Financial development and remittances: The role of institutional quality in developing countries

Abstract

This study explores the impacts of migrants’ remittances and institutional quality on financial development in developing countries, and further tests the hypothesis that institutional quality influences the impact of remittances on financial development. Applying an unobserved dynamic factor model to 46 countries for the period of 1996 to 2016, a composite institutional quality index is first estimated that represents national institutional quality. Using fixed- and random-effects instrumental variable (IV) estimations, evidence is then provided that demonstrates that remittances and institutional quality promote financial development, and more importantly, that institutional quality can play a significant role in enhancing the impact of remittances on financial development, especially when institutional quality attains a certain high level. These results suggest that in countries with stronger institutions, remittances are transmitted more effectively and efficiently to promote financial development than in countries with weaker institutions. Moreover, in accordance with previous literature, financial openness and trade openness are shown to be critical for financial development.