Deregulating the Telecommunications Sector in Developing Countries: The Role of Democracy and Private Interests

Deregulating the Telecommunications Sector in Developing Countries: The Role of Democracy and Private Interests Wei Li University of Virginia CEPR Lixin Colin Xu The World Bank 1 Abstract. We investigate the determinants of deregulation experiences between 1990 and 1998 using a panel dataset covering 50 developing countries. Our data support political economy hypotheses derived from a generalized private interest theory that takes explicit account of the differences in political structure from less democratic countries to more democratic ones. Countries with stronger pro-reform interest groups (the financial services sector and urban consumers) are more likely to deregulate, but those with incumbents that have stronger incentive to oppose the reforms are less likely to deregulate. The effects of interest groups are stronger in more democratic countries, suggesting that democracy appears to affect the pace of reforms by magnifying the influence of interest groups. Key Words: Political economy, democracy, telecommunications, deregulation, tariff-setting, political structure, special interest groups. JEL codes: L9, utilities and transportation; L5, regulation and industry policy; H1, structure and scope of government. 1 We are grateful for useful discussions and comments from Witold Henisz, Karla Hoff, Philip Keefer, Ioannis Kessides, Charles Kenny, Steve Knack, Jia Liu, Taye Mengistae, Taylor Reynolds, Michael Ross, Mary Shirley, Patrick Walsh, and participants of the ABCDE workshop on regulation of the World Bank. We are especially indebted to Christine Zhen-wei Qiang for our earlier collaboration and for sharing data with us. Li gratefully acknowledges the financial support from the Darden School Foundation and the Batten Institute. The views expressed here do not reflect those of the World Bank or its member countries. Correspondence: Wei Li, Darden School of Business, University of Virginia, Charlottesville, VA 22906; Email: weili@virginia.edu, telephone: (434) 243-7691, fax: (434) 243-7681. Colin Lixin Xu, Development Research Group, World Bank, 1818 H Street, N.W., Washington, DC 20433; Email: LXU1@worldbank.org, telephone: (202) 473-4664, fax: (202) 522-1155. 1

Deregulating the Telecommunications Sector in Developing Countries: The Role of Democracy and Private Interests I. INTRODUCTION Fueled by rapid technological innovations, the past two decades have witnessed dramatic transformations of telecommunications regulation around the world. More than 150 countries have introduced new telecommunications legislation or have modified existing regulations, mostly moving towards deregulation. The old way of administratively assigning spectrum rights has been replaced in many countries with competitive bidding for such rights under the organization of the regulators. Regulatory barriers of entry into various market segments in this sector have been lowered. Such sizeable changes in the regulatory regime in this sector beg the question: what explains the cross-country and time-series differences in these deregulation experiences? Answers to these questions may have important implications. The sheer importance of the sector is clear. Currently, the sector s revenue from services alone accounts for approximately two to three percent of GDP in most countries, and it has been perhaps the fastest growing sector in many countries. Recent research suggests that development in this sector may offer substantial positive externalities to the rest of the economy by, among other things, increasing the information flow and reducing transaction costs in the economy. Roller and Waverman (2001) find that telecommunications investment significantly increases economic growth. Since most of the deregulation in telecommunications policies occurred in the past two decades, sufficient data to evaluate cross-country differences in deregulation experiences are only now emerging. In this paper, we examine the political economy of deregulation in the telecommunications sector by merging two cross-country datasets. The first dataset combines information from two main sources: regulation indicators compiled by Pyramid Research (a division of the Economic Intelligence Unit) and performance measures from the ITU (International Telecommunications Union). This dataset has information on regulatory changes from more than 50 developing countries from 1990 to 1998. Our second data set is a 2

new cross-country data set of political structure compiled by researchers in the World Bank (Beck et al., 2000). We have extracted from it a rich set of variables characterizing the political economy environment of each sample country. Our empirical work is guided by a generalized private-interest theory that incorporates the political economy of not only democratic but also nondemocratic societies. We posit that policy outcomes in a country hinge upon competition either among interest groups in the policy market under a democratic institution or among politicians pursuing private interests subject to institutional constraints (e.g., checks and balances) under a less democratic institution. Whether a country deregulates its telecommunications sector will depend, among other factors, on its political structure and the configuration of interest groups. Our empirical analysis yields findings that are broadly consistent with the predictions of the private-interest theory. We find that countries with stronger pro-reform interest groups (the financial services sector and urban consumers) are more likely to deregulate, while those with incumbents that have a stronger incentive to oppose the reforms are less likely to deregulate. The effects of interest groups are stronger in more democratic countries, suggesting that democracy appears to affect the pace of reforms by magnifying the influence of interest groups. We hope that the empirical knowledge learned here will fill the main hole in research on telecommunications reforms (Noll, 1999) the lack of systematic empirical studies of the political economy of telecommunications reforms. So far there have been many case studies on telecommunications reforms (see Kikeri, Nellis, and Shirley, 1992; Wellenium and Stern, 1994; Levy and Spiller, 1996; and Petrazzini, 1996 among others). With a large sample, we are able to use regression analysis to explore the role of interest groups and political structure on regulatory reforms. Such systematic analysis is obviously impossible in case studies. In this regard, this paper complements Li, Qiang, and Xu (2001), which examines political economy determinants of privatization and competition in the telecommunications sector around the world. 2 More generally, by examining political economy drivers on both the demand and supply sides of regulatory reforms in countries governed by heterogeneous 2 Recently many authors have tried to construct cross-country samples in order to ascertain statistical effects of the reforms. They include Boubakri and Cosset (1998); Petrazzini and Clarke (1996); D Souza and Megginson (1998); and Megginson, Nash and Van Randenborgh (1994); Ros (1999), Boylaud and Nicoletti (2000), 3

political regimes, we also hope to contribute to the emerging literature on the determinants of policy reforms (see Rodrik 1996 for a nice summary). II. DEREGULATION IN THE TELECOMMUNICATIONS SECTOR Regulatory Autonomy and Transparency Until the early 1990s, the regulation of telecommunications services in most countries was implicit and opaque, because the state-owned operator in many countries was under a self-regulation regime. 3 With the rise of corporatization and privatization, the introduction of effective competition, and the change in the nature of services offered, the active presence of separate regulators became urgent. While there were only ten regulatory agencies around the world that were separate from the operators at the beginning of the 1990s, the number increased to 84 by August 1999. Europe now has the highest concentration of separate regulators, followed by the Americas and Africa. With continued liberalization in this sector around the world, and partly also because of the requirements imposed by the World Trade Organization (WTO) reference paper on regulatory principles, the number of separate regulators is expected to continue to grow. In many developing countries, regulators now oversee a wide range of regulatory functions. Their responsibilities include setting capacity expansion targets, approving (and in some cases setting) tariffs including interconnection charges, setting technical standards, facilitating technology transfers and licensing, arbitrating disputes among operators and users, allocating spectrum frequencies, monitoring service quality, and others. With the rapid increases in licensing revenues and spectrum auction income, the regulators reliance on government appropriation as a source of funding has diminished in many countries. The increasing financial independence of the regulators greatly complemented their increasing regulatory autonomy. According to Pyramid Research, from which we obtained our data, there is a clear trend towards regulatory autonomy in our sample. Bortolotti, D Souza, Fantini, and Megginson (2001), McNary (2001), Li and Xu (2001), and Wallsten (2000, 2001a, 2001b). 3 Factual information in this section is drawn from reports published by the International Telecommunications Union (ITU, 1999a, 1999b) and Pyramid Research (2000). 4

But the scope of the regulator s authority and autonomy varies from one country to the next. In some countries (e.g., Mexico, Bolivia, Kenya, and Paraguay), the regulator has broad authority over most regulatory issues. In others, the regulator has to share the regulatory responsibility with the telecommunications ministry and, in some cases, the operators. In Egypt and Madagascar, for example, specific regulatory functions such as numbering plan, tariffs and interconnection rate structure are jointly determined by both the operator and the regulator. In Brazil, the regulator, Anatel, has been given the mandate to oversee all the telecommunications regulatory functions, but it must share with the courts the authority over arbitration of disputes. In this paper we seek to understand the political economy determinants of cross-country as well as time series differences in regulatory policy changes. As the regulatory institutions become more autonomous, their policies are also becoming more transparent. Many regulatory institutions around the world have published their policy papers on the internet. More important, the allocation of spectrum rights has increasingly been done via open, competitive auctions. Data from Pyramid Research show a steady improvement in regulatory transparency for most countries between 1990 and 1998 (see the Appendix). Tariff Deregulation An important shift in regulatory policies in the telecommunications sector is to allow operators more discretion in setting tariffs. The rigid traditional regulatory regime whereby the ministry of telecommunications sets most tariffs and interconnection charges has been replaced with more flexible ones. An important institutional innovation is the RPI-X rule for price cap regulation pioneered by British Telecom in 1984. 4 Under the RPI-X rule, only the upper limits of the increases in tariffs are restricted. The operator has the freedom to determine price changes within the upper bounds. Variations of the RPI-X rule now include flexibility in the frequency of price changes and price cap on the average price of a basket of services rather than each individual service price. According to Pyramid Research, which tracks the evolution of tariff policies in the world, the quality of tariff policies is thought to have improved dramatically. As will be shown later, the cross-country average index of the quality 4 See Wheatley, 1999, p. 282. In general, the RPI-X rule sets an upper limit for price increases at the rate of retail price inflation minus some predetermined amount (X) selected to reflect expected productivity increase. 5

of tariffs rose significantly for both fixed-line services and for wireless services between 1990 and 1998. III. HYPOTHESES Although deregulation can improve efficiency when it is done appropriately, politics plays an important role in shaping the regulation policies (see Levy and Spiller, 1996; and Galal and Nauriyal, 1995). Especially important are the country s political structure and configuration of interest groups. Given the diverse characteristics of our sample countries, a useful organizing framework for our cross-country analysis must incorporate the political economy of not only newly industrialized democracies but also less developed and less democratic countries. As it is traditionally stated, private-interest theory views policy outcomes in a democratic society as the equilibrium results of competition in the policy market, where politicians supply policies, while constituents and organized groups demand them (Peltzman, 1976; Becker, 1983; and Stigler, 1986). Politicians seek elected public offices, and their votes increase with both campaign contributions from special interests and the benefits that their constituents receive. But the public official in a democracy is the agent of his constituents. With imperfect information and imperfect public oversight, his private interests (i.e., preferences differing from those of his constituents) do have the potential of shaping policy outcomes. Since the degree of popular participation in the political process differs from one country to the next, opportunities to pursue private interests likely differ across countries. Facing less political competition, the ruling politician in a less democratic society likely will have more discretion to affect policy changes that further his private interests. In extreme cases (e.g., Shleifer and Vishny, 1994), he or she chooses policies that maximize rents or bribes. Politicians ability to extract rents may be limited when there are conflicts of interests among different groups of politicians, creating a more competitive environment for policymaking. In this case, the configuration of these groups of politicians may affect telecommunications policies in ways that are similar to interest group politics in more democratic societies. 6

Therefore, in a generalized form, private interest theories predict that the politician/regulator may either pursue private interests or be captured by special interest groups, which are characterized by low organization costs and concentrated benefits. In this section, we apply this framework to derive hypotheses regarding the determinants of deregulation. Private interests Policy outcomes depend on, among other things, the distribution of costs and benefits among different interest groups, the cohesiveness of each group, and the degree of democracy in the environment. Democracy may matter because it offers effective channels for its constituents to voice concerns and erects lower barriers for its constituents to organize interest groups. Deregulation often implies less political control and less cross-subsidization in the telecommunications sector. On the demand side for such policy reforms, businesses that rely heavily on telecommunications services are likely the main beneficiaries: subsidies to consumers and, in particular, to rural consumers are reduced and services for businesses are broadened. Among businesses, firms providing financial services are often the largest users of telecommunications services. For instance, insurance and financial institutions alone accounted for 30% of the telecommunications business market in the UK in 1990 (Wheatly, 1999, pp. 93-95). The financial industry is therefore expected to benefit from improved and expanded services and lower tariffs. Financial services firms may also benefit directly, since deregulation may increase the demand for financial services as telecommunications firms rely more on external funds and less on government appropriations. It is thus plausible that countries with a larger financial sector would be more likely to push for deregulation in the telecommunications sector. Relative to rural consumers, urban consumers are more likely to gain from the reforms that reduce cross-subsidization and increase service offerings in densely populated areas. If urban consumers are better organized than rural consumers who live in sparsely populated areas, due possibly to lower costs of organization, they will exercise more influence over policy outcomes in more democratic societies. As a proxy, the proportion of urban population may be used as an indicator of the relative effectiveness of urban consumers in influencing 7

policies. We therefore expect more urbanized countries more likely to deregulate. If democratic institutions facilitate interest group politics, as we presume, the effects on deregulation of pro-reform groups the financial sector and urban population should be stronger in more democratic countries. Hypothesis 1. Holding everything else constant, countries with a larger financial sector and a higher share of urban population are more likely to deregulate, and more so in more democratic countries. Deregulation in telecommunications also implies lower entry barriers in many market segments. Incumbent firms therefore tend to oppose deregulation, which is expected to reduce their market power. Since telecommunications infrastructure is highly capital intensive, incumbent firms that invested heavily in telecommunications infrastructure in the past have a particularly strong incentive to block any reform that may reduce the value of their past investments. Countries with a more substantial initial telecommunications infrastructure may therefore face stronger opposition from incumbent firms and their investors against deregulation, may thus be more reluctant to deregulate. As a result, history may matter here (Noll, 1999). And it may matter more in more democratic countries given the presumption that democratic institutions facilitate interest group politics. In the estimation, we use the number of main fixed telephone lines per 100 people in 1990 as an indicator of the initial state of telecommunications infrastructure. The discussion here thus suggests the following hypothesis. Hypothesis 2. Holding other things constant, countries with a greater number of main lines per capita initially are more likely to oppose deregulation, more so in more democratic countries. Deregulation, however, may not benefit politicians if it weakens their political and regulatory control of the sector and hence their ability to extract rents from it. To the extent that they pursue private interests such as excess employment and low prices, politicians may resist pressures to reform (Shleifer and Vishny, 1994). Their resistance will be stronger if the telecommunications sector has been profitable and has served as their cash cow. More importantly, in such circumstances their resistance is also likely to succeed because the telecommunications operators do not drain taxpayers income and the taxpayers and their interest representatives (such as the Treasury) are less likely to argue for regulatory changes. 8

We therefore expect countries to be less likely to deregulate if they have a more profitable telecommunications sector. Hypothesis 3. Higher profitability in the telecommunications sector makes deregulation less likely. If politicians are perfect agents of their constituents and if the heterogeneity of constituent interests is fully observed, ideology should not affect the policy outcomes. When politicians interests are not perfectly aligned to those of their constituents, their ideologies may affect policy outcomes (Kalt and Zupan, 1984). Parties with different ideologies prefer distinct policies; right-of-center parties, for instance, likely prefer deregulation. Indeed, a large body of empirical literature finds that party identity appears to matter (Alt and Lowry, 1994; Clarke and Cull, forthcoming; Jones, Sanguinetti and Tommasi, 2000). Beliefs and ideologies of voters and politicians are also found to help explain regulatory changes over the past two decades (see, for instance, Kalt and Zupan 1984, Poole and Rosenthal 1997). 5 Since the scenario of perfect agent is unlikely, we thus have the following hypothesis: Hypothesis 4. Countries with a right-of-center government are more likely to deregulate. But the ideology effect may simply be the result of biases due to omitted variables, since the heterogeneity of constituent interests often cannot be fully observed (Peltzman, 1984, 1985, and 1998, pp. xvii-xix). The biases will be present when the majority of the constituents and/or the dominant interest groups prefer deregulation and choose to elect a right-of-center party that advocates deregulation. We will discuss the possible biases more when we examine our empirical findings. Political Structure The extent to which interest groups can influence policies and therefore telecommunications deregulation will often depend on the country s political structure. An important dimension of political structure is the division of power that creates checks and balances in governance. While democratic countries are often characterized by effective veto power exercised by opposition parties, non-democratic countries often have a dominant ruling 9

party. The difference in party competition can significantly affect the success of reform initiatives. Two opposite forces associated with checks and balances, however, make its impact on deregulation difficult to pin down. On the one hand, the division of power often leads to policy gridlocks, making deregulation less feasible (Cox and McCubbins, 1997). And when reforms do proceed, the passed reform legislation can be far from being efficient, with the amount of inefficiency reflecting the compromises made in order to gain majority votes. The relatively large deadweight loss associated with a more pronounced division of power should make telecommunications reforms less likely (Becker, 1983). On the other hand, by subjecting a reform program to the scrutiny of both the ruling and the opposition parties, it increases the credibility of the reform program to private investors (Levy and Spiller, 1996), thus increasing the likelihood of success in implementing the program (the credibility effect ). In addition, the division of power limits the discretion of ruling politicians and creates a more competitive environment for policy-making. It therefore attenuates rent extraction by ruling politicians. Other Factors In addition to the political economy determinants discussed above, whether and by how much a country deregulates its telecommunications sector also depends on other factors such as technology, the state of economic development, and history. Many of these factors are likely to be correlated with the political economy determinants. To minimize biases in our estimates, we control for these factors in our empirical analysis. Below we discuss briefly the likely effects of these factors and how these factors can be measured. It is generally thought that technological innovations have been one of the main drivers of regulatory reforms in the telecommunications sector. New technologies, such as wireless technologies and the internet, have enabled new entrants to offer products and services that compete against those offered by incumbents. The convergence of telecommunications and information technologies promises to blur industry boundaries and to make previously unrelated firms competitors. These developments have spurred the demand for better and more responsive regulations. In our empirical analysis we shall proxy the technological changes 5 Poole and Rosenthal (1997) find that much of the variation in regulation/deregulation that is not well explained by private interest group variables or party politics can be explained by an ideology measure that locates a 10

with changes in the indicators of economic development (such as per capita GDP and illiteracy rate) and industrial development (such as the ratio of manufacturing output to GDP). Fastergrowing and industrializing countries are likely faster adopters of new technologies. These indicators may measure the push from the demand side for telecommunications reforms. We recognize, however, that these variables are not ideal proxies for technological change since they also capture certain economic and political characteristics of the market for telecommunications services. For example, a richer country with more educated population tends to be a larger market for telecommunications services. While a larger market may accommodate more viable competitors, it may also strengthen incumbent firms financial and political influence, reducing the likelihood of deregulation. To control for country size effect separately, we also include population as an explanatory variable. IV. EMPIRICAL IMPLEMENTATION The Data Our empirical work relies on several major sources of data, which we describe in more detail in the Appendix. Reflecting the fact that deregulation is multi-faceted, multiple indicators of deregulation in the telecommunications sector are available from Pyramid Research, which publishes a database on information infrastructure indicators for developing countries. In this paper we focus on three pairs of indicators that measure the quality of each country s regulatory regime along three different dimensions regulatory autonomy, regulatory transparency, and the quality of tariff policy regime each with data available for both fixed-line and mobile telecommunications. An increase in each of the indicators suggests a perceived improvement in the quality of the regulatory regime on a particular dimension. Since these six indicators are highly correlated with each other, with coefficients of correlation ranging from 0.6 to 0.9, we choose to use information extracted from these indicators in our analysis rather than the indicators themselves. To extract relevant information, we construct two composite indices for deregulation as the principal components of the available indicators (see the Appendix for more details on this procedure). The legislator on a simple left-right scale based on their complete history of roll-call votes. 11

regulatory regime quality index, R Q, encompasses information on the quality of regulatory autonomy and transparency for both fixed-line and mobile telecommunications, while the tariff regime quality index, T Q, encompasses information on the quality of tariff policy regime for both fixed-line and mobile telecommunications. Instead of aggregating the available indicators as one deregulation indicator, we have opted to distinguish the procedural deregulation (autonomy and transparency) from substance deregulation (tariff setting). In doing so, we would like to see how the political economy determinants affect these two aspects of deregulation differently. It is useful to note that we have also tried a more aggregate index made of these six sub-indices, and we obtain very similar results. Figure 1 plots the cross-country averages of the two constructed composite indices. Both indices increased significantly over time, indicating marked progress in deregulating the telecommunication sector. The progress is especially visible in the quality of tariff regime. It is worth noting that, while more democratic countries had better regulatory and tariff regimes than less democratic ones for most of the sample period, less democratic countries gained more grounds in deregulation (Figure 2). But there does not appear to be a strong relationship between income levels and the progress of deregulation during the sample period, though a weak positive relationship appears likely (Figure 3). Explanatory variables, collected from various sources described in the Appendix, are listed in Table 1 along with their summary statistics. To avoid contemporaneous bias, we use lagged values and initial values for most of the performance measures and macro variables included in the regression. Our estimation sample consists of 50 countries from 1990 to 1998. Due to missing data for some countries in some of the years, the full sample has 296 observations. The list of countries is given in Table 3. Empirical Results In order to test the hypotheses outlined in Section 3, we estimate a linear regression model on the composite indices where S ' S S S it it it S Q it for S = R or T : Q = X β + γ t+ ε, (1) X it is a vector of explanatory variables for country i in year t, as suggested in Section 3 along with some control variables. We include a time trend in the regression to account for the 12

global technology and ideology trends. While the data are longitudinal, we opt not to include country-specific fixed effects because many of our important explanatory variables (e.g., financial depth, political structure, and the initial main line density) have relatively little or no time-series variations during the sample period. The first two columns in Table 2 report the OLS estimates of the equation for the regulatory regime quality index, estimates of the equation for the tariff regime quality index, R Q it, while the remaining two columns report the OLS T Q it. Columns (1) and (3) report the baseline estimates for the two equations. In order to test the hypothesis that democracy as a political institution facilitates regulatory changes by magnifying the role of interest groups and by moderating politicians discretion, we include in the model interaction terms between all explanatory variables and a dummy variable, high democracy, which equals 1 if a country has a democracy score higher than the median score of 1.5 in a particular year. Columns (2) and (4) report the OLS estimates of the model with these interaction terms. The democracy ratings of sample countries in 1995 are given in Table 3. Inspection of the regression results listed in Table 2 reveals that the hypotheses discussed in Section 3 are in general consistent with the data. Focus first on Hypothesis 1. It is posited that countries with more financial depth and a higher concentration of urban population are more likely to deregulate, and the effects are stronger in more democratic countries. The estimate of the coefficient on lagged financial depth is positive and significant in the quality of regulatory regime equation. More importantly, the estimated marginal effect of financial depth is more than 50 percent stronger in more democratic countries than in less democratic countries. However, on the quality of tariff regime, the estimated marginal effect of financial depth is negligible for the full sample. But among countries with higher levels of democracy, the estimated effect of financial depth on T Q it is positive and statistically significant. Among less democratic countries, the effect of financial depth on the quality of tariff regime is negative and marginally significant. Similarly, the concentration of urban population has statistically positive effects on both measures of deregulation, and the effects are significantly stronger in countries with high democracy ratings. In countries with low democracy ratings, the concentration of urban population appears to have a negligible effect on the quality of regulatory regime and a negative effect on the quality of tariff regime. We therefore find 13

support for the hypothesis that pro-reform interest groups, such as the financial sector and urban population, are effective in pushing for the reforms that are expected to benefit them in more democratic countries. But these groups are less successful in less democratic countries. As discussed in Section 3, incumbent firms tend to oppose deregulation, which is expected to reduce their market power. Countries whose incumbent firms made more substantial investments in telecommunications infrastructure in the past may therefore face stronger opposition from the incumbents and their investors against deregulation. As a proxy measuring the strength of incumbent opposition to reforms, the number of main fixed phone lines per 100 inhabitants in 1990 should, therefore, have negative effects on deregulation. Our regression results in Table 2 confirm this prediction: countries with higher tele-density in 1990 tend to do less deregulation between 1990 and 1998. The negative effects are stronger in highdemocracy countries. The fact that incumbents are more likely to succeed in opposing reforms in more democratic countries suggests again that democratic institutions may have facilitated interest group politics. To analyze the determinants from the supply side for policy reforms, we turn to estimates of the coefficients relating to Hypothesis 3. Here we expect that profitability in the sector will have a negative effect on the reforms. Inspection of the estimates of the coefficient on lagged profitability shows that the sector s profitability has the predicted negative effects on the quality of both regulatory and tariff regimes. But the only significant negative effect is on the quality of tariff regime. Our empirical results thus offer, at best, weak support for the prediction that politicians fiscal motives for resisting deregulation that reduces the sector s monopoly rents. The reforms may also be determined by factors beyond private interests. As expected, the regression results show that ideology right-of-center orientation of the government has strong, positive effects on the quality of regulatory and tariff regimes for the full sample. Interestingly, ideology has a much weaker effect in low-democracy countries. This is hardly surprising. In these countries, the legislature may simply be ineffective and its ideological inclination therefore does not have much impact. However, since we do not control the heterogeneity of constituents interests, which are unobserved, it remains possible that the estimated positive effects of ideology simply reflect the effects of unobserved heterogeneity of constituents interests that are correlated with the ideological orientation of the ruling party 14

(Peltzman, 1984). Without additional data, we are unable to ascertain the degree to which the estimated effects are due to biases from omitted variables. In spite of the prominent role that it plays in enhancing the impact of private interests and ideology on the reforms, democracy, as a stand-alone political institutional determinant, appears to have negative, but insignificant, effects on the quality of regulatory regime, and significantly negative effects on the quality of tariff regime. But this is not surprising. Both democracy and the division of power another important political institution are expected to have ambiguous effects on deregulation. As discussed, while democracy and the division of power help to restrain ruling politicians discretion and to establish credibility in policies, they can also introduce gridlocks. Estimates of the coefficients on checks and balances show that it has, in most cases, positive but insignificant effects on the dependent variables. This suggests that the benefit of checks and balances from constraining politicians discretion exceeds the cost arising from gridlock by an insignificant margin. Our empirical findings suggest that the effects of democracy on regulatory reforms in the telecommunications sector are large and primarily indirect. Indeed, an F-test strongly rejects the null hypothesis that the interaction terms between the explanatory variables discussed above and the high-democracy dummy are jointly zero. Democracy plays an important role in affecting the pace of reforms by providing a political environment where interest groups lobby for or against policy changes. Inspection of the regression results listed in the bottom half of Table 2 shows that the control variables discussed in Section 3 can explain some variations in the deregulation experiences across countries. Variables that proxy global technological advance and each country s technological capabilities as well as some other characteristics of each country s market for telecommunications services time, illiteracy rate, GDP per capita, the ratio of manufacturing output to GDP, and population have significant effects on deregulation. For each dependent variable, the OLS regressions show a positive time trend, after controlling for other variables. In addition, countries with higher rates of illiteracy, and hence lower capability in adopting new technology, appear to lag behind other countries in telecommunications deregulation. The negative effects of illiteracy are significantly stronger in high-democracy countries. These findings thus suggest that global technological advance 15

and each country s technological capabilities are important determinants of telecommunications deregulation. The estimated effects of other control variables are harder to interpret. Per capita GDP and the ratio of manufacturing output to GDP have negative effects on deregulation among high-democracy countries and positive effects on the quality of tariff regime among lowdemocracy countries. A large population is associated with significant improvements in the quality of tariff regime in high-democracy countries, but with deterioration in the quality of tariff regime in low-democracy countries. It is worth noting that our empirical findings are robust to changes in the specification that exclude all or some of the control variables. IV. CONCLUDING REMARKS Our empirical findings are consistent with the generalized interest group theory. We find that cross-country deregulation experiences in the telecommunications sector in the past decade can be explained, in large part, by their differences in the configurations of interest groups and the political structure in particular, the decision-making mechanisms and the ideology of the legislature. Deregulation is more likely in countries with a strong presence of pro-reform interest groups, as characterized by a larger financial sector and a greater proportion of urban consumers. Deregulation is less likely in countries with incumbents that have made large investments and hence have strong incentive to oppose the reforms that introduce competition. The effects of interest groups depend in important ways on the degree of democracy. Democracy appears to play an important role in facilitating the actions and the influence of both the pro-reform interest groups (the financial sector and urban consumers) and the anti-reform interest group the incumbents. The division of power measured by the existence of checks and balances, however, does not appear to have much impact on the reforms after controlling for democracy. Our findings suggest that interest groups and democracy have significant impact on policy outcomes. But these institutional variables tend to take time to change in many developing countries. Given the recent findings that telecommunications reforms improve economic efficiency (Ros, 1999; Wallsten, 2001a; Li and Xu, 2001), and that the telecommunications sector is a very important contributor to economic growth (Roller and 16

Waverman, 2001), heavy regulation of the telecommunications sector may remain a bottleneck for growth in many developing countries for some time to come. But this prediction may be too pessimistic as it ignores the role of rapidly changing technology. Our empirical findings in the paper have confirmed that the rapid global technological advance and improved technological capabilities in many developing countries have significant positive effects on telecommunications reforms. Technological advances may well overcome any institutional inertia in developing countries to bring about regulatory reforms in the telecommunications sector. 17

Appendix The Pyramid Data Set To compile the telecommunications regulation quality indicators we rely upon, Pyramid analysts draw upon a variety of information sources. They include the Economist Intelligence Unit (from their Country Data, Country Risk and Country Report products), the World Bank, local publications, local industry players and analysts, as well as Pyramid analysts own knowledge of the social and economic conditions in a given country. For each indicator, the analysts assigned a score between 1 (the worst) and 6 (the best) for each country in each year based on their subjective understanding of the elements affecting a particular dimension of the country s telecommunications regulation. The scores are benchmarked at a regional level and then at a global level. In this paper, we use three Pyramid indicators that measure the quality of a country s telecommunications regulatory regime along three different dimensions regulatory autonomy, regulatory transparency, and the quality of tariff and interconnection policy regime each with data available for both fixed-line phone and mobile phone segments. The regulatory autonomy indicator evaluates the ability of the regulatory institution to enact policies regardless of any influence from a larger governing body, where a higher value implies more autonomy. The regulatory transparency indicator evaluates the extent to which the regulatory body publicly communicates its policies and efforts to the public, where a higher value implies more transparency. The tariff regime quality indicator measures the quality of tariff and interconnection policy regime. An important component of this indicator is the degree of freedom that telecommunications operators have in the determination of tariff structures. For each of the indicators, an increase in the score over time implies an improvement in the quality of telecommunications regulation. To extract relevant information, we construct the following composite indices for deregulation as the principal components of the available indicators. 6 Q = 0.496 regulation autonomy FP + 0.506 regulation autonomy MP + R it 0.494 regulation transparancy FP + 0.504 regulation transparancy MP. Q = 0.707 tariff policy FP + 0.707 tariff policy MP. T it Here superscripts FP and MP refer to fixed phone and mobile phone, respectively. Note that each individual (RHS) variable is standardized as a variable distributed with mean 0 and variance 1. The descriptive statistics of these indices are shown in Table A.1 Table A.1. Sample statistics of the constructed indices Mean Standard deviation Minimum Maximum Q 0 1.802-3.234 5.170 R it T Q it 0 1.624-4.484 5.839 Explanatory variables From the World Development Indicators, we construct log(gdp per capita), log(population), illiteracy rate, and urban/total population. The number of main lines per 100 inhabitants and profitability are constructed based on the ITU data. 6 See Greene (1997), p. 424. The use of principal components is an attempt to extract from the X matrix a small number of variables that, in some sense, account for most or all of the variation in X. 18

Financial depth is constructed as an index of principal components of three variables measuring financial depth: 0.60 M2/GDP + 0.53 stock/gdp + 0.59 bank/gdp. Here again, each component variable is standardized to have mean 0 and variance 1. Each of the three component measures comes from Beck, Demirguc-Kunt, and Levine (2000). All the measures related to political structure except democracy are based on Beck et al. (2000). The democracy score is based on the polity 98 data set compiled by Gurr and Jaggers (1999) and the method of transformation in Longdregan and Poole (1996). In particular, we transform two measures one about autocracy and the other about democracy into a single indicator by subtracting the autocracy measure from the democracy measure. Ideology is constructed as the principal component index of three variables indicating the ideological inclination of the legislature, lagged by one year. The three variables are the right, the center, and the left inclination of the legislature, as defined in Beck et al. (2000). 7 The right inclination of the legislature, for instance, is constructed as J s 1(party 's ideology inclination was right) j 1 j j, = where s j represents the ratio of the seats taken by party j to the total seats taken by the first three largest parties and the largest opposition parties. The other two variables that measure the left and center inclination of the legislature are defined analogously. As the principal component of the above three variables, the ideology variable is constructed as: 0.59 (the right inclination of the government) + 0.45 (the centrist inclination of the government) 0.67 (the leftist inclination of the government). 7 Beck et al. (2000) defines the ideology inclination of a political party as right if it is conservative, Christian democratic, or right-wing; left if it is communist, socialist, social democratic, or left-wing; center if it is centrist or if its position can best be described as centrist (e.g., party advocates strengthening private enterprise in a social-liberal context). Otherwise, the ideology inclination of the party is classified as missing. 19

Reference Alston, Lee J.; Thrainn Eggerston ; and Douglass C. North. 1996. Empirical Studies in Institutional Change. Political Economy of Institutions and Decisions series. Cambridge, New York, and Melbourne: Cambridge University Press. Alt, James E., and Robert C. Lowry. 1994. Divided Government, Fiscal Institutions, and Budget Deficits: Evidence from the States. American Political Science Review v88, n4: 811-28. Beck, Thorsten; Clarke, George; Groff, Alberto; Keefe, Philip; and Walsh, Patrick. 2000. New Tools and New Tests in Comparative Political Economy: The Database of Political Institutions. Policy Research Working Paper 2283. Washington: World Bank. Beck, Thorsten; Demirguc-Kunt, Asli; and Levine, Ross. September, 2000. A New Database on Financial Development and Structure. World Bank Economic Review,. Becker, Gary S. 1983. A Theory of Competition among Pressure Groups for Political Influence. Quarterly Journal of Economics: 371-400. Bortolotti, Bernardo; Juliet D Souza; Marcella Fantini; and William L. Megginson. 2001. Sources of Performance Improvement in Privatized Firms: A Clinical Study of the Global Telecommunications Sector. Mimeo, University of Oklahoma. Boubakri, Narjess, and Jean-Claude Cosset. 1998. The Financial and Operating Performance of Newly Privatized Firms. Journal of Finance 53: 1081-1110. Boyland, Olivier, and Giuseppe Nicoletti, 2000. Regulation, Market Structure and Performance in Telecommunications. Economics Department Working Paper No. 237, Organization for Economic Cooperation and Development: Paris. Clarke, George, and Robert Cull. Forthcoming. Getting to Yes: Privatizing Banks in Argentina. Journal of Law and Economics. Cox, Gary W., and Mathew D. McCubbins. 1996. Structure and Policy: The Institutional Determinants of Policy Outcomes. Mimeo, UCSD. D Souza, Juliet, and William L. Megginson. 1999. The Financial and Operating Performance of Privatized Firms during the 1990s. Journal of Finance v54, n4: 1397-1438. Galal, Ahmed, and Bharat Nauriyal. 1995. Regulating Telecommunications in Developing Countries. Policy Research Working Paper 1520. Washington: World Bank. Greene, William. 1997. Econometric Analysis. New York: Maxwell Macmillan International Publishing Group. Gurr, Ted R., and Jaggers. 1999. Polity 98: Regime Characteristics, 1800-1998," http://www.bsos.umd.edu/cidcm/polity/. Irwin, Douglas A., and Randall Krozner. 1999. Interests, Institutions, and Ideology in Securing Policy Change: The Republican Conversion to Trade Liberalization after Smoot-Hawley. Journal of Law and Economics v42, n2: 643-73. ITU. 1999a. Trends in Telecommunication Reform, Convergence, and Regulation. www.itu.int/itudoc/itu-d/trends99. 20

ITU. 1999b. World Telecommunications Development Report. www.itu.int/itud/ict/publications/wtdr-99. Jones, Mark P.; Pablo Sanguinetti; and Mariano Tommasi. 2000. Politics, Institutions, and Fiscal Performance in a Federal System: An Analysis of the Argentine Provinces. Journal of Development Economics v 61, n2: 303-33. Kalt, Joseph P., and Mark A. Zupan. 1984. Capture and Ideology in the Economic Theory of Politics. American Economic Review 74(3): 279-300. Kikeri, Sunita; John Nellis; and Mary Shirley. 1992. Privatization: The Lessons of Experience. Washington: World Bank. Levy, Brian, and Pablo Spiller. 1996. Regulations, Institutions, and Commitment: Comparative Studies of Telecommunications. Political Economy of Institutions and Decisions series. Cambridge, New York, and Melbourne: Cambridge University Press. Li, Wei; Christine Zhen-Wei Qiang; and Lixin Colin Xu. 2001. The Political Economy of Telecom Privatization and Competition. Mimeo, World Bank. Li, Wei, and Lixin Colin Xu. 2001. Liberalization and Performance in the Telecommunication Sector Around the World: Is Privatization Sufficient? Mimeo, the World Bank. McNary, Robert. 2001. The Network Penetration Effects of Telecommunications Privatization and Competition. Mimeo, Stanford University. Megginson, William L.; Robert C. Nash; and Matthias Van Randenborgh. 1994. The Financial and Operating Performance of Newly Privatized Firms: An International Empirical Analysis. Journal of Finance 49: 847-59. Noll, Roger. 1999. Telecommunication Reform in Developing Countries. Palo Alto: Stanford University. Peltzman, Sam. 1976. Toward a More General Theory of Regulation. Journal of Law and Economics 19(2): 211-40. Peltzman, Sam. 1984. Constituent Interest and Congressional Voting. The Journal of Law and Economics 27, 181-210. Peltzman, Sam. 1985. An Economic Interpretation of the History of Congressional Voting in the Twentieth Century. American Economic Review 75(4): 656-675. Peltzman, Sam. 1998. Political Participation and Government Regulation. Chicago and London: University of Chicago Press. Petrazzini, Ben A. 1996. Telecommunications Policy in India: The Political Underpinnings of Reform. Telecommunications Policy v20, n1: 39-51. Petrazzini, Ben. A., and Theodore H. Clark. 1996. Costs and Benefits of Telecommunications Liberalization in Developing Countries, Working paper. Hong Kong: Hong Kong University of Science and Technology. Poole, Keith T., and Howard Rosenthal.. 1997. Congress: A Political-Economic History of Roll Call Voting. Oxford: Oxford University Press. 21