High inflow of remittances limits the central bank's ability to influence through the traditional monetary policy. Here are excerpts from a recent article by Barajas et al in the latest edition Finance & Development magazine.
On fiscal policy
Remittances directly expand the tax base, which makes it easier for countries to maintain fiscal sustainability, in the sense of avoiding a situation of ever-expanding public debt. However, remittances can also skew the behavior of governments, in undesirable ways. First, and somewhat paradoxically, the very expansion in the revenue base could distort government incentives, lowering the costs of engaging in wasteful spending. Second, the supplemental income that remittances provide to households increases their ability to purchase goods that substitute for government services and reduces their incentive to hold the government accountable.
On monetary policy
For low-income countries, there is growing evidence that monetary policy transmission is substantially weaker than in advanced economies. While a variety of transmission channels may operate, Mishra, Montiel, and Spilimbergo (2012) argue that weak securities market development, imperfect integration with international financial markets, and highly managed exchange rates are likely to leave poorer countries with only one operable channel—bank lending. A change in the policy rate ripples through markets for short-term securities, ultimately affecting banks’ cost of funds at the margin and thus their ability to lend to private entities, whether people or firms.
However, even the bank-lending channel may be seriously weakened if there is little banking competition, the quality of institutions is poor, interbank markets in which banks deal with each other are underdeveloped, and information is lacking about the quality of borrowers. These factors conspire to short-circuit the transmission of moves in the short-term policy rate to banks’ cost of funds.
[...]remittances expand bank balance sheets by providing a stable and essentially costless source of deposits—because they are largely insensitive to interest rates. [...]because the remittance deposits increase the amount of financial intermediation (the process of banks matching up savers and borrowers), remittances might be expected to contribute to stronger monetary policy transmission.
[...]although banks might receive ample and virtually costless additional funding year after year from deposited remittances, that does not mean they will increase lending to the private sector one for one. Remittance-recipient economies—such as economies in most of the developing world—are often plagued by a number of problems, including a weak institutional and regulatory environment and a dearth of creditworthy borrowers.
[...]remittance flows may have a hand in weakening governance. This fragile lending environment reduces banks’ willingness to lend beyond a very limited pool of “qualified” borrowers, a reluctance that the additional lendable funds do nothing to counteract. Banks in recipient countries, then, tend to hold larger shares of liquid assets, excess reserves, and government securities than banks in nonrecipient countries. As a result, because banks are flush with liquidity, an interbank market—in which institutions in need of short-term funds borrow from those with excess balances—fails to develop. Because the policy rate is designed to affect the marginal cost of funds for banks, when there is virtually no interbank market, the effect of policy rate movements is weakened or nonexistent. The bank lending channel becomes impaired.
On transmission mechanism
Our empirical analysis confirms that, as remittances increase, monetary transmission through the bank lending channel weakens notably. Based on a sample of 58 countries worldwide between 1990 and 2013, we find that the strength of transmission, measured as the direct effect of a change in the policy rate on changes in bank lending rates, declines continuously as the size of remittances increases. In countries that do not receive remittances and have competitive banking systems, nearly 90 percent of a change in the policy rate is transmitted to the bank lending rate. In contrast, in an economy that receives 5 percent of GDP annually in remittances, only about 4 percent of the same change to the lending rate is transmitted, even when banking systems are competitive. In fact, when remittances reach 7.6 percent of GDP, the policy rate has no effect on bank lending rates. If the banking system is not competitive, the turning point occurs at a much lower level of remittances—1.2 percent of GDP.
[...]remittance-recipient countries may opt to scale back plans for full monetary policy independence. In fact, research suggests that greater remittance inflows are indeed associated with greater intervention in foreign currency markets, whether to fully fix the exchange rate or manage its fluctuations.
