From Diaspora Dollars to Default Risk: Remittances and Sovereign Spreads

Abstract

Most developing countries are characterized by two facts: (1) net emigration, and (2) net remittances received. This paper studies how these two facts interact with the sovereign default risk. In theory, the effect of remittances is ambiguous. On the one hand, they provide additional income that increases the governments ability to repay. On the other hand, they reduce the production share of income and thus undermine the sanctioning mechanisms enforcing repayment available to international lenders. Using a panel of developing countries, we document a positive correlation between spreads and net remittances. We then construct a sovereign default model with emigration and remittances. Critical to the ability of the model to reproduce the positive correlation is the countercyclical nature of emigration and remittances. Because the government internalizes that default leads to an increase in remittances that partially cushions against the default penalties, in equilibrium, countries with a large income share from remittances face a steeper government bond spread schedule and hold less debt. Our model, calibrated to countries' average emigration and net remittances, successfully replicates the observed correlations between emigration, remittances, and spreads.

Keywords: Sovereign default, migration, remittances