Exchange Rate Regimes Shape Remittance Impacts on Currency Values, Finds IMF Report

The IMF Working Paper titled “How Do Remittances Affect the Real Exchange Rate? An Empirical Investigation”, authored by Alina Carare, Juan Pablo Celis, Metodij Hadzi-Vaskov, and Yasumasa Morito, delivers an empirically rich and policy-relevant analysis of the macroeconomic effects of remittance flows. Conducted under the auspices of the International Monetary Fund’s Western Hemisphere Department, and supported by the University of Wisconsin through Morito’s internship, the study probes how exchange rate regimes and macroeconomic structures influence the relationship between remittances and the real effective exchange rate (REER). Drawing on data from 79 to 146 countries between 2008 and 2021, the paper fills a significant research gap by clarifying how external competitiveness may be affected by these increasingly vital capital inflows.

The Rising Power of Remittances

Remittances have become a defining feature of the economic landscape in many developing and emerging economies. Countries such as Honduras and Nicaragua now receive remittances equal to more than 25 percent of their GDP, far above the global average. These flows act as both economic stabilizers and income lifelines, particularly in countries with weak formal safety nets. However, they also pose a potential macroeconomic challenge: appreciation of the REER. When foreign currency inflows increase significantly, they can drive up the value of the domestic currency or domestic prices, making exports more expensive and undermining the tradable sector. This phenomenon, often dubbed the “Dutch disease”, has generated concern among policymakers who fear losing industrial competitiveness. Previous studies have produced conflicting results. Some highlight significant REER appreciation effects, especially in Latin American and Caribbean nations, while others find the impact diluted by factors such as openness, consumption patterns, or exchange rate policies.

A Deeper Dive into Exchange Rate Regimes

The authors of the paper take a fresh empirical approach to understanding the nuanced effects of remittances across different exchange rate systems. Using a Balassa-Samuelson framework, they construct an index of REER overvaluation that isolates the portion of REER not explained by long-run fundamentals such as GDP per capita. A simple cross-country comparison reveals that economies with floating exchange rates tend to show a positive correlation between remittance inflows and REER overvaluation. In contrast, fixed exchange rate regimes appear to buffer this effect. However, recognizing the limitations of correlation analysis, the authors employ a dynamic panel model, specifically the Blundell-Bond estimator, to account for potential endogeneity and control for other macroeconomic drivers like terms of trade, policy interest rates, and financial openness. The results confirm that in floating regimes, a one-time remittance shock leads to significant REER appreciation within a year, largely through nominal exchange rate adjustments. In fixed regimes, appreciation is more sluggish and occurs via gradual price increases, reflecting the greater rigidity and controlled nature of these systems.

Structure of the Economy Matters Too

While the exchange rate regime plays a central role, the structure of the domestic economy is equally influential. Countries that import a larger share of goods are found to experience less REER appreciation from remittance shocks. In these economies, much of the remittance-driven consumption is absorbed through imports, limiting upward pressure on non-tradable goods prices. Conversely, in economies with low import-to-GDP ratios, more remittance income is spent on domestically produced goods and services, which tend to drive up local prices and thus the REER. The authors also find that larger economies, often less import-dependent, show stronger appreciation effects than smaller, more open economies. This structural channel confirms that not all countries are equally vulnerable to the Dutch disease and that macroeconomic size and openness can significantly mediate the effects of foreign inflows.

The Role of Remittance Dependency

One of the most compelling findings of the study is the impact of remittance dependency. Countries receiving remittances above the global median (as a share of GDP) consistently show REER appreciation, regardless of their exchange rate regime. This effect becomes even more pronounced in countries that also have low import intensities. When high remittance flows coincide with limited imports, the appreciation effect is robust across all classifications, indicating a structural vulnerability that no exchange rate framework can fully neutralize. The authors also analyze how REER undervaluation at baseline interacts with remittance shocks. Their results suggest that when currencies start out undervalued, remittance inflows can push them closer to equilibrium, especially under floating regimes. In contrast, when remittance flows are high and the REER is already close to or above equilibrium, appreciation pressures risk overshooting, leading to harmful overvaluation.

Policy Takeaways for Remittance-Rich Nations

The study concludes with a strong policy message: countries with high and rising remittance inflows must actively monitor their real exchange rate to avoid eroding competitiveness in the tradable sector. Structural reforms are necessary in economies where remittance income is primarily spent on non-tradable. These could include incentivizing diversification toward higher value-added exports, reducing barriers to importing capital goods, and using targeted fiscal policies to offset inflationary pressures. Exchange rate management, while helpful in the short term, may not be sufficient on its own. In economies where remittance dependency is entrenched and openness is limited, the appreciation effect is both statistically and economically significant, posing long-term risks to external balance and industrial growth. The findings not only contribute to the academic literature on Dutch disease and exchange rate economics but offer practical guidance to policymakers in an era where remittances are increasingly pivotal to development financing.