Question 1: Can institutions explain why capital does not flow from rich to poor countries?

Recent research provides an affirmative answer to this question. For example, Alfaro, Kalembi-Özcan, and Volos-ovych (2008) empirically investigate the factors behind the lack of capital flows from rich to poor countries, the so-called “Lucas paradox.” They argue that during 1970-2008, low institutional quality was the most important factor behind that paradox. The empirical findings suggest that improving Turkey’s institutional quality to the U.K.’s level could lead to a 60 percent increase in foreign investment, while improving Peru’s to Australia’s could quadruple the level of foreign investment. Drawing the policy implication from their study, Alfaro Kalembi-Özcan, and Volosovych conclude that countries aiming to attract capital flows should strengthen protection of property rights, law and order, bureaucratic quality, and government stability.

Question 2: Do institutions shape the pricing of sovereign risk?

The simple answer is that institutions have some independent influence on sovereign spreads beyond the fiscal and economic outcomes they shape. Akitoby and Strat-mann (2009; forthcoming (a) and (b)), using a panel of 32 emerging-market countries during 1994–2003, find that institutions indeed matter for the pricing of sovereign risk. Democracy, regardless of how it is measured—the Kauf-mann voice and accountability index, the Freedom House index of political rights, the Polity index, or the International Country Risk Guide (ICRG) democratic accountability index— was found to be negatively associated with spreads. Specifically, a one standard deviation in the ICRG

democratic accountability index reduces spreads by about 25 percent. Stronger civil liberties also exert a negative impact on spreads, as civil liberties foster democracy. These results lend support to the idea that financial markets reward democratic regimes. Put differently, the markets tend to penalize nondemocratic regimes by charging them relatively higher spreads. Since the study shows that more government accountability lowers spreads, creditworthiness will benefit from stronger checks and balances. Akitoby and Stratmann also report that the ICRG political risk factor has a negative and statistically significant impact on spreads. Similarly Baldacci, Gupta, and Mati (2008) confirm that political factors matter for credit risk in emerging markets, with lower political risk leading to tighter spreads.

Question 3: Do financial markets discriminate between political institutions?

Yes, there is some evidence suggesting that financial markets indeed discriminate between political institutions in the sense that, for the same fiscal outcome, market participants differentiate between right- and left-wing governments, or between majoritarian and proportional electoral systems. Akitoby and Stratmann (2008; forthcoming (b)) examine how fiscal variables interact with political institutions to affect sovereign spreads. They find strong evidence that financial markets penalize left-wing regimes that undertake spending-driven expansion. The penalty is estimated at about 3 percent higher interest rates. This may be because right-wing governments are often associated with fiscal conservatism and smaller-size government, while left-wing governments are often proponents of larger government and broader social transfer programs. The findings also show that financial markets reward left-wing governments more than right-wing ones when government revenues increase. Put differently, right-wing governments get lower benefits from a revenue-based consolidation. One reason for this could be that government spending is already low when the government is conservative, so the marginal benefit from consolidation is less than if government spending is high.

With regard to the differentiation between majoritar-ian and proportional electoral systems, the results show that financial markets penalize “majoritarian” regimes—as opposed to proportional regimes—that undertake spending-driven expansion, presumably because these regimes are often associated with larger government and broader transfer programs. This finding is also consistent with the view that the majority-rule countries tend to have what is called in the United States “pork barrel” spending, which is spending targeted to electoral districts. Financial markets may believe that such spending increases when current expenditures and government investment rise. Much of what may be contained in the category of government investment (building roads and bridges) may have low returns under a majoritarian system when it is spending targeted to districts or swing states.

Question 4: How do institutions shape bank loans?

Given the prevalence of bank-based financial systems across the world, a large body of research has focused on how bank loans respond to laws and institutions. Using a sample of loans in 43 countries, Qian and Strahan (2007) investigate the effects of creditor rights on the ownership and terms of bank loans. They find that stronger creditor protection leads to more concentrated ownership, longer maturities, and lower spreads. The findings suggest that creditor rights interact with borrower characteristics to shape bank loans.

Bae and Goyal (2009) examine whether laws and enforcement are equally important to the three aspects of loan contracting—maturity, spreads, and size. Using over 63,000 loans to firms in 48 countries during 1994–2003, they conclude that it is enforcement, not merely the laws, that shape loan contracting. They show that better enforcement results in loans with bigger size, longer maturity, and lower spreads.

Question 5: How do institutions shape the pricing of corporate risk?

Institutions also affect corporate spreads. Using syndicated loans issued by firms in 38 emerging markets during 1990–2006, Agca and Celasun (2009) examine how external debt interacts with creditor rights to affect the pricing of corporate risk. They find that external debt has a significant and robust effect on corporate spreads in emerging markets. This adverse impact is magnified in countries with weak creditor rights.

Question 6: How do institutions shape private access to capital markets?

Research shows that institutions shape sovereign risk. A critical issue is how sovereign risk in turn affects private sector access to capital in emerging markets. Using firm-level data from 31 emerging-market economies, Das, Papaioannou, and Trebesch (2010) investigate how sovereign risk influences private sector access to international capital markets. They find that sovereign default exerts a strong negative impact on external borrowing volumes by domestic firms. Put differently, improved country risk perceptions enhance corporate borrowing. The study also concludes that political risk, as measured by the ICRG index, has an independent negative effect on both private sector debt and equity issuances. The policy implication of these findings is that countries can help promote private sector development by taking measures to reduce sovereign risk and avoid perceptions of default risk. Here, well-functioning institutions will go a long way.

Question 7: How do institutions shape stock market development?

It is widely believed that stock markets play a critical role in promoting saving and efficient allocation of financial resources. It is therefore critical to investigate what determines stock market development. Using a panel data of 42 emerging countries for 1990-2004, Yartey (2008) investigates the institutional and macroeconomic determinants of stock market development. After controlling for macroeco-nomic variables, he shows that political risk, as measured by the ICRG index, is a leading determinant of stock markets. To find out what types of institutions matter, the study further disaggregates political risk into four components: law and order, democratic accountability, bureaucratic quality, and corruption. All four components were found to be statistically significant in explaining stock market development.