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The Institutional Determinants of Bilateral Trade Patterns
de Groot, H.L.F.; Linders, G.J.M.; Rietveld, P.; Subramanian, U.
published in
Kyklos
2004
DOI (link to publisher)
10.1111/j.0023-5962.2004.00245.x
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Publisher's PDF, also known as Version of record
Link to publication in VU Research Portal
citation for published version (APA)
de Groot, H. L. F., Linders, G. J. M., Rietveld, P., & Subramanian, U. (2004). The Institutional Determinants of
Bilateral Trade Patterns. Kyklos, 57(1), 103-123. https://doi.org/10.1111/j.0023-5962.2004.00245.x
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Download date: 09. Aug. 2022
KYKLOS, Vol. 57 - 2004 - Fasc. 1, 103–124
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The Institutional Determinants
of Bilateral Trade Patterns
Henri L. F. de Groot, Gert-Jan Linders,
Piet Rietveld and Uma Subramanian*
I. INTRODUCTION
Recent research in international economics points at the likely relevance of bar-
riers to trade other than tariffs and quotas. Rauch (2001) focuses on the impor-
tance of information costs that are related to physical (and cultural) distances.
Deardorff (2001) argues that international trade patterns to a large extent de-
pend on largely unobservable trading costs, instead of factor endowments and
technology. On the same note, Anderson (2001) states that informal trade bar-
riers appear to be very large even between similar countries, such as the US and
Canada. Thus, informal trade barriers may help explain the home bias or border
effect in trade (McCallum 1995). Also Obstfeld and Rogoff (2000) highlight
the possible role of unobserved trade costs in sorting out some of the apparent
puzzles in international economics.
The unobserved barriers to trade are often related to incomplete or asymmet-
ric information and uncertainty in exchange. North (1990, 1995) argues that,
because of imperfect insight and incomplete information, people form institu-
tions. He defines institutions as ‘humanly devised constraints that shape human
interaction’ (1990, p. 3). These rules of the game are intended to reduce the un-
certainty in exchange, and lower transaction costs. The impact of institutions on
transaction costs has received a lot of attention in the literature on economic
growth and development (e.g., Hall and Jones 1999, Olson 1996, Knack and
Keefer 1995). This literature builds on the notion that poor governance entails
negative externalities for private transactions, and consequently raises transac-
* Corresponding author: Henri L. F. de Groot, Department of Spatial Economics, Vrije Univer-
siteit, De Boelelaan 1105, 1081 HV Amsterdam, The Netherlands, Tel: +31 20 444 6168 (6090),
Fax: +31 20 444 6004, Email: hgroot@feweb.vu.nl. Gert-Jan Linders and Piet Rietveld: Dept of
Spatial Economics, Vrije Universiteit and Tinbergen Institute. Uma Subramanian: World Bank,
Washington. We are grateful to an anonymous referee of this journal for useful and stimulating
comments on an earlier version of this paper. Furthermore, we thank Silvia Stiller and partici-
pants of the ERSA 2003 conference for comments on an earlier draft.
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tion costs with negative effects on growth and development. We can neatly ex-
tend these arguments to international trade (see Wei 2000). Because interna-
tional transactions involve multiple governance systems, the effectiveness of
domestic institutions in securing and enforcing property rights in economic ex-
change is an important determinant of trade costs. Furthermore, formal rules af-
fect informal norms of behaviour and inter-personal trust, which influence the
mores and conventions of doing business. These, in turn, may also impact on
risk perceptions and preferences in international transactions. We therefore in-
vestigate the hypothesis that institutions matter for international trade
1
.
In order to identify the effects of institutions on bilateral trade, we estimate
gravity equations. The ‘gravity model’ of bilateral trade is inspired by Newton’s
equation of gravity in physics, which relates the gravity force with which two
bodies attract each other proportionately to the product of their masses, and in-
versely to the square of their distance. Interpreting trade between two countries
as the economic analogue of the mutual gravitational force between two bodies,
with their respective GDPs reflecting mass, we see the intuitive rationale for a
gravity model of bilateral trade
2
. In general, the gravity model considers trade
between a pair of countries as an increasing function of their national incomes
and a decreasing function of their geographical distance (Frankel and Rose
2002). Other variables that relate to both countries, or either of the two coun-
tries separately, may also enter into the equation (population size, land area,
contiguity, etc.). The model has performed well empirically. Amongst others,
studies by Helpman and Krugman (1985) and Deardorff (1998) show that both
new trade theories of product differentiation as well as the classical Heckscher-
Ohlin theory of comparative advantage can provide a theoretical rationale for
the gravity model of bilateral trade.
Compared to the literature on institutions and growth, the impact of institu-
tions on international trade flows has received relatively little attention
3
. Two
1. Evidently, the growth and trade lines of research are closely related. Many studies have identi-
fied openness to international trade as an important determinant of economic growth (e.g., Fran-
kel and Romer 1999). Thus, even if institutions are shown to be of less direct importance for
economic performance than trade (cf. Dollar and Kraay 2002), a strong link between the quality
of governance and trade reconfirms the importance of good governance for long-run economic
performance. See, for example, Frankel and Rose (2002) who use a gravity model approach to
argue that the main benefits of a currency union for economic performance are related to its pos-
itive effect on trade and openness, which affect performance beneficially.
2. The analogy doesn’t entirely follow suit. While the resulting force with which either of the two
particles attracts the other is equal (irrespective of their individual mass), trade from one country
to the other may in general be different from its counterpart.
3. Anderson (2001) and Den Butter and Mosch (2002) are examples in the literature that focus on
the effects of informal institutions on trade.
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THE INSTITUTIONAL DETERMINANTS OF BILATERAL TRADE PATTERNS
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recent empirical studies have considered the impact of institutions on trade in
a gravity model context (Anderson and Marcouiller 2002, Koukhartchouk and
Maurel 2003). Anderson and Marcouiller have been amongst the main contrib-
utors to extend institutional analysis of the economy explicitly to the field of in-
ternational trade. Their most recent contribution combines the analysis of the
effects of institutions in a theoretical model with empirical estimates of the im-
pact of institutional effectiveness on trade. Koukhartchouk and Maurel (2003)
analyse the effects of joining international institutions such as the WTO and the
EU on trade patterns. They introduce variables reflecting institutional quality
into the analysis of potential trade effects for Central and Eastern European
countries.
Our paper intends to contribute to this virgin literature in two ways. First, we
have used the most recent and comprehensive data-set on the quality of govern-
ance available. This database was constructed for the World Bank by Kaufmann
et al. (2002). Indicators from 17 different sources, constructed by 15 organisa-
tions have been combined, including the sources used by Anderson and Mar-
couiller (World Economic Forum’s Global Competitiveness Report) and
Koukhartchouk and Maurel (Heritage Foundation, Economic Freedom Index).
Second, we intend to analyse not only the effect of institutional quality on trade,
but also the effect of similarity in governance quality. In this way, we capture
both the country-specific effect of good governance on trade, and the bilateral
influence of institutional distance on patterns of trade. We expect that institu-
tional homogeneity results in similar, hence familiar, informal business proce-
dures, which may reduce transaction costs.
We proceed as follows. Section II discusses the measures of institutional
quality that we have used in the analysis. In sections III and IV, we present and
discuss the regression results for alternative specifications of a basic and ex-
tended gravity model, respectively. Section V concludes.
II. DATA DESCRIPTION AND MODEL SETUP
In the empirical analysis that follows, we make use of both country-specific and
bilateral data from various sources. Gross domestic product for exporting and
importing countries are examples of country-specific variables that we include
in the analysis. Geographical distance, adjacency, main language and religion,
amongst others, are examples of other characteristics that we take into account
for each pair of countries. We focus on trade patterns in 1998, for a set of more
than 100 countries. We use bilateral exports as dependent variable, such that
each country pair yields two observations, with each country either as exporter
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or importer. Since these variables are more or less standard in the literature, we
do not extensively discuss them here. Appendix A further describes these data
and their sources.
Since the main emphasis in this paper is on the effects of institutions, we
take a closer look at the institutional variables. We have used the database con-
structed by Kaufmann et al. (2002). They have constructed six indicators of
perceived institutional quality. Each indicator captures some related aspects of
the quality of governance. They either reflect the political process, the quality
of the state apparatus and its policies, or the success of governance. We discuss
these indicators in turn.
1. ‘Voice and Accountability’ reflects the extent to which citizens can partici-
pate in selecting government and hold it accountable for the actions taken.
This score includes various characteristics of the political process as well as
assessments of the independence of the media. It reflects whether citizens
and business can prevent arbitrariness in the behaviour of government and
enforce good governance when needed.
2. ‘Political Stability’ refers to the perceived likelihood of the government be-
ing destabilised or overthrown by unconstitutional interference or excesses
of violence against persons and possessions. These factors are highly detri-
mental for the continuity of policy and the stability of the economic environ-
ment.
3. ‘Government Effectiveness’ is a measure for the quality of government in-
puts. It represents, amongst others, the perceived quality and independence
of the bureaucracy. This indicates the ability of government to formulate and
implement good policies.
4. ‘Regulatory Quality’ is directly focused on the quality of implemented pol-
icies. It includes the perceived incidence of policies that inhibit the market
mechanism, and excessive regulation of foreign trade and business develop-
ment, and as such closely reflects the transaction costs that result from pol-
icy intrusion by the state in private trade.
5. ‘Rule of Law’ indicates the quality of the legal system. It indicates society’s
perceived success in upholding fair and predictable rules for social and eco-
nomic interaction. Essentially, it focuses on the quality of the legal system
and the enforceability of contracts.
6. ‘Control of Corruption’ represents the extent of ‘lawless’ or unfair behav-
iour in public-private interactions. It complements regulatory quality and
rule of law indicators, pointing at the impact of bad governance on economic
interaction. Corruption, like regulatory intrusion, affects transaction costs
by adding a ‘third-party’ involvement to private transactions. An added com-
ponent of corruption to trading costs is its arbitrary, uncertain nature.
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