According to the World Bank, remittances are now the second largest resource inflow for developing countries behind foreign direct investment (FDI). Remittances represent a stable inflow of foreign currency for many small developing economies. For some, remittances are now a greater source of foreign exchange than foreign direct investment and portfolio investment flows.
Understanding how remittances impact the volatility in exchange rates is a significant step forward in establishing the role of remittances in financial development. In economies with high levels of partial dollarization, dependence on both foreign and local currency may translate to greater sensitivity of exchange rates to changes in foreign exchange inflows. Partially dollarized economies experience greater exchange rate and inflation volatility derived from inflows of remitted funds. For highly dollarized economies with significant and consistent inflows of remittances, central bank policies that concern volatility in exchange rates will need to take into consideration how remittances impact currency markets and rising prices.
Recently, the global stock and commodities markets have taken a hit; the US dollar is trumping major emerging market currencies, boosting global remittances in the interim. There has been a substantial spike in remittances, particularly in South Asian countries, taking advantage of the depreciating currencies. Remittance to countries like India has received about 15 to 20 percent growth. However, the location of remittance workers plays a significant role on the impact of volatile currencies on remittances. For example, Nepali workers based in Malaysia and Japan, where the value of some currencies like Ringgit (Malaysia) and Yen (Japan), is declining, which results in workers holding their earnings rather than postponing it to their domicile nation. Likewise, many Nepali workers in countries like Qatar and UAE whose currencies are pegged to the US dollar are remitting money on an urgent basis.
Additionally, remittances mitigate the exchange rate volatility derived from the outflow. Remittances have an indirect stabilizing effect of exchange rate volatility in times when other kinds of capital flows are fluctuating drastically by offering a regular source of foreign currency into the dollarized economy. Because economies with high degrees of partial dollarization are more sensible to changes in foreign currency inflows, when diminishing capital flows result in less foreign currency entering the economy, remittances are able to negate part of the effect on exchange rate volatility. With sizable remittance inflows, the supplemental source of foreign currency mitigates the size of short-term exchange rate moves.
Remittances are expected to correlate positively with the stock of migrants abroad, and with the level of financial development. The level of the exchange rate matters because remitters take into account the value of the domestic currency when they remit. An appreciation of the domestic currency can reduce the remittances ratio because it presents a form of the cost for the remitter. Even so, remittances might increase following an appreciation of the domestic currency when the remitter targets a specific and stable quantity of money. Thus, it can be noted that remittances expressed in the sending country currency increase with the appreciation of receiving country currency.
Depreciation of a currency helps in inward remittances. For example, in India, where remittances are one of the significant contributors to the foreign exchange reserve and makes up nearly 25 percent of total foreign exchange reserves in the country, the depreciation of the Indian rupee always has a positive impact on the remittances. The country has witnessed 50 to 80 percent growth in remittance activity from several nations, particularly the Gulf areas, during the recent months. A similar trend occurred in 2012, 2013 and 2014 when the rupee witnessed a sustained depreciation.
Remittance flows do not react to the same incentives and conditions as foreign investment flows. Conditions that may cause net outflows of capital may not bear on the influx of remittances. By keeping a regular stream of foreign currency into the dollarized economy, remittances stabilize exchange rate volatility under conditions when other sources are decreasing.