Remittances and Domestic Investment in Developing Countries: An Analysis of the Role of Financial Sector Development
This paper addresses the relationship between remittances and home country investment in developing countries. It highlights, through both a theoretical model and an empirical analysis, the role of financial sector development (FSD) in the impact of remittances on home country investment. The key contribution of the paper is to show that different transaction costs traditionally associated with the FSD, namely 'Cost of Bank Depositing' and 'Cost of External Finance', have conflicting effects on the marginal impact of remitances on investment. Our stylized model, which addresses the specificities of remittance flows through the loanable funds market, yields several intuitive results. First, the marginal impacts of remittances on bank-deposits and formal investment are positive. Second, both marginal impacts increase when the Cost of Bank Depositing declines. Third, a decrease in Cost of External Finance lowers the marginal impact on formal investment, and does not affect the marginal impact on bank deposits. Hence, since FSD lowers both transaction costs, it has an ambiguous effect on the marginal impact on investment. The empirical analysis on a sample of 100 developing countries, using both cross-section and panel-data methodologies, confirms our model's predictions.
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