IJAR-BAE (March 2012)

www.setscholars.org/index.php/ijarbae Full length Original Research Paper IJAR-BAE ISSN: 1839-8456

Vol. 01. Issue 01. Article No. 07

International Journal of Applied Research in BUSINESS ADMINISTRATION & ECONOMICS

Contribution of Remittance on Current Account of Balance of Payments in Bangladesh: VECM Estimation

Mohammad Abdul Hannan Pradhan1, Sabiha Afrin1*, Mohammad Rafiqul Islam2
1 2

Assistant Professor, Department of Economics, Shahjalal University of Science and Technology, Bangladesh Associate Professor,Department of Economics, Shahjalal University of Science and Technology, Bangladesh *Corresponding authors e-mail: sabiha_afrin@yahoo.com

Article History
Received: 15-02-2012 Accepted: 16-03-2012 Available online: 31-03-2012

ABSTRACT
As a large man power exporting country in the world, Bangladesh earns a substantial amount of workers remittances. In the past twelve years workers remittances have grown continuously starting from $1525 million. Inflow of remittance has increased nearly fivefold between 1997 - 98 to 2009-10. These remittances contribute a significant portion in the current transfer of Balance of Payment (BOP). It is acknowledged that remittances are less costly as well as less volatile inflows of foreign currencies and thus serves as a stable source to reduce the deficit of current account of BOP. It is not possible to overlook the contribution of remittances on the growth process of economy as it is the single largest source of foreign currency and for the last decade it was around 35% of export earnings. The objective if this paper was whether remittances play any role to improve the current account deficit in Bangladesh. Vector Error Correction (VEC) model was used to show the relationships between the steady growths of remittance and improvement of current account deficit and found the significant positive relation. Some policies were suggested for the smooth flow of remittance and transmitting this resource into productive sector.

Keywords: Migrant workers, remittances, current account balance, balance of payment, VEC.

JEL Classification: C50, F24, F32, G28.

Citation: Pradhan A.H., Afrin S.and Islam R.(2012), Contribution of Remittance on Current Account of Balance of Payments in Bangladesh: VECM Estimation. IJAR-BAE 1(1): p. 70 77.

Copyright: @2012 Pradhan A.H. et al. This is an open access article distributed under the terms of the Creative Common Attribution 3.0 License.

1.0

Introduction

The state of current account in Bangladesh has shown a remarkable improvement in recent years. External resource flows, such as Foreign Direct Investment (FDI), portfolio investment, remittances of migrants could play a vital role of offsetting current account deficit. Remittances have become the most powerful means to improve the economic condition of the country of the migrated people about 6.7 million to more than 140 countries (Mamun, K.A. and H.K. Nath, 2010, Chowdhury, M.B., 2011). International remittance is the surplus portion of earnings sent back by nationals or the expatriate population from the country of employment, Taylor, J.E., et al., (1996). At present the international migration not only change the destiny of individual migrants but also improve the economic development of developing and least developed countries (LDCs). It is generally acknowledged that remittances are much less unpredictable than any other types of capital flows. It can be a major source of external finance and could help to ease current account deficit (Chowdhury, M.B. , 2011). The importance of foreign remittance in the economy of Bangladesh is widely recognized and requires little iteration. Along with the Ready Made Garments (RMG) sector and nonJournal homepage: www.setscholars.org/index.php/ijarbae

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farm activities in the agricultural sector, remittance has been identified as one of the three key factors that have been responsible for reducing the overall incidence of poverty in Bangladesh, Chowdhury, M.B. (2011) and Osmani, S., (2004). Remittances are one of the vital sources of foreign currency earning i.e. more than half of the export earnings that maintains balance of payment and foreign currency reserve of Bangladesh (Mamun, K.A. and H.K. Nath, 2010, Chowdhury, M.B., 2011). The current account of the balance of payment includes the remittance as income receipts under the net factors income from abroad. The current account balance has been surplus for last decade due to a huge increase in remittance, a large part of current transfers (Bangladesh Economic Review (BER), 2011). The paper starts with objectives and methodology; part 2 is about contextual background. Part 3 is analysis and findings; and finally part 4 ends with conclusion and policy recommendations.

2.0

Objectives and methodology of the study

The main objective of the study is to draw a clear picture about the contribution of foreign remittance on balance of payment, especially on the current account balances in Bangladesh. The paper is based on secondary data collected from Bangladesh Economic Review various issues. A critical and exhaustive review of literature was also done for the purpose of the study. To analyze the data some statistical tools such as summary statistics have been used. And finally we estimate Vector Error Correction (VEC) Model to show the relation between remittance earning and current account balances. Our main two variables are Current Account Balance (Cu) and Remittances Earnings (Re) of a small economy of Bangladesh for the sample period 1997 to 2009. First, we conduct formal unit root tests of the series to confirm whether they are stationary. To check for cointegration, we will run the following regression: (1) Here we can normalize on cu because (Cu) is responding to (Re). Then we can perform a test for stationary of the residuals: = (2) Then the unit root test equation for residuals is et =
^

-1

(3)

Since the cointegration relationship does not contain an intercept term, the 5% critical value is -2.76. The unit root t-value may be more or less than-2.76. We reject the null of no cointegration if the calculated value is less than the -2.76. Otherwise, it may not be reject if the value is more than 2.76.If we reject null hypotheses, then we can conclude that the two variables are cointegrated i.e. the Cu is linked to Re. Then we can estimate error correction model by least squares. The estimated VEC model for

Cu t= 0 1 t-1
Re t= 0+1t-1
^

(4)

(5)

The appropriate sign of the error correction coefficient i.e. 1 and 1 will show the desired results.

3.0 3.01

Contextual background Balance of payments (BOP)

A balance of payment is an accounting record of all economic transactions between a country and the rest of the world. These transactions consist of payments for the countrys export and imports of goods, services, and financial capital, as well as financial transfers. The BOP summarizes international transactions for a specific period, usually a year, and is prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and investments,
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are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as a negative or deficit items. When all components of the BOP are included it must balance - that is, it must sum to zero. There can be no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counter balanced in other ways - such as by funds earned from its foreign investments, by running down reserves or by receiving loans from other countries.

BOP= Current account (Cu) - Financial account (Fi) Capital account (Ca) (-or+ balancing item)
The overall BOP always balances when all types of payments are included; imbalances are possible on individual elements of the BOP, such as the current account. This can result in surplus countries accumulating hoards of wealth, while deficit nations become increasingly indebted. Historically there have been different approaches to the question of how to correct imbalances and debate on whether they are something governments should be concerned about. With record imbalances held up as one of the contributing factors to the recent financial crisis, plans to address global imbalances as well as Bangladesh are now high on the agenda of policy makers for future.

3.02

The current Account

In economics, the current account is one of the two primary components of the balance of payments; and another is the capital account. It is the sum of the balance of trade (exports - imports of goods and services), net factor income (such as interest and dividends) and net unilateral transfer payments (such as foreign aid).

Current account Balance (CAB) = Balance of trade(X-M) + Net factor income from abroad (Income ReceiptsIncome Payments) + Net unilateral transfers from abroad (- or + balancing item)
Here, X=Export, and M=Import, Income=money received from investments made abroad, remittances etc. Net Unilateral Transfers consists of gifts that we receive minus gifts that we offer. Unilateral transfers are gifts by residents on one country to residents of another country. A current account surplus increases a country's net foreign assets by the corresponding amount, and a current account deficit does the overturn. Both government and private payments are included in the calculation. It is called current account because goods and services are generally consumed in the current period. The balance of trade is the difference between a nation's exports of goods and services and its imports of goods and services, if all financial transfers, investments and other components are ignored (Stern, R.M., 2007). A nation is said to have a trade surplus if it export more than its import. Positive net sales overseas generally add to a current account surplus; negative net sales abroad generally contribute to a current account deficit. Because exports generate positive net sales, and because the trade balance is typically the biggest component of the current account, a current account surplus is usually associated with positive net exports. So a surplus is indicative of an economy that is a net creditor to the rest of the world. It shows how much a country is saving as opposed to investing. The net factor income or income account, a sub-account of the current account, is usually presented under the headings income payments as outflows, and income receipts as inflows. Income refers not only to the money received from investments made abroad1 but also to the money sent by individuals working abroad, known as remittances, to their families back home. If the income account is negative, the country is paying more than it is taking in interest, dividends, etc. The various subcategories in the income account are related to specific respective subcategories in the capital account, as income is often composed of factor payments from the ownership of capital (assets) or the negative capital (debts) abroad. From the capital account, economists and central banks determine implied rates of return on the different types of capital.

Investments are recorded in the capital account but income from investments is recorded in the current account.
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In the traditional accounting of balance of payments, the current account equals the change in net foreign assets. A current account deficit implies a paralleled reduction of the net foreign assets.

Current account = changes in net foreign assets

Theoretically, the balance should be zero, but in the real world this is implausible, so if the current account has a deficit or surplus, this tells something about the state of the economy, both of its own and in comparison to other world markets.

3.03

Interrelationships in the balance of payment

If there are no changes in official reserves, the current account is the mirror image of the sum of the capital and financial accounts. The established response is that the current account is the main causal factor, with capital and financial accounts simply reflecting financing of a deficit or investment of funds arising as a result of a surplus. However, more recently some observers have suggested that the opposite causal relationship may be important in some cases. In particular, it has controversially been suggested that the United States current account deficit is driven by the desire of international investors to acquire U.S. assets, Bernanke, B., (2005). However, the main viewpoint undoubtedly remains that the causative factor is the current account and that the positive financial account reflects the need to finance the country's current account deficit.

3.04

Reducing or increasing current account deficits

A deficit in current account reflects an economy that is a net debtor to the rest of the world. That is, a country is investing more than it is saving and is using resources from other economies to meet its domestic consumption and investment requirements. So action to reduce a substantial current account deficit usually involves increasing exports (goods going out of a country and entering abroad countries) or decreasing imports (goods coming from a foreign country into a country). This is generally accomplished directly through import restrictions, quotas, or duties (though these may indirectly limit exports as well), or subsidizing exports. Influencing the exchange rate to make exports cheaper for foreign buyers will indirectly increase the balance of payments. This is primarily accomplished by devaluing the domestic currency. Adjusting government spending to favor domestic suppliers is also effective. Less obvious but more effective methods to reduce a current account deficit include measures that increase domestic savings (or reduced domestic borrowing), including a reduction in borrowing by the national government. It should be noted that a current account deficit is not necessarily bad for an economy, especially for an economy in the developing stages or under reform. The Pitchford Thesis states that a current account deficit does not matter if it is driven by the private sector (Cashin, P. and C. McDermott, 1998). Some feels that this theory has held true where a current account deficit persists. This has been attributed to persistent drawing on foreign investment generating a significant income deficit (Karunaratne, N.D., 2010). A deficit in the current account also implies that a country is a net capital importer, if foreign aid is a part of current account. The volume of a countrys current account is a good sign of economic activity (Gupta, S., C.A. Pattillo, and S. Wagh, (2009). By scrutinizing the four components of it, we can get a clear picture of the extent of activity of a countrys industries, capital market, services and the money entering the country from other governments or through remittances. When analyzing a current account deficit or surplus, it is vital to know what is fueling the extra credit or debit.

4.0

Analysis and findings of the study

In accounting sense the balance of payment is always balances. To understand weakness or strong side of the BOP, we have to analyze the main influencing factors or items. Since the independence, our trade balance is deficit. Net services and income are also in deficit. Only current transfer is the surplus factor due to remittances. For this contribution, current account balances becomes deficit to surplus.

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4.01

Scenario of remittances in Bangladesh

Theoretical and empirical literature on remittances is rich, as many studies on the motives, causes, and effects of workers remittances in the growth and development process have been conducted. According to Elbadawi and Rocha (1992) the determinants of remittances can be divided into two main categoriesendogenous migration and portfolio approaches. The key determinants and the motivating factors behind the endogenous migration approach are economic situations facing the migrant and their family as well as demographic information describing the nature of family ties or the existence of other family arrangements (Chami, R., C. Fullenkamp, and S. Jahjah, 2005).The main determinants of the portfolio approaches to remittances include interest rate differentials on deposits between the host and home countries, rate of return on real estate in the home country, black market premium, inflation rates, political risk and uncertainty (Salisu, M., 2005). On the basis of these approaches, remittances can be divided into what (Wahba, S., 1991) describes as fixed and discretionary remittances. The fixed remittances support the family leaving behind the home country while the discretionary remittances go to investment purposes. Remittances are sometime difficult to measure, because it is calculated from the balance of payment data under the lines workers remittances and compensation to employees. But these are likely to understate the extent of remittances, as some remittance flows occur through informal (non-market) channels, and are excluded from the official records. It should be mention here that although various strategies to transfer remittance have taken over last one decade even the choice of remittance channel is 46% formal and 54% informal (Siddiqui, T. 2003). Bangladesh is considered as one of the major manpower exporting country of the world. The outward migration of labor and the remittances that are generated as a result have been a feature after the liberation of Bangladesh. The flow of migration to other countries increased during mid 1970 due to oil exploration of Middle East countries as there was tremendous demand for unskilled workers. On an average the country exports 140,000 people annually (Gupta, P., 2005). The main source of remittance of Bangladesh is migrant workers living in Kingdom of Saudi Arabia (KSA), which contributed 39.3% remittance during 2005 fiscal year (Al Hasan, R. 2006. Formal remittance contributed 6% of GDP of Bangladesh in the year 2004.If informal channel were included this contribution, it would have reached to 910% of GDP (Al Hasan, R. 2006). Just two years after 2004, in the year 2006 the contribution of formal remittances increased from 6% to 9% of GDP. The following table presents the estimated amount of remittance of Bangladeshi migrants. It provides estimates of total remittances during fiscal year 1997-98 to 2009-2010 (Bangladesh Economic Review (BER), 2011). Table 1: Country wise Remittances Earnings ($millions)
Year 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 KSA 589.29 685.49 916.01 919.61 1147 1254.3 1386.0 1510.4 1696.9 1734.7 2324.2 2121.4 2552.6 UAE 106.86 125.34 129.86 144.28 233.49 327.40 373.46 442.24 561.44 804.84 1135.1 209.70 1424.0 Qatar 57.81 63.94 63.73 63.44 90.60 113.5 113.6 136.4 175.6 233.1 289.8 253.2 278.4 Oman 87.61 91.93 93.01 83.66 103 114.0 118.6 131.3 165.2 196.4 220.6 216.2 266.8 Bahrain 32.42 38.94 41.80 44.05 54.12 63.72 61.11 67.18 67.33 79.96 138.20 121.8 126.75 Kuwait 213 230 245.0 247 285.7 338.59 361.24 406.80 494.39 680.70 863.7 726.40 767.80 USA 203.13 239.43 241.30 225.62 356.24 458.05 467.81 557.31 760.69 930.33 1380.1 1213.7 1084.1 UK 65.80 54.04 71.79 55.70 103.3 220.2 397.5 375.7 555.7 886.9 896.1 577.9 638.7 Malaysia 78.09 67.52 54.04 30.60 46.85 41.40 37.06 25.51 20.82 11.84 82.40 168.60 430.67 Singapore 7.69 13.07 11.63 7.84 14.26 31.06 32.37 47.69 684.84 80.24 130.10 115.40 145.45 Others 83.59 95.82 81.14 59.91 65.29 99.61 123.18 147.60 238.81 339.32 444.50 309.60 154.57 Total 1525.44 1705 1949 1882.10 2501.13 3061.97 3371.97 3848.29 4801.88 5978.47 7914 7033 8270

Source: Bangladesh Economic Review Various Issues. Ministry of Finance, Government of Bangladesh. The official records on remittances indicate that the country received about total US$1525 million overseas remittances in 1997-98.Since then foreign remittance receipts have grown at an exponential rate. The trend of remittance flow to Bangladesh has exhibited a steady growth pattern rising from US $ 1525 million in 1997 to US $7033.9 million by 2009. Inflow of remittances has increased nearly five-fold between 1997 -98 to 2008-09 (Bangladesh Economic Review (BER), 2011).

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Figure 01: Flow of Remittances Earnings ($millions)

4.02

The current account and remittances of Bangladesh

Bangladesh current account has been improving remarkably over the past year as lower imports have diminished the trade deficit while remittances have continued to grow at a rapid rate. Remittance has become an important aspect for the developing countries because of its economic benefit both at micro and macro level. It is viewed as a very stable source of foreign exchange [18]. Bangladesh has been enjoying a sizeable current account surplus as an increasing amount of the inflow of remittances help to pay import liabilities and hence improve balance of payment position, strengthen foreign exchange reserves and finance external debt. The following table shows to what extent the current account movements are related to workers remittances. The average contribution of remittances in the current transfer was 80.09% over the period 1997 to 2009.The contribution of remittances in the current transfer shows a steady growing trend from 81.41% in 1999 to 94.99% in 2008. Remittances provide an important resource for mitigating current account deficits over these years. There appears to be a positive linkage between remittances and current account balance and hence the economic growth, but this relationship does not show any systematic pattern. Figure 1 indicates the contribution of workers remittances in current transfers and in the current account balance. Table2: Flow of Remittances, Current Transfer, and Current Account Balances ($m).
Year 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 Current Transfers 1876 2195 2394 2171 2826 3440 3743 4290 5348 6554 8743 10226 11613 Workers remittances 1525 1706 1949 1882 2501 3062 3372 3848 4802 5978 7915 9689 10987 % of current transfers 81.30 77.72 81.41 86.69 88.50 89.01 90.1 89.70 89.80 91.21 90.53 94.75 94.60 Current account balance -463 -477 -418 -1098 157 176 176 -557 824 952 680 2536 2618

Source: Bangladesh Economic Review Various Issues. Ministry of Finance, GOB. By conducting formal unit root tests (Dickey-Fuller Test with no constant) of the series to confirm whether they are stationary, we have =0.9299 for cu and =0.9848 for Re. They indicate that both series are stationary. To check for cointegration, the estimated result of equation (1) is cu t=0.342 Re t , R2=0.7314 intercept term is omitted because it has no economic meaning. Then we perform a test of stationary of the residuals = - 0.342 Re t
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Figure2: Flow ofRemittance, Current Transfer, and Current Account Balance. The estimated unit root test for residuals is e t =-1.247t-1. The unit root t-value is -3.37. It is statistically highly significant even at 1% level. This result implies that remittance is linked to current account balances. If Ret were to increase by one unit, cut would increase by 0.342. But cu may not respond fully by this change. To ascertain how much it will respond, we estimate VEC model by least squares. The estimated VEC model for (Cut and Ret) is
^

Cu t= -1072.327-1.098t-1 (t) (-1.97) (-2.59)

and Re t= 1078.931+0.446t-1 (t) (1.70) (0.87)
^

Estimated equation of (4)

Estimated equation of (5)

The results show that both error correction coefficients are of the appropriate sign. The negative error correction coefficient in the equation (4) (-1.098) indicate that cu falls, while the positive error correction coefficient in equation (5) (+0.446) indicates that Re rises, when there is appositive cointegrating error (t-1>0 or cut-1>0.342Ret-1). This outcome is consistent with the view that the current account balance is likely to significantly responsive with remittance earning in Bangladesh.

5.0

Conclusions and policy recommendations

In line with the intense migration flows from developing to advance countries, the transfers of funds by migrants back to their country has become increasingly significant. Increasing attention to migrants transfer of funds is not due to the size, but also to their good features. This good property makes it a good candidate to reduce macroeconomic stability in the receiving country. This paper has focused on the theoretical literature on remittances and investigated its link with current account situation. In terms of remittances the trend in Bangladesh has been steady and positive. It shows an increasing trend in the last 13 years. The contribution of remittances in current transfers is not less than 80% in this time period. The findings in the paper can be summarized as follows: 1. The positive link between remittances and current account situation, suggest that remittances could play an important role to mitigate current account deficit. 2. Workers remittance and current transfer is positively correlated are which about 0.82. 3. The positive association between remittances and economic growth suggest the crucial role of remittances in the economic growth and development process.

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4. These results have important implications for policy makers. At present these remittances are largely used to meeting the consumption needs of the family members left in the country rather than channeled towards the directly productive activities. Significant percentage of these remittances transmitted via informal channels thereby escaping the official records. Attempts should be taken by the policy makers for transmission remittances through less costly and hassle free methods and bring these remittances to mainstream remittances. Besides efforts, we should take steps to encourage both remitters and recipients on the value adding nature of their remittances through different initiatives, including microfinance, small & medium size enterprise projects, special interest rate on remittance deposits. Along these, the government should take some strategic objectives, such as, expansion and diversification of the countries of employment, improving the skill component of the emigrant workforce, reducing the cost of emigration by curbing recruitment abuses, provision of safety nets for migrants and their families etc. However, the success of these initiatives depends again on the existence of macroeconomic and political environment.

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