The foreign aid and remittance nexus: Evidence from South Asia

A large body of literature has examined the determinants and impact of two external financial flows: foreign aid and remittances. Little, however, is known about the interlinking of the two flows, especially in South Asia. This study, using panel data from four South Asian countries for 1980–2015, examines the relationship between foreign aid and remittances and their links. Contrary to the traditional linear relationship reported in the literature, we find a quadratic (U‐shaped) relationship between foreign aid and remittances. The results show that remittances initially fall when aid increases at the lower level of aid‐dependency (aid‐to‐GDP); they then increase with rising aid at a higher aid‐dependency level. The empirical findings also suggest that foreign aid's support of human capital increases remittances overall. Furthermore, we find that the foreign aid‐led human‐capital channel of migration (particularly of skilled people) reduces remittances, while the aid‐led human‐capital channel of economic growth increases remittance flows in South Asia. Moreover, the dynamic modelling estimation suggests that foreign aid positively affects (or complements) remittance flows in the short run but, in the long run, negatively affects remittances, indicating the substitutability of the two flows.