Transmission Troubles

• Author: Adolfo Barajas, Ralph Chami, Christian Ebeke, and Anne Oeking

Transmission Troubles Finance & Development, September 2016, Vol. 53, No. 3

Adolfo Barajas, Ralph Chami, Christian Ebeke, and Anne Oeking

Heavy inflows of remittances impair a country’s ability to conduct monetary policy

Many developing and emerging market economies are modernizing the way they conduct monetary policy to make it more transparent and forward looking, with more emphasis on exchange rate flexibility, an explicit inflation objective, and greater reliance on a short-term interest rate as the policy instrument.

But to be successful these countries must have an operable “transmission mechanism” that permits changes the central bank makes in the policy rate to propagate through the economy and ultimately affect spending decisions by households and firms. Several recent studies find that this transmission mechanism is missing or severely weakened in lower-income countries.

We have found the same weakened transmission mechanism in middle-income and emerging market economies that are major recipients of remittances—that is, money citizens living abroad send home to their families. That means policymakers in those economies should be aware of the difficulties they face in pursuing a fully modern monetary policy, and they may want to consider measures to strengthen the transmission mechanism or other approaches to help them conduct monetary policy.

Remittances are large and growingInternational inflows of workers’ remittances are a fixture in many developing and emerging market economies. Worldwide, official measures of these flows have been on a steady upward trend, from negligible amounts in 1980 to approximately $588 billion in 2015—$435 billion of which were received by developing economies. As a source of foreign funds in recent years, workers’ remittances have amounted to close to 2 percent of GDP on average for all emerging market and developing economies, while foreign direct investment (FDI) represented 3 percent, portfolio investment amounted to nearly 1 percent, and official transfers (foreign aid) were just over ½ percent. In 2014, some 115 countries received remittances equivalent to at least 1 percent of GDP, and 19 countries received 15 percent or more. Compared with private capital or official aid flows, remittances have been more stable—their cyclical volatility has proved to be appreciably lower—and they suffered a much milder contraction following the global financial crisis that started in 2008.

In some countries, remittances dwarf other external flows. For example, in 2015 in Jordan—among the top 30 recipients in recent years—remittance inflows amounted to about 9 percent of its GDP, more than 4 times FDI inflows and 3½ times private Eurobond placements.

While it is undeniable that remittances bring tangible benefits to the receiving country, supporting income and consumption of remitters’ families back home, it is also to be expected that flows of this magnitude year after year would have sizable effects on the overall economy—not all of them necessarily beneficial. A survey of economic research (Chami and others, 2008)...