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July – December 2019

Remittances in sub-Saharan Africa: Do they help or hamper financial sector development?

Remittances in sub-Saharan Africa Do they help or hamper financial sector development

By Dr Pieter Opperman and Prof Charles Adjasi

  • DEC 2019
13 minutes to read

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It’s about sending money home

Migration is part of Africa as people search for opportunities to improve their lives. Those who find work in other countries, send money home to help those left behind. In the past, migrants used both formal and informal systems to transfer money to their countries of origin. However, it is now required that these external sources of funding are transferred through official channels. This has a significant impact on the formal banking system and on financial sector development.

Also, according to the World Bank, sub-Saharan Africa remains the most expensive region to send money to, with Nigeria the leading remittance-receiving country in the region. With billions of dollars being “sent home”, it is worth investigating the impact of these remittances on the financial system.

What did the study investigate?

Migration in Africa is increasing. A better understanding of the consequences of remittance-receiving patterns – not only remittance levels – on the receiving economies and how this affects financial sector development is therefore becoming more important.

Migration in Africa is increasing. A better understanding of the consequences of remittance-receiving patterns … is therefore becoming more important.

This study looked at the relationship between remittances, remittance volatility and financial sector development in sub-Saharan Africa between 2002 and 2014. The study distinguished between the effect of remittances and remittance volatility on financial sector depth and financial sector efficiency.

This is important for policy purposes considering the increased importance of remittances as a source of external financing for people in sub-Saharan Africa. This knowledge can help to craft appropriate policies to harness the full benefits of these remittance flows.

The good and the bad about remittances

The related literature has not provided a consistent theoretical framework to explain the relationship between remittances and financial development. Yet, there are various reasons why remittances could have a positive impact on the banking sector and stock market development:

  • Banks: The banks handling the remittances can, for example, increase their income by charging processing fees. They can also gain valuable information about these often unbanked households, enabling them to offer credit and other banking products to the remittance recipients. It was also found that when remittances are irregular, households tend to save this money for a rainy day or for asset accumulation – which means banks could offer them financial products to safeguard these funds.
  • Stock market development: Through smoothing household consumption over time, spending could be delayed via saving and investment in the stock market. Remittances, as an external source of income, can contribute to disposable income which may lead to more investment in stocks, prompting more stock market investment.
  • Macroeconomic stability: A high level of stable remittances would help to protect a country from capital flight from the stock market and therefore have a positive impact on stock market development.

From a policy perspective this knowledge can help to craft appropriate policies to harness the full benefits of these remittance flows.

However, remittances may also negatively impact the development of the financial  sector:

  • When remittances are used for survival, it does not benefit financial development in the long run.
  • It could be argued that, in countries with less developed banking sectors, households are more inclined to use the remittance money for household expenses. Households are therefore provided with a substitute way to finance their needs without relying on the formal banking system. The more people receive remittances, the less their need to take up credit from a bank. Remittances will therefore have a negative effect on financial depth measures such as domestic credit to the private sector because of lower credit demand.
  • Remittances can act as substitutes to the banking sector if banks increasingly charge higher transaction costs.
  • Households receiving an increase in disposable income record higher consumption levels, shrinking the labour supply because of an increased demand for leisure. As the labour supply decreases, real wages increase and are further stimulated by the consumption boost. Households subsequently react to higher wages by increasing their labour supply, which can lead to a slight increase in aggregate employment. Overall, this can lead to higher wages, consumption, inflation and interest rates, which could be detrimental to financial sector development.
  • A remittance shock could reduce disposable income and negatively impact stock market development. Remittance volatility can negatively impact stock market development.

Remittances, remittance volatility and financial sector development

The results from the study indicated that remittances act as a substitute for the formal banking system in sub-Saharan African countries. Remittance volatility was negatively related to banking sector depth.

Evidence was found that remittance volatility is detrimental to banks’ financial efficiency. An increase in remittance volatility would increase banks’ net interest margins and overhead costs to total assets. Banks end up charging more with increased remittance volatility. When banks and intermediaries charge extreme transfer fees because of volatile flows, it can negatively impact financial system efficiency.

When remittances are used for survival, it does not benefit financial development in the long run.

It was found that remittances significantly impact stock market efficiency but not stock market depth. This should not be surprising as most sub-Saharan African stock markets remain thin and illiquid providing limited investment opportunities. Furthermore, self-interest remittances are driven by investment opportunities and are more sensitive to financial development levels. In sub-Saharan Africa it appears as if remittances are motivated by altruistic reasons.

About the cost of remitting money to another country

The researchers felt that the cost of remittance transfers needs to be looked at.

According to the World Bank, Africa is the most expensive region to send money to. In addition, it should be noted that the high transaction costs associated with remittances may encourage migrants to rather use informal channels. Or maybe the question should be: Do some remittances end up via informal channels due to the high cost of transfer and subsequently result in irregular and volatile flow in the formal financial system?

Instead of charging higher transactions fees, the banks handling the remittances can gain valuable information about these often unbanked households, enabling them to offer credit and other banking products to the remittance recipients.

The current structure and policy stance of many African countries with respect to the financial sector is inclined towards universal banking. This may reduce the incentive for banks to structure innovative offerings alongside remittances so as to encourage retention of remittances in the banking system for savings and investment. There are transfer policy implications for financial sector development. Perhaps we need specialised finance houses to handle remittance transfers and structure it with unique financial services and offerings which encourage savings and investment for recipients. However, it has been noted that a behavioural lethargy may exist in certain African countries towards new financial institutions due to the perceived high cost of financial services. A further policy implication is that behavioural constraints from the demand side should be taken into consideration by policy makers in the banking sector.

What are the implications of this study for policy development?

Here are some of the policy implications based on this study:

  • Understand the financial needs of remittance-receiving households: One policy implication is that the formal banking sector should investigate the financial needs of remittance recipients over and above basic transaction services. If banks offer other banking products to remittance-receiving households, this may lead to increased demand for credit from such households.
  • Monitor the predictability of remittances: The study results indicated that remittance volatility is detrimental to financial sector development. A policy implication is that sub-Saharan African countries should have measures in place to monitor the predictability of remittances. This is important as sub-Saharan Africa is the third highest recipient region of remittances as a percentage of GDP. In addition, the percentage of individuals living in countries other than those of their birth is rising.
  • Take a new look at self-interest remittances: Self-interest remittances, as opposed to remittances for altruistic reasons, are concerned with investment opportunities and are more sensitive to financial development levels. Countries in sub-Saharan Africa should consider policies to attract more investment from their diaspora.
  • Look at the high cost of transferring remittances: The cost of remittance transfers needs to be investigated. Lowering transaction costs should result in more remittances being channelled through formal channels, making flows more predictable and less volatile. More competition in the formal money transfer market may also help to decrease costs and encourage financial inclusion.

Perhaps we need specialised finance houses to handle remittance transfers and structure it with unique financial services and offerings which encourage savings and investment for recipients.

  • Find the original article here: Opperman, P., & Adjasi, C. K. D. (2019). Remittance volatility and financial sector development in sub-Saharan African countries. Journal of Policy Modeling, 41(2), 336-351. https://doi.org/10.1016/j.jpolmod.2018.11.001
  • Dr Pieter Opperman is a visiting local faculty member at USB.
  • Prof Charles Adjasi lectures in Development Finance at the University of Stellenbosch Business School. His fields of expertise include the development of financial markets in Africa, international trade dynamics and foreign direct investment.

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