The interaction between remittances, real exchange rate, and financial sector development :the case of labor-exporting MENA countries -

Abstract

For developing MENA countries, remittances constitute an expanding source of financial inflows, contributing to economic growth and improving citizens' living standards. However, remittance inflows can exert upward pressure on the real exchange rate resulting in the appreciation of the economy’s currency, a phenomenon known as the Dutch Disease. The appreciation effect on the real exchange rate stems from the fact that remittances constitute a source of income to households that is mainly spent on consumption of goods and services. This project argues that if these foreign inflows are channeled through an effective financial sector, specifically the banking sector, into productive investment activity and-or contributed to government debt financing, then the upward pressure on the real exchange rate would lessen, thus reducing or even preventing currency appreciation. After the general introduction, chapter 2 of this project discusses the micro- and macroeconomic consequences of remittances. It also presents a review of the literature on remittances, the real exchange rate, and financial sector development. Chapter 3 then provides an overview on labor-exporting MENA countries, shedding light on the impact of remittance inflows and the role of the financial sector in these economies. To test the stated argument, chapter 4 presents an empirical model applied on a panel of eight labor-exporting MENA countries. Ordinary Least Squares Fixed Effect estimation, Two-Stage Least Squares estimation and Generalized Method of Moments technique are employed to examine the interaction between the real exchange rate, remittances, and financial sector development. The empirical evidence reveals that while remittance inflows tend to have appreciating effect on the real exchange rate, the upward pressure is attenuated in countries with a well-established financial sector. Finally, chapter 5 concludes the project stating remarks and policy recommendations.