First World Congresss of Comparative Economics

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1 First World Congresss of Comparative Economics Roma Tre University Rome, June 25 27, 2015 Trade patterns and the Rule of Law Richard Frensch, a,c Roman Horvath, a,b and Stephan Huber a,c a: IOS Regenburg, b: Charles University, Prague, c: University of Regensburg Landshuter Str. 4, Regensburg g 1

2 What this is about Rule of Law, Rule-of-Law intensity, and patterns of trade Two-way causality Hypotheses Contribution Data Estimation strategies Results Conclusions 2

3 What this is about Rule of Law, Rule of Law intensity, trade patterns, Trade patterns react to the quality of legal institutions (Rule of Law) which strengthen or weaken comparative advantage (Nunn, 2007; Levchenko, 2007; Nunn and Trefler, 2014). World Bank GI: Rule of law captures perceptions of the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence. We observe: countries with better Rule of Law export more Rule-of-Law intensive goods. Rule-of-Law intensiveness is described by product(ion) complexity, and proxied by input concentration (Levchenko, 2007), share of user-specified inputs (Nunn, 2007), job complexity (Costinot, 2009), all three (Chor, 2010). Theory: investment specificity creates hold-up problems in complex production, resulting in investment inefficiency and rents for non-investors (e.g., trade unions or upstream or downstream producers; see Caballero and Hammour, 1998). Higher enforcability of contracts (better Rule of Law) lessens investment inefficiency and rents. International context: with identical technologies, a good Rule of Law generates comparative advantage in industries that are characterized by a high complexity of production processes (Levchenko, 2007). 3

4 Rule of Law and Trade Two-way causality and hypotheses Reversing causality can be justified if non-investors use rents to lobby for a bad Rule of Law (Levchenko, 2012). International context: Opening the economy to international competition forces noninvestors to lobby for a better domestic Rule of Law with partial loss of rents, to avoid losing all rents to foreign producers working under better Rule of Law. Two cet. par. hypotheses with identical technologies: I. (Rule-of-Law independent) trade liberalisation leads to better Rule of Law. II. In the long run, countries with (Rule-of-Law independent) higher propensities to export Rule-of-Law intensive goods have better Rule of Law. Levchenko (2012) tests II with cross section data (on dealing with endogeneity, more below). 4

5 Contribution We re-examine the effect of patters of international trade on the quality of legal institutions, i.e., the Rule of Law (RoL). First, we generalize Levchenko s (2012) result that countries exporting more RoL-intensive goods exhibit a better RoL to alternative, trade-based measures of RoL intensity, using a highly disaggregated product level global dataset. Second, using differentiation of trade flows on the use side, we go beyond previous results in identifying sectors in the economy responsible for positive (negative) impact of specialization on the RoL: apriori priori, we expect fragmented processes of production (generating parts, components and final products of capital goods and transport equipment) to be particularly prone to hold-up problems connected with incomplete contracts, and thus be pre-determined to benefit from better RoL. However, there are sources of rents and rent-seeking: resource rent seeking may negatively impact in the quality of legal institutions 5

6 Data Bilateral trade flows We use CEPII s BACI trade data-set, derived from UN-Comtrade: bilateral trade flows in HS Code 92, at the 6-digit level (5,017 goods) for for almost 200 countries (i.e., 1.4 bn. bilateral trade flows). Bilateral proxies for trade costs We use unilateral and bilateral CEPII data to proxy trade costs, mainly on geography (area, distance, common border, landlocked, population). Country-specific data: institutional indicators and control variables RoL indicator from the Worldbank Quality of Governance database (see Teorell et al., 2013) GDP per capita and population data from PWT 8.0 (2014) trade liberalization i information i from Wacziarg and Welch (2008) and legal tradition information from LaPorta et al. (1998) 6

7 Estimation strategies To identify the influence of trade patterns on institutions, endogeneity has to be dealt with. Levchenko (2012) does this via a two-step approach. (i) Construct a country-specific measure of RoL-intensive exports ( institutionally intensive trade ) that combines geographically pre-determined information on trade flows with Nunn s (2007) ISICindustry-specific measures of the complexity, and thus RoL intensity, of production. (ii) Regress RoL quality on constructed measures of RoL intensive exports and controls. We follow this general approach using, however, three different estimations strategies A. Levchenko (2012), but substituting Nunn s (2007) ISIC-specific complexity measures by trade-based RoL intensity measurement (Hausman, 2007; also used in Regolo, 2013) to increase product disaggregation to improve RoL intensity measurement to cover more activities, especially primary production B. As in A, however constructing three country-specific measures of RoL intensity of exports for primary, fragmented and other goods categories, respectively. C. We account for RoL variation only by countries geographically pre-determined export shares in goods categories (primary, fragmented, and other goods). 7

8 Estimation strategy A 8

9 Estimation strategy A 9

10 Estimation strategy A 10

11 11

12 Version 1 Version 2 Version 3 Version 4 Version Version Version Version Nunn (IIT)

13 Estimation strategy A: Results RoLIX i (Version 1) 0.004*** (0.001) RLIX(V RoLIX i (Version 2) 0.004*** (0.001) RoLIX i (Version 3) 0.004*** (0.001) RoLIX i (Version 4) 0.004*** (0.001) IIX Nunn/Levchenko 0.004*** (0.001) RoLIX i (based on HS-6-digit) 0.004*** (0.001) 001) Constant ** * ** * ** ln openc legor fr *** *** *** *** *** *** legor ge 0.061** 0.060** 0.061** 0.060** 0.065** 0.060** legor sc * * 0.067** 0.057* legor so *** *** *** *** *** *** ln gdppc 0.084*** 0.084*** 0.084*** 0.084*** 0.087*** 0.089*** ln area 0.014** 0.013** 0.014** 0.013** 0.014** ln pop ** Observations Adjusted R-squared Note: All estimations with robust standard errors (partly shown); *** p<0.01, ** p<0.05, * p<0.1 13

14 RoL intensities RoL intensities for different activities (BEC) 14

15 RoL intensities Broad Economic Categories (BEC) The United Nations Statistics Division s Classification by BEC (Broad Economic Categories, available online at allows for headings of the SITC, Rev.3 to be grouped into 19 activities covering primary and processed foods and beverages, industrial supplies, fuels and lubricants, capital goods and transport equipment, and consumer goods according to their durability. The BEC also provides for the rearrangement of these 19 activities (on the basis of SITC categories main end-use) to approximate the basic System of National Accounts (SNA) activities, namely, primary goods, intermediate goods, capital goods, and consumer goods 15

16 RoL intensities RoL intensities for different goods categories (BEC) Notes: Fragmented: parts and components of capital goods and transport equipment plus capital goods and transport equipment, BEC headings 41, 42, 51, 521, 522, 53; Primary: BEC headings 111, 21; Other: BEC headings 112, 121, 122, 22, 61, 62, 63 16

17 Estimation strategy B: Results RoLIX i (primary) RoLIX i (other) RoLIX i (fragmented) trade lib RoLIXi (primary)*trade lib RoLIXi (other)*trade lib RoLIX i (fragmented)*trad lib (0.008) (0.019) (0.016) *** 0.007*** 0016*** 0.016*** (0.002) 0.004** (0.002) (0.002) (0.004) 0.009** * (0.002) (0.007) (0.032) (0.019) (0.028) (0.028) (0.030) (0.017) (0.002) (0.005) * (0.004) (0.008) ln openc ** ** ** legor fr *** *** *** *** *** legor ge 0.060** 0.046* legor sc legor so *** *** *** *** *** ln gdppc 0.086*** 0.104*** 0.079*** 0.083*** 0.081*** ln area 0.015** 0.028*** 0.019*** 0.021*** 0.019*** ln pop Constant ** *** * Observations All Adjusted estimations R-squared with robust standard errors (partly shown); *** p<0.01, 0.798** p<0.05, * p<

18 Estimation strategy C Geographically pre-determined export shares: various goods categories and RoL (bivariate) 18

19 Estimation strategy C Geographically pre-determined export shares: various goods categories and RoL (bivariate) 19

20 Estimation strategy C: Results Export share primary Export share fragmented Export share primary * trade lib Export share fragmented * trade lib trade lib (0.110) (0.131) * (0.069) (0.161) (0.033) (0.175) (0.271) (0.090) * (0.114) (0.234) (0.254) (0.394) (0.158) legor fr *** *** *** *** legor ge 0.073** 0.051* 0.047* 0.053* legor sc 0.098*** 0.060* 0.058** 0.058* legor so *** *** *** *** ln gdppc 0.106*** 0.103*** 0.105*** 0.102*** ln area 0.020*** 0.030*** 0.030*** 0.028*** ln pop *** *** *** *** Constant *** *** *** *** Observations Adjusted R-squared Note: All estimations with robust standard errors (partly shown); *** p<0.01, ** p<0.05, * p<0.1 20

21 Conclusions Models, in which institutions both create rents and shape comparative advantage, allow for testable hyptheses on the influence of trade patterns on institutions. We test these hypotheses against the background of institutionaltional variation across countries and by operatonalising trade patterns as different goods categories by use. First, we confirm and generalize previous results (Levchenko, 2012) that countries exporting more RLi RoL-intensive i goods exhibit a better RL RoL to trade-based d measured RoL intensity, using a highly disaggregated product level global dataset. Second, using differentiation of trade flows on the use side, we go beyond previous results in identifying sectors in the economy responsible for positive (negative) impact of specialization on RoL. Our results suggest trade flows generated by primary (fragmented and other) production to exert a significantly negative (positive) influence on RoL. However, we cannot show trade flow shares generated by fragmented production to exert a significantly positive influence on RoL over and above that of other, non-primary products. Third, attempts to test whether trade liberalisation is associated with better RoL so far yields inconclusive results. In one specification, we find a significantly postive impact of trade lib on the effect on RoL generated by fragmented production processes. 21

22 Conclusions Further research questions Kuncic (2013) contains alternative indicators for quality of economic, legal, and political institutions for up to 151 countries Hierarchy of institutions: political institutions as further controls To ensure exogeneity of trade liberalization measures: rely on IMF program episodes Are effects of geography g on institutions via trade patterns realised along extensive or intensive margins of trade? Extensions seem possible: derive testable hypotheses on potential influences of trade patterns on other institutions (especially labour market). 22

23 References Caballero. Ricardo J., and Mohamad L. Hammour, The macroeconomics of specificity. Journal of Political Economy106(4), 1998, Cadot,Olivier,Tumurchudur, Bolormaa, and Miho Shirotori, Revealed Factor Intensity Indices at the Product Level. Policy issues in international trade and commodities study series No. 44, UNCTAD, Geneva Chor, Davin, Unpacking sources of comparative advantage: a quantitative approach. Journal of International Economics 82(2), 2010, Costinot, Arnaud, On the origins of comparative advantage. Journal of International Economics 77(2), 2009, Frankel, J. A., and D. Romer, Does trade cause growth? American Economic Review 89(3), 1999, Hausman, Ricardo, Jason Hwang, and Dani Rodrik, What you export matters. Journal of Economic Growth 12(1), Kuncic, A., Institutional quality database. Technical report, Kiel, La Porta, R., F. Lopez de Silanes, AShlif A. Shleifer, and drvi R. Vishny, Law and dfinance. Journal of Political i leconomy 106, 1998, Levchenko, Andrei A., Institutional quality and international trade. Review of Economic Studies 74(3), 2007, Levchenko, Andrei A., International trade and institutional change. Journal of Law, Economics, and Organization 29(5), 2012, Nunn, Nathan, Relationship specificity, incomplete contracts, and the pattern of trade. Quarterly Journal of Economics 122(2), 2007,

24 References Nunn, Nathan, Relationship specificity, incomplete contracts, and the pattern of trade. Quarterly Journal of Economics 122(2), 2007, Nunn, Nathan, and Daniel Trefler,Domesticinstitutions institutions as a source of comparative advantage.nber Working Paper No , February Published in the HB of International Economics, vol. 4. Rauch, James E., Networks versus markets in international trade. Journal of International Economics 48, 1999, Regolo, Julie Export diversification: How much does the choice of the trading partner matter? Journal of International Economics 91, 2013, Teorell, J., N. Charron, S. Dahlberg, S. Holmberg, B. Rothstein, P. Sundin, and R. Svensson, The quality of government dataset. Technical Report version 15, The Quality of Government Institute, University of Gothenburg, Wacziarg, R., and K. H. Welch, Trade liberalization and growth: New evidence. The World Bank Economic Review 22(2), 2008,