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Research: What changes institutions?

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
September 2005
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With one billion people in developing countries living on less than $1 a day, the elimination of extreme poverty remains high on the policy agenda of the international community. Sustained high rates of economic growth are critical to poverty reduction, and improved growth performance in many cases requires improvements in the quality of basic economic institutions such as property rights and governance, including a reduction in corruption. But what spurs institutional improvements? Can better institutions be built quickly? The September 2005 World Economic Outlook (WEO) takes stock of existing knowledge and identifies several factors that appear to enhance institutional quality.

Many developing countries have made considerable progress toward a stable macroeconomic environment, but another key precondition for sustained high growth and higher standards of living is good institutions. The April 2003 WEO estimated that if the overall quality of sub-Saharan Africa’s institutions could rise to that of developing Asia’s, African per capita GDP would nearly double over the long term. Improving institutions, however, can be a slow and complex process.

Change is possible

Basic economic institutions reflect rules that have been codified in law as well as informal conventions and traditions. Every country’s institutions are thus the product of a complex interaction of economic and political factors, history, and culture, and are often quite persistent (see chart, this page). For example, European centrally planned economies provided only minimal protection of private ownership and lacked the innovation and dynamism of free market economies. In the postcommunist era, these countries have typically adopted western-style legal codes, but improvements in the business climate—reduced corruption, speedy court proceedings, and expeditious business registration procedures—have been slower to develop.

Despite this tendency toward institutional persistence, the experience of the past three decades suggests that rapid institutional change is possible and has, in fact, helped raise living standards in many countries. The WEO identified 65 cases of significant improvements in economic institutions (“transitions”) since the early 1970s (see chart, page 275).

Analysis of these transitions suggests that several underlying factors may have increased the potential for institutional improvements. First, the earlier collapse of colonial systems altered institutional structures geared toward the systematic extraction of profits. Second, rapid technological improvements helped economies move away from sectors, such as natural resource mining, that are prone to rent seeking. Third, globalization has afforded new economic opportunities amid declining transportation and communication costs. And, finally, the fall of communism radically altered governance in many economies, taking away another major source of institutional persistence.

Determinants of change

Using data for 90 countries over 1970-2004, the WEO evaluated how various factors influence the probability of large improvements in economic institutions. Several aspects appear to increase the likelihood of such transitions:

  • Trade openness. A move from complete autarky to full liberalization increases the probability of institutional transition by about 15 percentage points. Greater openness creates momentum for positive institutional changes because export sectors typically require constant innovation to keep up with international competition. In addition, imports reduce the ability of domestic producers to sustain monopolistic rents, which tend to impede institutional improvement.

  • Press freedom%. Greater accountability is typically associated with policies that benefit a country’s long-term growth prospects rather than the interests of a strong few.

  • Neighbors with higher institutional quality.Cross-country competition and the demonstration effects of regional success stories also can spur change.

  • Higher levels of education%. This is consistent with the notion that more educated populations are more effective participants in broader decision making.

Institutional quality differs sharply across regions

Over the past decade, institutional quality slowly improved in central and eastern Europe and Latin America, but remained poor in sub-Saharan Africa and the Commonwealth of Independent States (CIS).

1 Institutional quality is measured by Kaufmann, Kraay, and Mastruzzi’s 2004 aggregate governance index. Regional scores are calculated as simple averages.

Data: Kaufmann, Kraay, and Mastruzzi (2004), and IMF staff calculations.

Institutions are evolving

Most of the identified 65 institutions have occurred after the collapse of commuism.

Note: The bubble size represents the number of transitions in the five-year period.

1 only developing economies are included, expect for Asia, which also includes any transitions in the newly industrialized economies.

2 Commonwealth of Independent States.

Data: Gwartney and Lawson (2004), and IMF staff caculations.

In a complementary analysis, the WEO examined the factors that determine institutional quality across countries and time. Unsurprisingly, many of the same factors discussed above support good institutional quality more generally. The study also found that a large natural resource sector negatively affected institutional quality in some countries—since performance of these economies is determined largely by global demand and price conditions for the commodities concerned, there were unfortunately relatively few competitive benefits from institutional improvements and innovation.

As for foreign aid, the evidence was ambiguous: in the analysis of transitions, large aid inflows were negatively correlated with the probability of transition to better institutions. However, analysis of the overall quality of economic institutions did not produce any clear-cut result. On balance, any unfavorable effects of aid seemed to be greater in countries with weak institutions. More research is needed to better understand the effects of aid, but it appears that efforts aimed at improving institutions would also improve its effectiveness.

External anchors can help

Various external anchors and international initiatives can promote improvements in institutional quality. An economy’s openness, for example, supports positive institutional changes across many dimensions. Unilateral policies that reduce trade barriers as well as multilateral efforts to liberalize trade under the current Doha Round are likely to exert a strong positive effect on institutional transformation.

Other external anchors can play important roles, too. The process of European Union (EU) accession has supported institutional changes in central and eastern European countries. In nonmember countries, improvements could be stimulated through the recently launched EU Neighborhood Program. Similarly, the World Trade Organization has promoted positive institutional changes in accession candidates, notably China. In Africa, the New Partnership for Africa’s Development could become, through its Peer Review Mechanism, an important platform for diagnosing institutional weaknesses, formulating country-specific recommendations, and attracting investment to countries that have successfully implemented reforms.

Furthermore, the international community has taken on an important role in promoting transparency in developing countries and has recognized that in some areas, such as corruption, developed countries also need to take corrective steps. The OECD Convention on Combating Bribery in International Business Transactions obliges its signatory countries to treat corruption of a foreign public official just as they would corruption of a national public official. The U.K. Extractive Industry Transparency Initiative encourages both governments and companies operating in natural resource- exporting countries to disclose revenues and payments, thereby improving data quality and reducing the scope for misallocation of funds.

For their part, the IMF, the World Bank, and other international agencies have supported greater transparency through a variety of means, including through their lending conditions. In Uganda, public expenditure tracking surveys helped dramatically increase the ratio of actual primary education spending to the centrally budgeted allocation. The IMF’s fiscal transparency code promotes government accountability. Likewise, its transparency code for monetary and financial policies can help reduce noncompetitive practices in the financial sector.

On aid flows and their effects on institutional quality, the WEO analysis does not provide the definitive word. In the coming years, a number of countries are likely to see a large increase in aid flows in relation to government expenditures. Therefore, both donors and individual recipient countries need to carefully consider the potential institutional implications and try to structure aid delivery—and accompanying policy measures—to minimize risks of any adverse effects. Improving institutions can be seen as also improving the effectiveness of aid in helping to reduce poverty.

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