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Remittances and Financial Development in India

Dissertation

Submitted by

Ajay Kumar (75008)

for the award of the degree of

Bachelor of Financial and Investment Analysis

Shaheed Sukhdev College of Business Studies

Delhi University

April 2014

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Certificate

I hereby declare that the project work entitled “Remittances and Financial Development”

submitted to the SHAHEED SUKHDEV COLLEGE OF BUSINESS STUDIES, is a record

of an original work done by me under the guidance of Dr. Kumar Bijoy, Head of

Department, Department of Financial Studies, SSCBS, and this project work has not

performed the basis for the award of any other Degree or diploma/ associate ship/fellowship

and similar project if any other than this.

Date:

Place: Delhi

Ajay Kumar Dr. Kumar Bijoy Mrs. Poonam

Verma

(Student) (Supervisor) (Principal)

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Acknowledgments

In pursuit of the degree of Bachelor of Financial and Investment Analysis, the final project is

a critical component of the entire program course. As part of a student in Shaheed Sukhdev

College of Business Studies, University Of Delhi, I got an opportunity to gain invaluable

experience under the guidance of Dr. Kumar Bijoy for completion of my final graduation

project. His continuous support and valuable in hand experience provided me with the

conceptual understanding and practical approach needed to work efficiently for this project.

Sincere thanks to all the staff members and the entire praiseworthy faculty of CBS.

The present work is an effort to throw some light on “Remittances and Financial

Development in India”. The work would not have possibly come to the present shape without

the able guidance, supervision and help of a number of people. I convey my heartfelt

affection to all those people who supported during the course, for contributing tremendously

in completing my Research Report. I hope this report, reflecting my learning in the past

thirteen weeks, is as beneficial to the readers as it has been to me.

Sincerely thanking you all.

Ajay Kumar (75008)

Bachelor of Financial and Investment Analysis

Shaheed Sukhdev College of Business Studies

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1 CONTENTS

2 Abstract ........................................................................................................................................... 5

3 Research Objective ......................................................................................................................... 6

4 Review of Literature ....................................................................................................................... 7

5 Analysis and Observations .............................................................................................................. 9

5.1 Introduction ............................................................................................................................. 9

5.2 History................................................................................................................................... 11

5.2.1 Overview ....................................................................................................................... 11

5.3 By region ............................................................................................................................... 11

5.3.1 Asia ............................................................................................................................... 11

5.3.2 Latin America and the Caribbean ................................................................................. 11

5.3.3 Africa ............................................................................................................................ 13

5.4 Economic benefits ................................................................................................................. 15

5.5 Remittances to India ............................................................................................................. 15

5.5.1 Remittance by fiscal year .............................................................................................. 17

5.6 Financial sector development ................................................................................................ 19

5.6.1 Importance of Financial Sector Development ............................................................... 20

5.6.2 Measurement of Financial Development ...................................................................... 20

5.7 India Financial Development Fund ....................................................................................... 21

6 Data and Methodology .................................................................................................................. 22

6.1 Ratios .................................................................................................................................... 23

6.1.1 Bank deposits to GDP Ratio ......................................................................................... 23

6.1.2 Share of bank credit to GDP Ratio ................................................................................ 25

6.1.3 M2 to GDP ratio ............................................................................................................ 26

6.1.4 Gross value added of the financial sector to GDP ........................................................ 27

6.1.5 Private Sector Credit to GDP ........................................................................................ 28

6.1.6 Financial Institutions’ asset to GDP .............................................................................. 29

6.1.7 Accounts per Thousand Adults ..................................................................................... 30

7 Results ........................................................................................................................................... 33

8 Conclusion .................................................................................................................................... 35

9 Bibliography ................................................................................................................................. 38

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2 ABSTRACT

This Study Focus the impact of Remittances on financial Development in India . And, it

investigates the impact of remittances received by India From developed countries. This is an

important issue given recent studies showing that financial development can have significant

beneficial effects on households. Using household-level survey data, the impact of

remittances on households’ use of savings and credit instruments from formal financial

institutions. We find that although remittances have a positive impact on financial

Development by promoting the use of deposit accounts, they do not have a significant and

robust effect on the demand for and use of credit from formal institutions. If anything, by

relaxing credit constraints, remittances might reduce the need for external financing from

financial institutions, while at the same time increasing the demand for savings instruments.

For example in Sub-Saharan Africa only 24% of adults have a bank account even

though Africa's formal financial sector has grown in recent years. It is argued that as banking

services are in the nature of public good; the availability of banking and payment services to

the entire population without discrimination is the prime objective of financial Development

public policy.If anything, by relaxing credit constraints, remittances might reduce the need

for external financing from financial institutions, while at the same time increasing the

demand for savings instruments.

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3 RESEARCH OBJECTIVE

First, it is to analyze the impact of remittances on financial Development directly.

While previous studies have looked at the link between remittances and aggregate deposits and

credit amounts, this is the study to examine whether remittances foster the use of deposit accounts

and credit by households. This is important given the literature that has identified beneficial

effects from financial Development

Second, by looking at whether households apply for loans, this study is able to examine

the impact of remittances on the demand for credit and not purely on credit outcomes. This is

useful because it can allow us to begin to assess to what extent remittances might relax credit

constraints.

Third, by using household-level panel data, this study can circumvent some of the

limitations of the previous studies.

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4 REVIEW OF LITERATURE

King and Levine, Beck and Loayza and Demirguç-Kunt, (1993-2004)

The purpose of this study argues that by intermediating society’s savings and allocating them

to their best uses, financial systems have a critical function for economies’ growth. However,

financial sectors can also be a source of fragility. Critically, recent policy approaches towards

the financial sector have focused more on the size of the sector rather than its intermediating

function, which might have led to short-run growth at the expense of high volatility.

Reducing the financial safety net subsidy and adjusting the regulatory framework

strengthening incentives towards intermediation will not only make the financial system safer

but also increase the growth benefits of finance for the real economy.

Banerjee et al. (2010)

This paper reports on the first randomized evaluation of the impact of introducing the

standard microcredit group-based lending product in a new market. In 2005, half of 104

slums in Hyderabad, India were randomly selected for opening of a branch of a particular

microfinance institution while the remainder were not, although other MFIs were free to enter

those slums. Fifteen to 18 months after Spandana began lending in treated areas, households

were 8.8 percentage points more likely to have a microcredit loan. They were no more likely

to start any new business, although they were more likely to start several at once, and they

invested more in their existing businesses.

There was no effect on average monthly expenditure per capita. Expenditure on durable

goods

increased in treated areas, while expenditures on “temptation goods” declined. Three to four

years after the initial expansion (after many of the control slums had started getting credit

from Spandana and other MFIs ), the probability of borrowing from an MFI in treatment and

comparison slums was the same, but on average households in treatment slums had been

borrowing for longer and in larger amounts. Consumption was still no different in treatment

areas, and the average business was still no more profitable, although we find an increase in

profits at the top end. We found no changes in any of the development outcomes that are

often believed to be affected by microfinance, including health, education, and women’s

empowerment.

Aggarwal, Demirgüç-Kunt, and Martínez Pería (2011)

The Purpose of this study show the impact of remittances on the financial sector using

balance of payments data on remittances and aggregate data on bank credit and deposit

amounts for 109 developing countries over the period 1975-2007.

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Lopez-Cordova, Martínez Pería, and Woodruff (2011)

The Purpose of this study shows the importance of remittances to developing countries, their

impact on banking sector breadth and depth in recipient countries has been largely

unexplored. We examine this topic using municipality-level data on the fraction of

households receiving remittances and on measures of banking breadth and depth for Mexico.

We find that remittances are strongly associated with greater banking breadth and depth,

increasing the number of branches and accounts per capita and the amount of deposits to

GDP. These effects are significant both statistically and economically, and are robust to the

potential endogeneity of remittances, Development of a wide range of controls and even

municipal fixed effects specifications using an alternative panel data set from a sample of

municipalities.

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5 ANALYSIS AND OBSERVATIONS

5.1 INTRODUCTION Remittances have become a significant source of external financing for developing

countries. They reached US$307 billion in 2009 and In 2012, according to the World Bank Report,

$401 billion went to developing countries (a new record) with overall global remittances at $514

billion more than double the amount of official development assistance and over two-thirds of the

private capital flows received by developing countries in that year. Remittances are especially

significant for small developing countries neighbouring large rich economies. For example,

remittances account for approximately 17 percent of GDP and they represent the second most

important source of external flows after exports.

There is an extensive literature on the effects of remittances on growth, investment

in microenterprises, poverty, inequality, health, and education. However, there are not many

studies that address the effects of international remittances on the domestic financial system. This

question is important because the literature has shown that financial development can have a

significant impact on economic growth and poverty reduction.

Furthermore, there is evidence that promoting financial Development – facilitating households’

access to and use of financial services – can also have significant beneficial effects. Based on a

randomized evaluation of a microcredit program in India, find that access to microcredit leads to

greater investment in business durables, increases the number of businesses started, and improves

the profitability of existing ones. It conducted in a field experiment in which a finance company

randomly liberalized screening criteria on consumer loans in South Africa and find significant

positive effects of access to credit on consumption, economic self-sufficiency (measured by

employment status and income), and some aspects of mental health and outlook. Studies on the

impact of accessing and using savings products also find positive effects. In particular, the

literature has found that providing individuals access to savings instruments increases savings.

Using household-level survey data for the period 2001-2011, this study investigates the impact of

remittances on financial Development. In particular, we focus on whether remittances promote

the use of deposit accounts and credit by examining the impact of remittances on the likelihood

that households have a deposit account, apply for loans, and receive loans from formal financial

institutions.

There are several ways in which remittances could affect financial Development.

First, remittances might increase the demand for savings instruments. The fixed

costs of sending remittances make the flows lumpy, providing households with excess cash for

some period of time. This might potentially increase their demands for deposit accounts, since

financial institutions offer households a safe place to store this temporary excess cash.

Second, remittances might increase household’s likelihood of obtaining a loan.

Processing remittances flows provides financial institutions with information on the income of

recipient households. This information might make financial institutions better willing and able to

extend loans to otherwise opaque borrowers. On the other hand, since remittances might help

relax households’ financing constraints, the demand for credit might fall as remittances increase.

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To the best of our knowledge, there are only three papers that examine the direct link between

remittances and the domestic financial system. They find strong evidence indicating that

remittances promote financial development, measured by the ratio bank deposits to GDP, and the

share of bank credit to GDP. Focusing exclusively on Mexico and using municipality-level data,

find that municipalities where a higher proportion of households receive remittances have a

higher number of bank branches and accounts per capita, and larger shares of deposits to GDP.

Our paper contributes to the study of the impact of remittances on the financial sector in several

ways.

In particular, the survey data used in this study has the potential to capture remittances flows

received through formal and informal channels, minimizing concerns about measurement error in

remittances. Also, because we use household-level panel data we are able to control for

unobserved household characteristics that can affect both remittances and financial Development,

something that was not possible in the earlier studies. Finally, this study will offer evidence on

the impact of remittances on financial Development for a new country - for which remittances

represent a very significant share of GDP. We conduct probit estimations of the likelihood of

using deposit and credit services, allowing for department-, municipality-, or household-level

fixed effects to control for factors other than remittances that might affect financial Development

at the household level. Also, to deal with the potential endogeneity of remittances, we conduct

instrumental variables regressions. Our main instruments are economic conditions in developing

countries.

Our estimations show that households that receive remittances are more likely to have

a deposit account at a financial institution. Our most conservative estimates indicate that

receiving remittances increases the likelihood of having an account by at least 11 percent and an

additional colon per capita in remittances raises this probability by 5 percent. These effects are

sizeable given that on average only 19 percent of households have an account. However,

remittance-recipient households are not more prone to request or receive a loan. In fact, some

estimations show the opposite. This suggests that though remittances might have the potential to

encourage the use of savings instruments, they do not necessarily foster the demand for and use

of credit, perhaps because they help to relax credit constraints. A majority of the remittances from the US have been directed to Asian countries like India

(approx. 66 billion USD in 2011), China (approx. $57 billion USD), the Philippines (approx. 23

billion USD), Pakistan (apporx . 16 billion) and Bangladesh (approx. 14.5 billion USD). In Latin

America and the Caribbean, remittances play an important role in the economy of the region, totaling

over 66.5 billion USD in 2007, with about 75% originating in the United States. This total represents

more than the sum of Foreign direct investment and official development aid combined. In seven

Latin American and Caribbean countries, remittances even account for more than 10% of GDP and

exceed the dollar flows of the largest export product in almost every country in the region.

Percentages ranged from 2% in Mexico, to 18% in El Salvador, 21% in Honduras, and up to 30% in

Haiti.

What is Remittance? A remittance is a transfer of money by a foreign worker to an individual in his or her home country.

Money sent home by migrants competes with international aid as some of the largest financial inflows

to developing countries. In 2012, according to the World Bank Report, $401 billion went to

developing countries (a new record) with overall global remittances at $514 billion. The economic

impact remains contested among researchers, however, remittance transfers do draw people towards

the financial services that are available to them.

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5.2 HISTORY

5.2.1 Overview

Remittances are not a new phenomenon in the world, being a normal concomitant to

migration which has always been a part of human history. Several European countries, for

example Spain, Italy and Ireland were heavily dependent on remittances received from their

emigrants during the 19th and 20th centuries. In the case of Spain, remittances amounted to

the 21% of all of its current account income in 1946. All of those countries created policies

on remittances developed after significant research efforts in the field. For instance, Italy was

the first country in the world to enact a law to protect remittances in 1901 while Spain was

the first country to sign an international treaty (with Argentina in 1960) to lower the cost of

the remittances received. Since 2000, remittances have increased sharply worldwide, having

almost tripled to $529 billion in 2012. In 2012, migrants from India and China alone sent

more than $130 billion to their home countries.

5.3 BY REGION

5.3.1 Asia

A majority of the remittances from the US have been directed to Asian countries like India

(approx. 66 billion USD in 2011), China (approx. $57 billion USD), the Philippines (approx.

23 billion USD),Bangladesh (approx. 21.5 billion USD) and Pakistan (apporx. 16 billion).

Most of the remittances happen by the conventional channel of agents, like Western Union,

Xpress Money, UAE Exchange and MoneyGram. However, with the increasing relevance

and reach of the Internet, online and mobile phone money transfers from companies such as

Remit2India, Azimo and Xoom.com have grown significantly.A common shop for remittance

in Angeles City, Philippines

According to a World Bank Study, the Philippines is the second largest recipient for

remittances in Asia. It was estimated in 1994 that migrants sent over US2.6 billion back to

the Philippines through formal banking systems. With the addition of money sent through

private finance companies and return migrants, the 1994 total was closer to US 6 billion

annually. Looking at current remittance flows, the total is estimated to have grown by 7.8 per

cent annually to reach US 21.3 billion in 2010. Remittances are a reliable source of revenue

for the Philippines, accounting for 8.9 per cent of the country's GDP.

The Estrada administration in 2000 declared it "The Year of Overseas Filipino Worker in the

Recognition of the Determination and Supreme Self-Sacrifice of Overseas Filipino Workers."

This declaration connects monetary remittances of overseas workers as the top foreign-

exchange earnings in the Philippines.

5.3.2 Latin America and the Caribbean

In Latin America and the Caribbean, remittances play an important role in the economy of the

region, totaling over 66.5 billion USD in 2007, with about 75% originating in the United

States. This total represents more than the sum of Foreign direct investment and official

development aid combined. In seven Latin American and Caribbean countries, remittances

even account for more than 10% of GDP and exceed the dollar flows of the largest export

product in almost every country in the region. Percentages ranged from 2% in Mexico, to

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18% in El Salvador, 21% in Honduras, and up to 30% in Haiti. The Inter American

Development Bank's Multilateral Investment Fund (IDB-MIF) has been the leading agency

on regional remittance research.

Through the providers listed on Send Money Home migrant workers can now view a price

comparison on remittances to Latin American and Caribbean countries.This research has

often been carried out in collaboration with Manuel Orozco of the Inter-American Dialogue,

his remittance research can be found at the Dialogue and at the IDB. In this region, Mexico,

one of the best documented examples of migration and remittances, received remittance

inflows of almost 24 Billion US$ in 2007, 95% of which originated in the US.

A significant study conducted by the Inter-American Development Bank (IDB) in 2004

provides useful insight into remittance and related migration patterns between Latin America

and the United States. The study reveals that over 60% of the 16.5 million Latin American-

born adults who resided in the United States at the time of the survey regularly sent money

home. The remittances sent by these 10 million immigrants were transmitted via more than

100 million individual transactions per year and amounted to an estimated $30 billion during

2004. Each transaction averaged about $150–$250, and, because these migrants tended to

send smaller amounts more frequently than others, their remittances had a higher percentage

of costs due to transfer fees.

Migrants sent approximately 10% of their household incomes; these remittances made up a

corresponding 50–80% of the household incomes for the recipients. Significant amounts of

remittances were sent from 37 U.S. states, but six states were identified as the "traditional

sending" states: New York (which led the group with 81% of its immigrants making regular

remittances), California, Texas, Florida, Illinois, and New Jersey. The high growth rate of

remittances to Mexico (not the total amount) is unlikely to continue. In fact, according the

Mexican central bank, remittances grew just 0.6 during the first six months of 2007, as

compared to 23% during the same period in 2006. Experts attribute the slowdown to a

contraction in the U.S. construction industry, tighter border controls, and a crackdown in the

U.S. on illegal immigration.

As the foregoing statistics illustrate, increased migration from Latin America to the United

States has resulted in a very significant amount of remittance activity. The numbers also help

us understand the dependence between a developed country and developing countries: The

United States needs Latin Americans to supply its labor markets—the migration improves

business profitability and reduces the costs of production, while Latin American countries

depend on the flows of remittances that result from the migration of labor. This dependence

has also resulted in what experts call "micro-geographies," tightly knit networks that integrate

U.S. communities with communities throughout Latin America, such as migrants from

Oaxaca, Mexico who have settled in Venice Beach, California. Oaxacans not only send

money back to their communities, but they also travel back and forth extensively.

As of recently, remittances from the U.S. to Latin America have been on the decline. While

there were USD 69.2 billion worth of remittances sent in 2008, that figure has fallen to USD

58.9 billion for 2011. This trend is a result of many factors including the global recession,

more economic opportunity in Latin American countries, and rising fees charged by coyotes

to smuggle immigrants across the border. The pattern of migration has changed from a

circular flow, in which immigrants work in the U.S. for a few years before returning to their

families in their home countries, to a one-way stream whereby migrants find themselves

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stuck in the United States. As a result, the new wave of migrants are both less likely to leave

and more likely to stay in the U.S. for longer periods of time. Overall, this trend has

contributed to falling levels of remittances sent to Latin American countries from the United

States.

5.3.3 Africa

Remittances to Africa play an important role to national economies, but little data exists as

many rely on informal channels to send money home. Today's African Diaspora consists of

approximately 20 to 30 million adults, who send about USD 40 billion annually to their

families and local communities back home. For the region as a whole, this represents 50

percent more than net official development assistance (ODA) from all sources, and, for most

countries, the amount also exceeds foreign direct investment (FDI). In several fragile states,

remittances are estimated to exceed 50 percent of GDP. Most African countries restrict the

payment of remittances to banks, which in turn, typically enter into exclusive arrangements

with large money transfer companies, like Western Union or Money Gram, to operate on

their behalf. This results in limited competition and limited access for consumers, although

there are a number of new players aiming to disrupt this established MTO (Money Transfer

Operator) model, such as Xoom and Willstream , which leverage increasing mobile phone

penetration in the region and provide different rate structures to Diaspora customers.

According to a World Bank study, Nigeria is by far the top remittance recipient in Africa,

accounting for $10 billion in 2010, a slight increase over the previous year ($9.6 billion).

Other top recipients include Sudan ($3.2 billion), Kenya ($1.8 billion), Senegal($1.2 billion),

South Africa ($1.0 billion), Uganda ($0.8 billion), Lesotho ($0.5 billion), Ethiopia ($387

million), Mali ($385 million), and Togo ($302 million). As a share of Gross Domestic

Product, the top recipients in 2009 were: Lesotho (25%), Togo (10%), Cape Verde (9%),

Guinea-Bissau (9%), Senegal (9%), Gambia (8%), Liberia (6%), Sudan (6%), Nigeria (6%),

and Kenya (5%).

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Top recipient countries

Top recipient countries of remittances (in billions of US Dollar)

Country Remittances

2008 Remittances

2009 Remittances

2010 Remittances 2011

India

49.98 49.2 53.48 63.82

China

22.69 22.9 33.44 40.48

Mexico

26.04 22.08 22.08 23.59

Philippines

18.63 19.73 21.37 22.97

Nigeria

19.21 18.37 19.82 20.62

France

16.28 16.06 16.71 19.31

Egypt

8.69 7.15 12.45 14.32

Germany

10.97 11.3 11.73 13.16

Bangladesh

9.01 10.72 11 12.87

Pakistan

7.04 8.72 9.69 12.26

Belgium

10.42 10.44 10.3 10.91

Sri Lanka

6.78 5.94 6.54 9.92

Spain

10.15 8.95 9.11 9.91

Vietnam

6.81 6.02 8.26 8.6

South Korea

9.07 7.28 7.06 8.49

Ukraine

6.78 5.94 6.54 7.82

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5.4 ECONOMIC BENEFITS

As remittance receivers often have a higher propensity to own a bank account, remittances

promote access to financial services for the sender and recipient, an essential aspect of

leveraging remittances to promote economic development.

The stability of remittance flows despite financial crises and economic downturns make them

a reliable financial resource for developing countries. As migrant remittances are sent

cumulatively over the years and not only by new migrants, remittances are able to be

persistent over time. Remittances are often sent by circular migrants, migrant workers who

move back and forth between their home and host countries in a temporary and repetitive

manner. These workers have the benefit of working in a high-income country and sending

their remittances to a low-income country, thus benefitting financially. At the state level,

countries with diversified migration destinations are likely to have more sustainable

remittance flows.From a macroeconomic perspective, remittances can boost aggregate

demand and thereby GDP as well as spur economic growth. However, some research

indicates that remittances may also have adverse macroeconomic impacts by increasing

income inequality and reducing labor supply among recipients.

A 2011 study develops a long-run growth model for a labour exporting country that receives

large inflows of external income—the sum of remittances, FDI and general government

transfers—from major oil exporting economies. The long-run economic benefits of external

income is then evaluated using data for Jordan

5.5 REMITTANCES TO INDIA

Remittances to India are money transfers from Non-resident Indians (NRIs), employed

outside the country to family, friends or relatives in India. India is the world's leading

receiver of remittances, claiming more than 12% of the world's remittances in 2007.

Remittances to India stood at $67.6 billion in 2012-13, accounts for over 4% of the country's

GDP. As per the Ministry of Overseas Indian Affairs (MOIA), remittance is received from

the approximately 25 million members of the Indian diaspora.

Under the Foreign Exchange Management Act (FEMA) of 1999, Non Resident Indians

(NRIs) and Persons of Indian Origin (PIOs) can keep three types of accounts namely, Non-

Resident Ordinary Rupee Account (NRO Account), Non-Resident (External) Rupee Account

(NRE Account) and Foreign Currency Non Resident (Bank) Account – FCNR (B) Account.

Since 1991, India has experienced sharp remittance growth. In 1991 Indian remittances were

valued at 2.1 billion USD, in 2006, they were estimated at between $22 billion and $25.7

billion. which grew to $67.6 billion in 2012-13, up from $66.1 billion the fiscal year, 2011-

2012, when the remittance exceed the foreign direct investment (FDI) inflow of $46.84

billion into India.

Money is sent to India either electronically (for example, by SWIFT) or by demand draft. In

recent years many banks are offering money transfers and this has grown into a huge

business. Around 40% of the international remittances flow to the three states of Kerala,

Punjab, Uttar Pradesh and Goa which are among the top international remittance-dependent

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economies of the world. Research work on remittances to India is listed in the India

Migration Bibliography.

A 2012 study, by Reserve Bank of India revealed 30.8% of total foreign remittances was

from West Asia, compared to 29.4% from North America and 19.5% from Europe.

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5.5.1 Remittance by fiscal year

The following table illustrates the remittances to India as percent of GDP, 1990–2013.

Year Remittances

(US$ billion)

Percent

GDP

1990–

1991 2.1 0.7

1995–

1996 8.5 3.22

1999–

2000 12.07 2.72

2000–

2001 12.85 2.84

2001–

2002 15.4 3.29

2002–

2003 16.39 3.39

2003–

2004 21.61 3.69

2004–

2005 20.25 3.03

2005–

2006

24.55

(projected) 3.08

2006–

2007 29.10 4.08%

2007–

2008 37.2 3.60%

2008–

2009 51.6 3.12%

2009–

2010 55.06 3.40%

2011–

2012 66.1 4.00%

2012– 67.6 4.34%

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Remittance inflows to GDP (%)

2013

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5.6 FINANCIAL SECTOR DEVELOPMENT

Financial sector development in developing countries and emerging markets is part of the

private sector development strategy to stimulate economic growth and reduce poverty.

Financial sector is the set of institutions, instruments, markets. It also includes the legal and

regulatory framework that permit transactions to be made through the extension of credit.

Fundamentally, financial sector development concerns overcoming “costs” incurred in the

financial system. This process of reducing costs of acquiring information, enforcing

contracts, and executing transactions results in the emergence of financial contracts,

intermediaries, and markets. Different types and combinations of information, transaction,

and enforcement costs in conjunction with different regulatory, legal and tax systems have

motivated distinct forms of contracts, intermediaries and markets across countries in different

times.

The five key functions of a financial system in a country are: (i) information production ex

ante about possible investments and capital allocation; (ii) monitoring investments and the

exercise of corporate governance after providing financing; (iii) facilitation of the trading,

diversification, and management of risk; (iv) mobilization and pooling of savings; and (v)

promoting the exchange of goods and services.

Financial sector development takes place when financial instruments, markets, and

intermediaries work together to reduce the costs of information, enforcement and

transactions.A solid and well-functioning financial sector is a powerful engine behind

economic growth. It generates local savings, which in turn lead to productive investments in

local business. Furthermore, effective banks can channel international streams of private

remittances. The financial sector therefore provides the rudiments for income-growth and job

creation.

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5.6.1 Importance of Financial Sector Development

There are ample evidence suggesting that financial sector development plays a significant

role in economic development. It promotes economic growth through capital accumulation

and technological advancement by boosting savings rate, delivering information about

investment, optimizing the allocation of capital, mobilizing and pooling savings, and

facilitating and encouraging foreign capital inflows.A meta-analysis of 67 empirical studies

finds that financial development is robustly associated with economic growth.

Countries with better-developed financial systems tend to enjoy a sustained period of growth,

and studies confirm the causal link between the two: financial development is not simply a

result of economic growth; it is also the driver for growth.

Additionally, it reduces poverty and inequality by enabling and broadening access for the

poor and vulnerable groups, facilitating risk management by reducing their vulnerability to

shocks, and raising investment and productivity that generates higher income.

Financial sector development also assists the growth of small and medium sized enterprises

(SMEs) by giving them with access to finance. SMEs are typically labor intensive and create

more jobs than large firms, which contributes significantly to economic development in

emerging economies.

Additionally, financial sector development also entails establishing robust financial policies

and regulatory framework. The absence of adequate financial sector policies could have

disastrous outcome, as illustrated by the global financial crisis. Financial sector development

has heavy implication on economic development‐‐both when it functions and malfunctions.

The crisis has challenged conventional thinking in financial sector policies and sparked

debate on how best to achieve sustainable development. To effectively reassess and re-

implement financial policies, publications such as Global Financial Development Report

(GFDR) by the World Bank and Global Financial Stability Report (GFSR) by the IMF can

play an important role.

The Global Financial Development Report, a new initiative by the World Bank, highlights

issues that have come to the forefront after the crisis and presents policy recommendation to

strengthen systems and avoid similar crisis in the future. By gathering data and knowledge on

financial development around the world, the GFDR report aims to put into spotlight issues of

financial development and hopes to present analysis and expert views on current policy

issues.

5.6.2 Measurement of Financial Development

A good measurement of financial development is crucial in evaluating the progress of

financial sector development and understanding the corresponding impact on economic

growth and poverty reduction.

However in practice, it is difficult to measure financial development given the complexity

and dimensions it encompasses. Empirical work done so far is usually based on standard

quantitative indicators available for a longer time period for a broad range of countries. For

21

instance, ratio of financial institutions’ assets to GDP, ratio of liquid liabilities to GDP, and

ratio of deposits to GDP.

However, since the financial sector of a country comprises a variety of financial institutions,

markets and products, these measures only serve as a rough estimate and do not fully capture

all aspects of financial development.

The World Bank’s Global Financial Development Database (GFDD) developed a

comprehensive yet relatively simple conceptual 4x2 framework to measure financial

development worldwide. This framework identifies four sets of proxy variables

characterizing a well-functioning financial system: financial depth, access, efficiency, and

stability.[9] These four dimensions are then broken down for two major components in the

financial sector, namely the financial institutions and financial markets

5.7 INDIA FINANCIAL DEVELOPMENT FUND

India Financial Development Fund (IFIF) is a USD$90 million fund that was set up in August

2008 as an off-shore India-focused equity fund, investing in high-growth, small to medium

MFIs and enablers.

IFIF’s triple bottom line objectives are financial Development, capital appreciation, and

social performance initiatives. Through its investments, IFIF will aim to:

Provide new MFIs with start-up, growth capital, strategic inputs, and technical advice

Support and enable product diversification by providing appropriate risk capital

Encourage the scaling up or creation of microfinance enablers, who will contribute to

building an efficient microfinance ecosystem

Play the role of an active, responsible investor seeking to deliver a competitive financial

return and support the expansion of social performance initiatives

22

6 DATA AND METHODOLOGY

Financial development, refers either to the ratio of bank credit to the private sector or the

share of bank deposits expressed as a percentage of GDP. These are the standard measures of

financial depth used in the literature (e.g., King and Levine, 1993). Data to construct these

ratios come from the International Financial Statistics (www.imf.org) and the World

Development Indicators (www.worldbank.org). Finding shows that where a higher proportion of

households receive remittances have a higher number of bank branches and accounts per capita, and

larger shares of deposits to GDP. Second, by looking at whether households apply for loans, this study is able to examine the impact of

remittances on the demand for credit and not purely on credit outcomes. This is useful because it can

allow us to begin to assess to what extent remittances might relax credit constraints.

Depth

Private Sector Credit to GDP

Financial Institutions’ asset to GDP

M2 to GDP

Deposits to GDP

Gross value added of the financial sector to GDP

Access

Accounts per thousand adults(commercial banks)

Branches per 100,000 adults (commercial banks)

% of people with a bank account (from user survey)

% of firms with line of credit (all firms)

% of firms with line of credit (small firms)

The data on remittances are obtained from the IMF’s 2013 World Economic

Outlook. With some exceptions, these data are constructed as the sum of three items in the

Balance of Payment Statistics Yearbook (IMF): workers’ remittances (current transfers made

by migrants who are employed and resident in another economy); compensation of

employees (wages, salaries and other benefits earned by non-resident workers for work

performed for resident of other countries); and migrant transfers (financial items that arise

from the migration or change of residence of individuals from one economy to another).

We empirically examine the relationship between financial development and remittances

by estimating a number of variants of equation (1), depending on the assumptions made about

the error term and the exogeneity of remittances.

FDi,t= β1Remi,t + β2Xi,t + αi + ui,t (1)

where i refers to the country and t refers to the time period from 2002 to 2012.

23

We first examine the relationship between financial development and remittances

by running fixed effects (FE) and random effects (RE) regressions, ignoring the potential for

biases due to reverse causation, omitted factors, or measurement error. FE and RE

estimations make different assumptions about the error term in equation (1). In the FE model,

the error term is the sum of αi and ui,t where αi represents individual specific fixed

parameters to be estimated and ui,t are independent and identically distributed errors with

zero mean and constant variance In the RE regressions, both αi and ui,t are independently

distributed and, furthermore, both are assumed to be independent from the regressors in the

equation. In conjunction with these estimations, we report F-tests for the joint significance of

the fixed effects and Hausman tests comparing the efficiency of random vis-à-vis fixed effect

estimates.

We conduct a number of different estimations to address the concerns outlined above.

First, we separately conduct estimations for the most recent period (2002-2012 ), because the

potential for measurement error should be smaller in this period, since remittance statistics

are likely to have improved over time. Second, we conduct estimations including time

dummies to mitigate the concern for omitted relevant regressors.

6.1 RATIOS

Studies Shows the impact of accessing and using savings products also find positive effects.

In particular, we focus on whether remittances promote the use of deposit accounts and credit

by examining the impact of remittances on the likelihood that households have a deposit

account, apply for loans, and receive loans from formal financial institutions.

6.1.1 Bank deposits to GDP Ratio

Year Bank Deposit to GDP(%)

2001 51.9

2002 53.2

2003 55.7

2004 57.6

2005 58.4

2006 60.9

2007 60.8

2008 67.7

2009 70.1

2010 71.8

2011 74.1

2012 76.6

24

25

6.1.2 Share of bank credit to GDP Ratio

Year Share of bank Credit to GDP(%)

2001 27.8

2002 31.1

2003 31.9

2004 35.6

2005 39.4

2006 43.2

2007 44.8

2008 48.5

2009 47.3

2010 49.5

2011 49.9

2012 51.5

26

6.1.3 M2 to GDP ratio

Year M2 to GDP(%)

2001 53.7

2002 56.7

2003 61.5

2004 62.1

2005 63.5

2006 64.5

2007 67.4

2008 71

2009 75.8

2010 76.3

2011 76.7

2012 76.1

2013 77.7

Gross value added of the financial sector to GDP

27

6.1.4 Gross value added of the financial sector to GDP

Year Gross value added of the financial sector to GDP(%)

2001 51

2002 52

2003 53

2004 53

2005 53

2006 53

2007 53

2008 53

2009 54

2010 55

2011 54

2012 56

2013 57

28

6.1.5 Private Sector Credit to GDP

Year Private credit by deposit money banks to GDP (%)

2001 27.81271

2002 29.91763

2003 30.77909

2004 31.4495

2005 35.2787

2006 38.54082

2007 41.11208

2008 44.39661

2009 44.6119

2010 44.66758

2011 47.14732

2012 49.9854

2013 51.4589

29

6.1.6 Financial Institutions’ asset to GDP

Year Central bank assets to GDP (%)

2001 6.782355

2002 5.61084

2003 3.224716

2004 2.197755

2005 2.197881

2006 2.053165

2007 2.016809

2008 1.787643

2009 1.998486

2010 3.368102

2011 4.613224

2012 4.935669

2013 5.186456

30

6.1.7 Accounts per Thousand Adults

Year Accounts per thousand adults

2005 9

2006 9

2007 8.9

2008 9

2009 9.4

2010 9.6

2011 10.1

2012 10.5

2013 11.4

31

32

Our estimations show that households that receive remittances are more likely to have a

deposit account at a financial institution. Our most conservative estimates indicate that

receiving remittances increases the likelihood of having an account by at least 11 percent and

an additional colon per capita in remittances raises this probability by 5 percent. These effects

are sizeable given that on average only 9 percent of households have an account. However,

remittance-recipient households are not more prone to request or receive a loan. In fact, some

estimations show the opposite. This suggests that though remittances might have the potential

to encourage the use of savings instruments, they do not necessarily foster the demand for

and use of credit, perhaps because they help to relax credit constraints.

FDi,t= β1Remi,t + β2’Xi,t + αi + ui,t

where i refers to the country and t refers to the time period

Data to construct these ratios come from the International Financial Statistics (IMF) and the

World Development Indicators (World Bank). As shown in Table 2, there is considerable

variation in financial development for our sample of countries with the ratio of deposits to

GDP ranging from 1.74% to 161.40% and the ratio of credit to GDP varying from 0.46% to

121.46%. Financial Developmentit=α+β1Remittancesit + β2Income/Wealthit + β3Educationit +

β4Returned migrantit + β5Other household characteristicsit +εit

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7 RESULTS

SUMMARY OUTPUT

Regression Statistics(Table-1) Multiple R 0.922010996

R Square 0.850104277 Adjusted R Square -1.111111111 Standard Error 0.000109802 Observations 1

ANOVA(Table-2) df SS MS F Significance F

Regression 10 6.15385E-07 6.15385E-08 51.04174 56 Residual 9 1.08509E-07 1.20565E-08

Total 19 7.23894E-07

(Table-3) Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Lower 95.0%

Upper 95.0%

Intercept

1.9E-201

1.9E-201

60.02205

1.9E-201

1.9E-201

62.05344

-4E-306 3.9E-

306

60.47448

6.2E-308

3.4E-307

67.136

-2E-306 2.5E-

306

73.67519

-2E-307 6.2E-

307

76.57478

0 0

74.62669

0 0

75.26033

4E-241 -1E-240

71.31186 0 #N/A 0 1 -2.3156E-306 2.3E-

306 -2E-306 2.3E-

306

76.31182 3.4669E-06 4.85265E-07 7.144350195 5.4E-05 2.36916E-06 4.56E-

06 2.37E-

06 4.56E-

06

75.83173

34

RESIDUAL OUTPUT (Table-4)

PROBABILITY OUTPUT

(Table-5)

Observation

Predicted 9.85605059721601E-

05 Residuals

Percentile 9.85605E-05 1 0.000262901 -0.000164341

50 9.85605E-05

Table 3 shows the estimation results for the impact of remittances on the likelihood that a

household has a deposit account. Receiving remittances increases the probability that the

household will have a deposit account by between 11 and 30 percent, depending on the type

of fixed effects included. Furthermore, an additional colon per capita in remittances raises the

likelihood of having an account by between 5 and 14 percent. These effects are sizeable

considering that in the sample 9 percent of households have deposit accounts.

As expected, Real per capita income and House and land ownership are also significant and

positive: more income and wealth make households more prone to having an account.

However, House and land ownership is not significant in the household fixed effects

regressions in columns 4 and 8. Concerning the variables included in Other household

characteristics,

The results for the likelihood of receiving a loan from a formal financial institution.. These

results could be driven by the fact that there are potentially two opposing effects of

remittances on credit: (1) remittances can be used as an informal type of collateral or as a

means to provide information on households’ income that might make financial institutions

more willing to provide credit; and (2) remittances may help relax households’ credit

constraints and, hence, could reduce their demand for credit. Thus, these two effects may well

be counteracting each other, causing remittances to be generally insignificant.

We find that Adults average education has a positive and significant influence on the

probability of receiving a loan..

Nevertheless, to try to assuage concerns about endogeneity, we run instrumental variables

regressions. Our main instruments are Household level Data weighted averages of economic

conditions in US states where Salvadoran migrants reside.

We find that our main results are robust to controlling for the potential endogeneity of

remittances. Namely, while remittances have a positive effect on the likelihood that a

household has a deposit account, neither the fact that a household receives remittances nor

the actual per capita amount received has a statistically robust impact on the likelihood of

applying for and receiving a loan.

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8 CONCLUSION

As the importance of remittances has grown, an issue which has received little attention is the

effect of remittances on the financial system. This issue is important given the evidence that

financial development matters for growth and poverty alleviation and the fact that financial

development has many beneficial effects for households.

This study examined the impact of remittances on financial development using data of India.

In particular, I analyzed the impact of remittances on the likelihood that households use

financial services such as deposit accounts and loans. Overall, I find that remittances have a

positive impact on financial development by promoting the use of deposit accounts. These

results hold controlling for unobserved household characteristics and using instrumental

variables regressions to correct for the potential endogeneity of remittances. On the other

hand, remittances do not have a significant effect on credit from formal financing institutions.

Hence, by relaxing credit constraints, remittances might reduce the need for external

financing by financial in stitutions, while at the same time increasing the demand for savings

instruments.

There are a number of potential avenues for future research. First, it would be interesting to

analyze the extent to which remittance recipients that have accounts, actively use these

accounts to save and manage their daily transactions. Second, it would be important to go

deeper into the reasons why those that receive remittances do not seem to have a higher

demand for credit. In particular, it would be useful to analyze whether indeed this is due to

the fact that remittances relax credit constraints or because the credit products offered to

remittance recipients are not considered adequate by this population.

Let me conclude with some thoughts on the challenges ahead.

First, weakening asset quality is an immediate concern for the banking sector. This is more so

as the banks’ credit composition in the recent years has changed towards longer term assets

such as infrastructure and housing. While improvement in macroeconomic policy

environment and expected revival in economic growth should help mitigate risks to some

extent, banks would have to make concerted efforts to improve asset quality.

Second, while on many efficiency parameters, Indian banks compare favourably to their

global peers, the net interest margin (NIM) remains relatively high. The banks need to further

enhance their productivity so that the intermediation cost between depositors and borrowers

is minimised. This, coupled with containment of NPAs, will help improve monetary

transmission.

Third, as the Indian economy reverts to its high growth path, the demand for credit will go

up. The consequent expansion of the banking sector will require more capital. Additionally,

as the Basel III norms are made applicable, the capital requirements would increase further.

The preliminary assessment by the Reserve Bank made in June 2012 showed a comfortable

position of Indian banks at the aggregate level to meet the higher capital norms. As per the

broad estimates from the Reserve Bank, public sector banks would require a common equity

of Rs1.4-1.5 trillion in addition to Rs 2.65-2.75 trillion as non-equity capital to meet the full

Basel III norms by 2018. Banks, therefore, need to design appropriate strategies for meeting

these capital norms.

36

Fourth, a key factor that accentuated the global financial crisis was excessive leverage. While

the Indian banking system is currently moderately leveraged, according to the guidelines

issued by the Reserve Bank, banks should strive to maintain a minimum Tier I leverage ratio

of 4.5 per cent pending the final proposal of the Basel Committee. It would be prudent for

banks not to dilute their leverage position in the interim period 5.

Fifth, there are proposals for expansion of the banking sector with new entrants. The Reserve

Bank has already invited applications for new banks. Further, as indicated in the annual

policy statement of May 2013, the Reserve Bank is preparing a policy discussion paper on

banking structure in India which would be placed in the public domain. The expansion of the

banking sector commensurate with the growth of the economy would not only enhance

competition but also facilitate financial Development.

What is interesting is that most receivers of small-ticket size cash remittances actually want

to open bank accounts in order to receive these transfers. Thus, offering them an opportunity

to access the banking channel and linking payments received to savings accounts will

promote financial Development.

After all, one must not forget the efforts and contribution of the over 11-million-strong

migrant worker population towards the country's social and economic development.

SMS alert facility for remitter and beneficiary is the highlight apart from instant credit to

Federal Bank accounts. The agreement was exchanged between A. Surendran, general

manager, retail & international business, Federal Bank and George M. Jacob, vice president,

legal corporate affairs and marketing, Muthoot Group.

Reserve Bank of India allowed various services such as payments to utility service providers,

tax payments, and EMI payments in India with a view to expand the scope of cross-border

inward remittances.

RBI also introduced facilities such as payments to utility service providers in India, for

services such as water supply, electricity supply, telephone (except for mobile top-ups),

internet, television, tax payments and EMI payments in to Banks and Non-Banking Financial

Companies (NBFCs) for repayment of loans, would be allowed under RDA.

Under RDA the existing arrangement, credit to non-resident (External) rupee accounts

maintained by NRI in Indian rupees, payments to families of NRIs, payments in favour of

Insurance companies, Mutual Funds and the Post Master for premia/ investments, and

payments in favour of bankers for investments in shares, debentures are allowed under RDA.

Among others, payment to cooperative housing societies, government Housing Schemes or

estate developers for acquisition of residential flats in India in individual names by the NRIs,

payments of tuition/boarding, examination fee to schools, colleges and other educational

institutions under RDA.

RDA also includes Payments to medical institutions and hospitals for medical treatment of

NRIs/their dependents and nationals of Gulf countries in India, payments to hotels by

nationals of Gulf countries/NRIs for their stay are allowed under the arrangement.

37

Payments to travel agents for booking of passages of NRIs and their families residing in India

towards their travel in India by domestic airlines/rail and trade transactions up to Rs 2 lakh

per transaction are also a part of the existing RDA.

Reserve Bank constituted an advisory group to implement a national bill payment system that

will enable households to pay utility bills, school fees, remittances and other bills using their

bank accounts. The RBI also announced the constitution of a GIRO Advisory Group (GAG)

to implement a national GIRO-based Indian Bill Payment System such that households will

be able to use bank accounts to pay school fees, utilities, medical bills and make remittances

electronically," RBI said in a notification. A GIRO is a payment instruction from one bank

account to another bank account initiated by a payer. It facilitates payment through cash,

cheque, credit/debit cards and prepaid payment instruments in transfer of funds to the bank

account of a beneficiary.

As the importance of remittances for developing countries has grown. An issue which has

received little attention is the effect of remittances on the financial system. This issue is

important given the evidence that financial development matters for growth and poverty

alleviation and financial Development has many beneficial effects for households. since

1993, remittance dependency appears to have grown in India as well as in different States

such as Kerala, Goa and Punjab. It estimates the domestic remittance market to be roughly

$10 billion in 2007-08, 60% being Inter-State transfers and around 70% being channelled

through the informal sector as against 25% in China. Further, around 50% of these

remittances went to households in the top consumption quintile suggesting that remittances

could be increasing source region inequality and its role in enhancing ‘financial

Development. Recent studies on India have highlighted the positive impacts of domestic

remittances on wealth creation and asset accumulation as well as in increasing teen schooling

attendance. More research on India would be required to understand the direct and indirect

effects of remittances on poverty alleviation and inequality.

38

9 BIBLIOGRAPHY

Demirgüç-Kunt, A., López Córdova, E., Martínez Pería, M.S., and Woodruff, C., (2011).

Remittances and banking sector breadth and depth: Evidence from Mexico. Journal of

Development Economics 95(2), 229-241

Gupta, S., Pattillo, C., and Wagh, S., (2009). Effect of remittances on poverty and financial

development in Sub-Saharan Africa. World Development 37(1)

King, R. and Levine, R., (1993). Finance and growth: Schumpeter might be right. Quarterly

Journal of Economics 108, 717-737.

Lopez Cordova, E., (2005). Globalization, migration, and development: The role of remittances.

Inter-American Development Bank, Integration and Regional Programs Department, Working

Paper 20

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