiegel, 1994)

Empirical contributions a great number of model specifications which investigate the impact of education on economic growth Some first researches were conducted

by using cross-section data The most recent studies used panel data set or adopted time-series analysis for specific countries However, because of the problems on conceptual and methodological, the relationship between education and economic growth remains controversial

A lot of researchers have confirmed the positive influence of education on economic growth For example, in most of Barro’s regression, school attainment

played a central part in long run economic performance To be more precise, with cross-section study in 98 countries over 1960 – 1965 periods, Barro (1991) found that whereas the economic growth had a positive relationship with primary and secondary enrollment, it was negative related to student-teacher ratios In 1996, he used panel data analysis for 91 countries over the period of 1965 – 1990 and concluded that the growth is positive associated with male secondary and higher schooling years Another papers also confirmed the same conclusion; however, when considering scores, male upper-level schooling was statistically insignificant (Barro & Sala-i-Martin, 2004) Zhang and Zhuang (2011) also used panel data set with GMM method for Chinese provinces over the period of 1997 – 2006 The paper introduced new variable called human capital structure into the model The result showed that human capital structure played extremely important role in promoting economic growth Besides, the performance of tertiary education was higher significant than primary and secondary education on growth

Despite theoretical arguments on the importance role of school attainment, there were some studies showed the negative impact of education on economic growth It

is said that the most important issue is the measurement problems Besides, the cognitive and skills cannot be produce by just a year of school but the contribution

of family and peers For example, Matthias and John (2014) tested the effect of private and social returns to education of government sector employees on economic growth of India The result found a statistically significant of the negative effect of government sector size on education’s effectiveness in promoting economic growth The reason came from the limited productivity of educated workers Another, Faisal and Abdul (2014) conducted a research to examine the impact of human investment on the key macroeconomic variables like labor, physical, human capital, consumption and investment at the same time The model showed a weak connection between human capital and labor market

Conceptual framework

State variables

- Capital accumulation

- Labor force participation

- Total factor productivity

CHAPTER III: METHODOLOGY

In this chapter, the study will discuss the analytical framework and the estimation technique used to examine how remittances impact on economic growth The data sources are provided in section 3

1 Analytical framework

The effect of remittances on economic growth will be capture through the impact of remittances on total factor productivity The study used the econometric formula which was based on the augmented Solow framework as was presented in equation (9) Moreover, it was extended by Giuliano and Ruiz-Arranz (2009) to included different control variables which determined economic growth The basic form of the relationship between remittances and growth is:

Where:

- ∆y is the growth rate of real per capita GDP,

- Rem is total worker’s remittances and compensation of employees received as a share of GDP

- is matrix of control variables which determines the economic growth, including:

 Initial per capita GDP: is an observation of the log of real per capital GDP

in 2000 Solow and Ramsey models revealed that initial per capita GDP would have negative relationship with economic growth because of the diminishing returns to reproducible factors To be more precise, richer countries seemed to growth at a slower rate Imai et al (2014), Nyamongo

et al (2012), Hassan and Rao (2011), Giuliano and Ruiz-Arranz (2009) added this variable to the model to allow for convergence

 Investment (Inv): is defined as gross fixed capital formation to GDP, expressed in log form Although it was considered as one of the most important channel through which remittances influence economic growth, Chami et al (2008) pointed out that including remittances into the production function exhibits that remittances impact economic growth through total factor productivity rather than capital accumulation

 Population (Pop): the growth rate of population Giuliano and Ruiz-Arranz (2009), Chami et al (2008) and Hassan and Rao (2012) used population growth as a control variable to represent for human resource

 Inflation (Inf): is proxied by natural growth in the Consumer Price Index In order to control the stability of the macro economy, the inflation rate was included in the model with the expectation of negative effect on growth (Giuliano, P & Ruiz-Arranz, M., 2009; Nyamongo, E et al., 2012)

 Openness (Openness): is defined as the ratio of sum of export and import to total output, expressed in log form The openness varies across countries due to the government policies and the country size Hassan and Rao (2011), Giuliano and Ruiz-Arranz (2009), Martinez, Cummings and Vaaler (2014), Imai et al (2014) used this variable to capture the country’s degree

of openness based on the restrictions on cross-border transactions

 Fiscal balance (Fisbal): is defined as the ratio of central government fiscal balance to GDP Although this variable does not create direct influence on productivity, it tends to entail distortions of private decisions through reflecting the government activities Therefore, Giuliano and Ruiz-Arranz (2009) used fiscal balance as a control variable to capture the macroeconomic environment

 Human capital formation (Hcf): is proxied by secondary school gross enrolment rate, expressed in log form It is expected to create a positive

impact on growth through its effect on productivity (Hassan, G M., & Rao,

B B., 2011; Nyamongo, E et al., 2012)

The measurement of variables in this study is provided in Table 1

Data are in constant 2005 international dollars

World Development Indicators

Initial GDP

per capita Real GDP per capita in 2000

World Development Indicators Remittances

The level of personal remittances computed as a share of GDP Data are the sum of two items: personal transfers and compensation of employees

World Development Indicators

Investment

The level of gross fixed capital formation in constant dollars

as a share of GDP Gross fixed capital formation refers to net increase in physical assets It does not take into account depreciation of fixed capital and land purchases

World Development Indicators

Openness

The level of the sum of exports and imports of goods and services measured as a share of GDP Exports and imports of goods and services represent the value of all goods and other market services provided to and received from the rest of the world

World Development Indicators

Inflation

Inflation as measured by the Consumer Price Index (CPI) reflects the annual percentage change in the cost to the average consumer of acquiring a basket of goods and services

World Development Indicators Population

The annual population growth rate for year t is the exponential rate of growth of midyear population from year t-1 to t,

expressed as a percentage

World Development Indicators

Human

capital

The secondary school enrollment rate is the ratio of total enrollment, regardless of age, to the population of the age group that officially corresponds to the level of education shown

UNESCO Institute for Statistics Table 1: Data description

The regression to be estimated is the following:

∆𝑦𝑖𝑡 = 𝛽0+ 𝛽1𝑦𝑖𝑡−1+ 𝛽2𝑅𝑒𝑚𝑖𝑡+ 𝛽3𝑙𝑛𝐼𝑛𝑣𝑖𝑡+ 𝛽4𝑃𝑜𝑝𝑖𝑡+ 𝛽5𝐼𝑛𝑓𝑖𝑡 + 𝛽6𝑙𝑛𝑂𝑝𝑒𝑖𝑡 +

This model suggests that the growth of real GDP per capita depends on the stock of capital, remittances and a set of control variables The primary purpose of this first model is the nature and the magnitude of 𝛽2 𝛽2 > 0 displays that the marginal impact of remittances on growth is positive In the case of 𝛽2 = 0, remittances exert

no impact on growth In the last case 𝛽2 < 0, remittances will have adverse effect on growth

Then, in order to examine whether remittances can effect on the impact of labor and capital on growth, the study uses interaction term between remittances and investment, population and human capital formation A positive sign of the estimated coefficient of interaction term indicates that remittances and investment, population and human capital are complement On the contrary, a negative coefficient of interaction term shows the substitute relationship To evaluate the interaction of each factor, each variable will be included separately in the regression equation The empirical model is specified as:

𝜕𝑙𝑛𝐼𝑛𝑣𝑖𝑡 = 𝛽3+ 𝛽9 𝑅𝑒𝑚; 𝜕∆𝑦𝑖𝑡

𝜕𝑃𝑜𝑝𝑖𝑡 = 𝛽4+ 𝛽9 𝑅𝑒𝑚

𝜕𝐻𝑐𝑓 𝑖𝑡 = 𝛽8+ 𝛽9 𝑅𝑒𝑚, respectively When β9 is positive, it means that in general, the higher value of remittances in the recipients’ countries, the higher impact of investment, population growth and human capital formation on economic growth

2 Estimation technique

In order to evaluate the effect of remittances on economic growth, the study uses system Generalized Method of Moments model (sGMM) with three following reasons:

Endogeneity: As discussed above, when taking into account the relationship

between remittances and growth, the endogeneity becomes the serious problems for the researchers Among four potential threats to endogeneity namely omitted variable bias, measurement error, sample selection bias and simultaneity, previous empirical research found out that the endogeneity problem in this relationship come from the fourth reason (Chami, R et al., 2003, Catrinescu, N et al., 2006, Chami,

R et al., 2008, Hassan, G M., & Rao, B B., 2011 & Nyamongo, E et al., 2012) In other words, that is the reverse causality between remittances and economic growth

In this case, if OLS is used, it will yield biased and inconsistent coefficient estimates The GMM method is a solution for solving endogenous problem

Instrument variables: Although there have been numerous researches for good

instrument variable for mitigating endogeneity problem, finding a best suitable variable seems to be the primary challenge for the researchers Until now, the instrument variables have been used namely 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 Each variable suffer from some different drawback However, internal instrument seems to be the most popular instrument that is used by numerous researchers Therefore, this study chooses GMM technique, which is

introduced by Arellano and Bover (1995) and Blundell and Bond (1998), with instrument variables are lagged values of right hand side variables to estimate the equation (4)

Finite sample: In GMM estimator, the difference GMM and system GMM are

increasing popular due to its simple implementation and the weak assumption on instrument variables These general estimators are designed in the panel data with few time periods and many individuals The difference GMM is called original estimator It means that different GMM applies the first-difference transformation to remove the fixed effects This approach will reduce the sample length, thus, it is more suitable in which number of individuals is comparatively large In addition, empirical study was done by Blundell and Bond (1998) revealed that first-difference estimation produced a large bias and low precision result in finite sample The performance of difference GMM is getting worse with the high level of persistency because in this case, lagged levels will be less correlated with the first-differences

In the study on economic growth with small number of individuals and display high level of persistency on some variables like physical and human capital stock, system GMM will have lower bias and higher efficiency than difference GMM

In order to test the consistency of sGMM technique, two diagnostic tests are used The first is Arellano-Bond test for second order autocorrelation in the first differenced residuals The second is J statistic Hansen test for over-identifying restrictions This kind of test is performed to evaluate the suitability of the model The null hypothesis of the J statistic implies that instruments are exogenous In other words, these instrument variables are uncorrelated with the error term If the null hypothesis is rejected, the instruments do not satisfy the requirement of orthogonality conditions