The political economy literature has tended to emphasize that special interests, motivated by a desire to protect rents, may act to block the introduction of reforms that are beneficial for society at large. Previous work, including for example IMF (2004) and Høj and others (2006), has highlighted a number of factors that can affect the balance of power between pro- and anti-reform groups. Such factors include the quality of broad political institutions, which may favor an early adoption of reforms; international factors, including the size of “reform gaps” vis-à-vis either countries at the “frontier” of the reform process or geographical neighbors that may spur reform through “peer pressure” channels; the presence of an IMF-supported program, which may serve to underpin the reform process; and the occurrence of economic crisis, which is often argued to be a catalyst of reform. This section presents evidence on the role of these factors in both developed and developing countries.
Institutional Quality
Institutions define the broad rules of the game within which economic agents influence the outcome of the reform process. How does the quality of broad political institutions affect progress with implementing structural reforms? Figure 4.1 sheds light on the issue by portraying the relationship between the timing of major reforms and the level of the institutional quality index. It shows that, on average for most sectors, countries with stronger institutions (proxied by the strength of property rights and the rule of law as measured by Kaufmann, Kraay, and Zoido-Lobatón, 2002) have introduced major reforms earlier, that is, there is a negative relationship between the year of major liberalizations and institutional quality. The results appear to be strongest for trade liberalization (as measured by the tariff-based indicator), and for the domestic financial sector and external capital account liberalization indicators.
Institutional Quality and Timing of Major Reforms
Source: IMF staff estimates based on Kaufmann, Kraay, and Zoido-Lobatón (2002).Note: The year of liberalization portrayed on the x-axis is the year of major reform—as measured by a one standard deviation or higher increase in the liberalization index over the preceding three years. The y-axis measures institutional quality, which is taken from Kaufmann, Kraay, and Zoido-Lobatón (2002), and captures the protection afforded to property rights as well as the strength of the rule of law, circa mid-1990s. This figure shows that major reforms occur earlier in countries where the quality of broad political institutions is higher, that is, the relationship between institutional quality and the year of liberalization is negative.Institutional Quality and Timing of Major Reforms
Source: IMF staff estimates based on Kaufmann, Kraay, and Zoido-Lobatón (2002).Note: The year of liberalization portrayed on the x-axis is the year of major reform—as measured by a one standard deviation or higher increase in the liberalization index over the preceding three years. The y-axis measures institutional quality, which is taken from Kaufmann, Kraay, and Zoido-Lobatón (2002), and captures the protection afforded to property rights as well as the strength of the rule of law, circa mid-1990s. This figure shows that major reforms occur earlier in countries where the quality of broad political institutions is higher, that is, the relationship between institutional quality and the year of liberalization is negative.Institutional Quality and Timing of Major Reforms
Source: IMF staff estimates based on Kaufmann, Kraay, and Zoido-Lobatón (2002).Note: The year of liberalization portrayed on the x-axis is the year of major reform—as measured by a one standard deviation or higher increase in the liberalization index over the preceding three years. The y-axis measures institutional quality, which is taken from Kaufmann, Kraay, and Zoido-Lobatón (2002), and captures the protection afforded to property rights as well as the strength of the rule of law, circa mid-1990s. This figure shows that major reforms occur earlier in countries where the quality of broad political institutions is higher, that is, the relationship between institutional quality and the year of liberalization is negative.In addition to broad institutional quality, as captured by property rights and rule of the law, there may be specific political institutions that foster or hinder economic reforms. Box 4.1, which is based on Giuliano, Mishra, and Spilimbergo (2008) analyzes the role of one such specific institution: the quality of democracy in a country. Democracy is measured using the standard, well-established measure of democracy from the Polity IV database. Empirical evidence strongly suggests that raising the quality of democratic institutions has a positive and statistically significant impact on economic reforms.
As foreshadowed earlier, a range of other factors may also play a role in determining the pace of structural reform. A regression framework is useful to disentangle the various effects, recognizing of course that a number of possible determinants—including, for example, the level of per capita income or educational attainment— are, like the quality of broad institutions, highly persistent, and therefore likely to be captured by the “fixed” or country effects in the regression framework.2
International Factors
Table 4.1 considers first the effect of the “reform gap,” defined as the (lagged) difference between the level of liberalization in a particular country and the reform level achieved in a country near the reform “frontier” (proxied here by the United States). The results suggest that a larger reform gap is associated with faster reforms in all sectors, as indicated by the positive and statistically significant coefficient in the first row of Table 4.1. Beyond liberalization gaps with respect to reform leaders, the proximity of reformist neighbors may also provide a stimulus for liberalization. Table 4.1 indicates that such “neighborhood effects” operate unevenly across sectors, with statistically significant effects in evidence only in the cases of the domestic financial sector and the telecommunications and electricity sectors (second row of Table 4.1).
Determinants of Reforms
Determinants of Reforms
| Dependent Variable: Change in Liberalization Index (t) |
Domestic Financial Sector Liberalization (1) |
External Capital Account Liberalization (2) |
Trade Liberalization (Tariff) (3) |
Trade Liberalization (Current Account) (4) |
Agricultural Liberalization (5) |
Telecommunications and Electricity Liberalization (6) |
|---|---|---|---|---|---|---|
| International factors Reform gap (t–1) | 0.041*** | 0.155*** | 0.195*** | 0.074*** | 0.105*** | 0.055*** |
| (0.010) | (0.014) | (0.016) | (0.012) | (0.013) | (0.016) | |
| Reform in neighbors (t–1) | 0.179*** | 0.143 | 0.108 | 0.114 | 0.063 | 0.327*** |
| (0.061) | (0.094) | (0.067) | (0.092) | (0.059) | (0.074) | |
| IMF-supported program (t–1) | 0.049*** | 0.091** | 0.092* | 0.060* | 0.002 | 0.082*** |
| (0.015) | (0.039) | (0.052) | (0.031) | (0.03) | (0.027) | |
| Economic crisis (t–1) | 0.024*** | -0.02 | -0.022*** | 0.004 | 0.008 | -0.005 |
| (0.005) | (0.013) | (0.007) | (0.009) | (0.009) | (0.007) | |
| Observations | 1,565 | 1,565 | 2,100 | 1,130 | 1,676 | 1,678 |
| Number of countries | 64 | 64 | 102 | 38 | 75 | 76 |
Determinants of Reforms
| Dependent Variable: Change in Liberalization Index (t) |
Domestic Financial Sector Liberalization (1) |
External Capital Account Liberalization (2) |
Trade Liberalization (Tariff) (3) |
Trade Liberalization (Current Account) (4) |
Agricultural Liberalization (5) |
Telecommunications and Electricity Liberalization (6) |
|---|---|---|---|---|---|---|
| International factors Reform gap (t–1) | 0.041*** | 0.155*** | 0.195*** | 0.074*** | 0.105*** | 0.055*** |
| (0.010) | (0.014) | (0.016) | (0.012) | (0.013) | (0.016) | |
| Reform in neighbors (t–1) | 0.179*** | 0.143 | 0.108 | 0.114 | 0.063 | 0.327*** |
| (0.061) | (0.094) | (0.067) | (0.092) | (0.059) | (0.074) | |
| IMF-supported program (t–1) | 0.049*** | 0.091** | 0.092* | 0.060* | 0.002 | 0.082*** |
| (0.015) | (0.039) | (0.052) | (0.031) | (0.03) | (0.027) | |
| Economic crisis (t–1) | 0.024*** | -0.02 | -0.022*** | 0.004 | 0.008 | -0.005 |
| (0.005) | (0.013) | (0.007) | (0.009) | (0.009) | (0.007) | |
| Observations | 1,565 | 1,565 | 2,100 | 1,130 | 1,676 | 1,678 |
| Number of countries | 64 | 64 | 102 | 38 | 75 | 76 |
Democracy and Reforms
Empirical evidence on the relationship between democracy and the adoption of economic reforms is scarce and limited to particular types of reforms and a small sample of countries. This box is based on Giuliano, Mishra, and Spilimbergo (2008), and studies the impact of democracy on the adoption of economic reforms using the new data-set on structural reforms.
Numerous theoretical arguments and historical examples suggest that political freedom can either hinder or facilitate economic reforms. A fully democratic regime can fall prey to interest groups, which put their goals before the general well being of citizens. In particular, interest groups can block reforms if there is uncertainty about the distribution of the benefits (Fernandez and Rodrik, 1991). On the other hand, in a newly independent country, a “benevolent dictator” can shelter the institutions, avoid that the state becomes captive of any specific interest group, and allow the state to perform its function in an efficient way.1 Take the historical examples of Chile, or Korea. In both cases, important economic reforms were undertaken under dictatorial regimes. The majority of the contemporary industrialized countries were not democracies when they took off (see Schwarz, 1992). In most cases, East Asian economies did not develop under fully democratic regimes. In addition to pressure from interest groups, democracy can lead to excessive private and public consumption and lack of sufficient investment (Huntington, 1968). Wages are typically higher under democracy (Rodrik, 1999). In contrast, dictatorial regimes can rely on financial repression to increase the domestic saving rate. Several countries with repressive political and highly regulated financial systems, including the Soviet Union and many East Asian economies, were able to increase savings and achieve sustained high economic growth rates.
Democracy and Reforms
Democracy and Reforms
| Dependent variable: Change in liberalization index (t) | |
|---|---|
| Democracy (t–1) | 0.025*** |
| (0.005) | |
| International factors Reform gap (t–1) | 0.081*** |
| (0.006) | |
| Reform in neighbors (t–1) | 0.176*** |
| (0.036) | |
| IMF-supported program (t–1) | 0.009*** |
| (0.002) | |
| Economic crisis (t–1) | 0.001 |
| (0.004) | |
| Observations | 9,440 |
| Number of countries | 102 |
Democracy and Reforms
| Dependent variable: Change in liberalization index (t) | |
|---|---|
| Democracy (t–1) | 0.025*** |
| (0.005) | |
| International factors Reform gap (t–1) | 0.081*** |
| (0.006) | |
| Reform in neighbors (t–1) | 0.176*** |
| (0.036) | |
| IMF-supported program (t–1) | 0.009*** |
| (0.002) | |
| Economic crisis (t–1) | 0.001 |
| (0.004) | |
| Observations | 9,440 |
| Number of countries | 102 |
The alternative view that democracy often accompanies economic reforms is also based on strong theoretical arguments. In general, dictators cannot credibly take commitments so any reform that involves problems of time-consistency cannot be undertaken (McGuire and Olson,1996). Autocratic rulers tend to be predatory so disrupting economic activity and making any reform effort meaningless; autocratic regimes also have an interest in postponing reforms and maintaining rent-generating activities for a restricted number of supporting groups. On the other hand, democratic rulers should be more sensitive to the interests of the general public, and so more willing to implement reforms that destroy monopolies in favor of the general interests.
The sharp contrast between these opposing views implies that the question is primarily an empirical one. While there is a vast amount of theoretical and empirical literature that considers the determinants of economic reforms in general, there is little empirical evidence on the relationship between democracy and reforms. The existing papers focus on reforms in particular sectors, such as international trade and finance, or specific countries over a short period of time, such as the post-communist economies. Giuliano, Mishra, and Spilimbergo (2008), instead, use the newly constructed large dataset on reform indicators to analyze the impact of democracy on economic reforms. Democracy is measured using the standard, well-established measure of democracy from the Polity IV database.2 The index is normalized so that 1 indicates the most democratic country and 0 the least democratic regime. Economic reform is defined as a positive annual change in the liberalization index. Reform indicators in different sectors are pooled in order to study the effect of democracy on the general ability of a country to undertake structural reforms in any sector. In addition, pooling of reforms allows one to obtain more precise estimates by increasing the number of observations substantially.3
The table shows the results from a panel regression framework, where reforms are regressed on lagged level of democracy and several controls. The regressions include country fixed effects to control for institutional differences across countries that are time-invariant. In addition, reform fixed effects control for differences across sectors. The coefficient on the lagged level of democracy is significant at the 1 percent level. The estimated coefficient suggests that a one standard deviation increase in the quality of democratic institutions explains about 9 percent of the variability in reforms.4
The theoretical predictions about the feedback effect from economic reforms to democratization are ambiguous as well. For example, economic liberalizations could be associated with a higher quality of democratic institutions if they increase the power of the middle class (Rajan and Zingales, 2003). On the other hand, liberalization could lower democracy through increases in income inequality and the associated political strife and violence (Quinn, 1997; and Dixon and Boswell, 1996). Overall, the empirical findings suggest that while democracy promotes reform, there is no evidence that economic reforms promote the process of political liberalization.
1 Along these lines, Haggard (1990) argues that “Institutions can overcome collective-action dilemmas by restraining the self-interested behavior of groups through sanctions: collective action problems can be resolved by command.” 2 The measure captures the quality of democratic institutions, on the basis of freedom of active and passive participation in elections, checks and balances on the executive, freedom of political association, and respect of other basic political rights. 3 Giuliano, Mishra, and Spilimbergo (2008) show that with the exception of the telecommunications and electricity sector, democracy promotes reforms in all sectors. 4 The estimated coefficient on democracy is unchanged if one includes additional determinants of reforms in the regressions, for instance, alternative indicators of crisis, human capital and bureaucratic quality, public expenditures, indicators for ideology of government (left, right, or center), form of government (presidential or parliamentary) and additional political variables such as number of executive constraints, the presence of legislative or executive elections, the number of years left in the current term for the executive, and the presence of an absolute majority in the legislature by the party of the executive. In addition, the results are robust to using an instrumental variables strategy, where democracy in neighboring countries is used as an instrument.IMF-Supported Programs
Previous studies (e.g., Ghosh and others, 2005) have suggested that structural conditionality in IMF-supported programs may play a role in spurring structural reform. The regression framework in Table 4.1 investigates this issue by including an indicator variable for the presence of an IMF-supported program. The results suggest that programs do seem to play a catalytic role in accelerating reforms across most of the sectors. The finding that IMF-supported programs accelerate the pace of liberalization of the external capital account, however, should be interpreted alongside the evidence presented in IEO (2005), which stresses the role of domestic ownership of capital account liberalization policies rather than IMF conditionality per se in the pursuit of such policies.
Economic Crises
While there is considerable anecdotal evidence to suggest a catalytic role of economic/financial crises in driving the reform process, whether this constitutes an empirical regularity is an issue that needs to be decided by recourse to the data. What, then, is the evidence on the role of economic crises in the reform process? The results in Table 4.1 indicate that the effect of crises on the pace of reform is mixed, with the data suggesting that crises play little systematic role in a preponderance of the sectors. Crises do appear to spur domestic financial sector reform, but actually seem to delay opening to international trade— possibly reflecting the need to secure additional sources of fiscal revenue in crises periods, including by recourse to higher tariffs.
Overall, the results in Table 4.1 and Figure 4.1 suggest that, while institutional quality served to underpin structural reforms among the industrial countries in the early years of the sample, the emergence of sizable cross-country reform gaps contributed to an acceleration of reform among the developing countries in the sample, especially since the early 1990s. Peer pressure effects associated with neighboring reformers supported the reform process in some areas, including domestic financial sector liberalization. Among the other factors driving reform, the presence of an IMF-supported program appears to have played a role in accelerating reforms in a number of sectors, while the occurrence of crises has tended to spur domestic financial sector reform and retard trade reform.
In practice, given the inclusion of fixed effects, the results in Table 4.1 focus on variables with a sufficient variability over time. The model without fixed effects (not reported) shows a statistically significant impact on the pace of structural reform of a number of the persistent factors mentioned in the text, including a positive effect of institutional quality on trade, domestic financial sector, and external capital account reforms, consistent with the evidence in Figure 4.1.
