INSTITUTIONS, GROWTH AND CONVERGENCE: AN EMPIRICAL SURVEY BASED ON PAKISTANI AND GLOBAL PRESPECTIVE

INSTITUTIONS, GROWTH AND CONVERGENCE: AN EMPIRICAL SURVEY BASED ON PAKISTANI AND GLOBAL PRESPECTIVE Dr.DANISH AHMED SIDDIQUI Assistant Professor, Karachi University Business School, University of Karachi daanish79@hotmail.com, 923333485884 Corresponding Author Postal Address: 98/3/1 lane 8, off khayaban e Rahat, Phase 7, DHA, Karachi 75500 Abstract This study reviewed the literature on sustainable economic growth and institutions in the context of developed and less developed countries specifically Pakistan. It also surveyed the studies conducted to empirically asses the validity of neo classical convergence. This review have clearly indicated that quality of institutions has become the most discussed factor influencing economic growth. Furthermore, the lack of convergence is also attributed to weak institutions. There is also sufficient empirical studies focusing on different types of institutions and their relative impact to economic variables. However, the role of institutions seems to be different when they are analyzed in a Pakistani prospective. It was witnessed that countries like Pakistan have done well economically despite their weak institutions. Hence, it is suggested that there is a need of country specific studies so that their unique dynamics are better captured. Keywords: Institutions; Pakistan; convergence; growth 1. Institutions and Economic Growth Empirical literature has identified various institutions influencing economic growth. Some of these include governance, law enforcement, justice, regulations, tax administration and institutions managing the monetary and fiscal policies [Soto 1989, 2000; Knack and Keefer 1995; Mauro 1995; Sachs and Warner 1995; Frye and Shleifer 1997; Johnson et al. 1998; Easterly and Levine 2002; Kaufmann and Kraay 2002; Rodrik 1997; Rodrik at al. 2002; Meon and Sekkat 2004; Kaufmann et al. 2005; and Jalilian et al. 2007]. In particular, Acemoglu et al. (2000, 2002, 2005) show the impact on growth is more pronounced in long run. Méon and Weill (2006); Olson et al. (1998) find evidence suggesting that institutional factors are strongly related to total factor productivity. They clearly exhibit higher productivity in countries with better institutional quality. With regard to causal effect between institutions and economic performance, studies like Olson et al. (1998); Acemoglu, Johnson, and Robinson (2000); Rodrik et al. (2002) indicate the clear evidence of uni-directional causality in the direction of institutions impacting growth. Some studies like World Bank (2003); Kirkpatrick, Parker, & Zhang (2006) investigated the role of institutions in promoting investment and capital creation found compelling evidence in this regard. Other studies reiterated institutional roles in improving international capital flows in particular FDI (Reisen and De Soto 2001; Smarzynska and Wei 2000) and portfolio investment Gelos and Wei (2002). A brief account of some of the studies that have been undertaken to find the institutional factors influencing the economic growth is given below. Soto (1989) finds that regulatory and legal barriers in Peru led to increase in informal activities, making both formal and informal sectors worse off. Formal sector were imposed on a disproportionate higher burden of taxation, while informal sectors face risk of expropriation due to little or no protection of property right and contract enforcement. At another place, Soto (2000) made an interesting note that, in 121

absence of well defined and enforced property rights, the informally owned assets (without property rights) cannot be used to generate capital, and this is the main cause of the underdevelopment of the poor. For instance, he argues that poor s wealth in Egypt is about 55 times larger than all the foreign direct investment made in the country, including building of the Suez Canal. Despite such a huge wealth, they lack any arrangement that could turn these informal assets into liquid capital. In another study, Mauro (1995) employing cross country, subjective indices of corruption, bureaucratic and judicial efficiencies, political stability, found corruption inhibiting investment and decreasing growth. Frye and Shleifer (1997) in a micro level survey of 105 shop owners in Moscow and Warsaw, observed a lower quality of institutions leading to private protection, regulatory burden and corruption in Moscow suggesting the theory of grabbing hand, better fit this economy. To convert into invisible hand, increase in the quality of governance in essential. In another study, Johnson et al. (1998) attempted to find factors responsible for increase in unofficial economy, and suggested that it is not due to higher burden of taxes or regulation as considered to be the case, but due to corruption and bribes rising out of higher degree of regulatory discretion and weaker rule of law. On a different note, Easterly and Levine (2002) proved that even the impacts of tropics, germs, and crops on income are influenced by the quality of institutions. A comprehensive study by Kaufmann and Kraay (2002) assembling world governance indicator indices of 175 countries for the period of 2000-01, found a strong positive correlation between incomes and governance, however interestingly, a strong positive causal effect is witnessed running from governance to incomes, but a weak and negative causal effect running in the opposite direction. This suggests that the notion of higher income leading to better governance did not found an empirical base. They also witness the working of grabbing hand form of government in many countries, favoring political elites. In another study, Rodrik at al. (2002) finds factors such as geography and trade, influencing income conditioned by the quality of institutions. At another place, Rodrik (1997) finds that institutional quality explains the growth performance of East Asian countries exceptionally well. Effect of institutions on trade is assessed in another study by Meon and Sekkat (2004) where they found lower quality of institutions inhibits greater participation on Middle East and North African regions in the world economy, and suggest that improvement in institutions would tend to increase the FDI flows and manufacturing exports. Causal link between institutions such as regulatory quality and economic growth is also explored by Jalilian et al. (2007) suggesting a strong positive link in this regards. A study by Acemoglu et al. (2005) based on the historical analysis of the division of Korea, and European colonization, emphasizes that institutions are the fundamental cause of differences in economic development. Institutional impact on technical efficiency captured by Méon and Weill (2006) in 62 countries employing six governance indicators, shows that better institutions improve efficiency. Attempts have also been made to assess the impact of institutions of investment flows. In particular Kirkpatrick, Parker, & Zhang (2006) show that regulatory quality positively influences foreign direct investment. Reisen and De Soto (2001) explored this effect on private capital flows on panel data of 44 countries over the period of 1986-97, which shows that foreign direct investment, portfolio equity investment, bond flows, as well as short-term and long-term bank lending, positively affect growth provided a sound institutional base. Gelos and Wei (2002) observe that international funds invest systematically less in less transparent countries. On the 122

other hand, herding among funds tends to be more prevalent in less transparent countries. There is also some evidence that during crises, funds flee non-transparent countries by a greater amount. In the following sections, the study will focus on the two brands of institutions that we used in our index of institutions. 1.1 Risk Reducing Institutions Increased risk of expropriation and confiscation of property rights would cause diversion of resources from productive activities to private arrangement in protecting their rights that can be avoided by properly institutionalizing Risk reducing social technologies. In other words, institutionalizing Risk reducing social technologies does not mean collectively hiring guards by society, proves to be cheaper. It means that no guards are required in the first place. Different components of Risk reducing social technologies, particularly Property rights protection, are analyzed empirically and their impact of growth is established [Scully 1988; Gwartney, Holcombe and Lawson 1999; Kanwar and Evenson 2001; Boettke and Subrick 2002]. In particular, other studies Like Cozzi (2001) attributed patent protection to growth and inequality. [Soto 2000; La Porta et. al. 1997,1998], link property rights, investment and financial rights protection as well as enforcement of contracts to financial development, making complex financial product such as mortgages and equity market development. [Johnson, McMillan and Woodruff 2002; Macaulay 1963; Galanter 1981 and Ellickson 1991] particularly lay emphasis on judicial system, and contend that if the courts are slow, inefficient, then corrupt informal contract enforcement appears as a solution to court failures. Specifically, Johnson, McMillan, and Woodruff (2002) prove weakly effective property rights discourage new entrants and competition as well as discourage existing players in reinvestment of their earnings in profitable avenues. Some studies like [Olson 1993; Londregan and Poole 1990; and Alesina,Ozler, Roubini and Swagel 1992] focus on another risk reducing institution of political stability as shown that political violence affects the economic performance. Some of the above mentioned studies are elaborated below. A study by Scully (1988) conducted on 115 countries over the period of 1960-80, proves institutional measures such as political and civil liberties, rule of law, and market economies, produce a strong positive impact on economic growth and efficiency measures, exhibiting increase in growth of about three times and increase in efficiency of about 2.5 time. Gwartney, Holcombe and Lawson (1999) developed index of institutions covering economic, fiscal and political institutions to prove that their impact on economic growth is significant. Study by Kanwar and Evenson (2001) explicitly focused on institutions enforcing intellectual property right as measured by R&D investment and patent protection, in cross country panel study over the period of 1981-90, found compelling evidence that these institutions cause innovation. In another study, Boettke and Subrick (2002) attribute long run economic development to institutions improving rule of law. The results suggests institutions such as property rights protections, reducing uncertainty could induce economic development. Similar conclusion reached by La Porta et al. (1997) covering 49 countries shows that Countries with poorer investor protections, measured by both the character of legal rules and the quality of law enforcement, have smaller and narrower capital markets. They further assert in La Porta et al. (1998) poor property rights protection make shareholders with small holdings, insecure and lead to their concentration in the largest public sectors companies In a firm level survey conducted by Johnson, McMillan and Woodruff (2002) 123

of manufacturing sector in eastern European countries, found large size of unofficial sectors. The major reasons were high taxes, corruption of officials, less faith in courts and informal protection, out of which corruption being most significant. An interesting historical study by on informal rules governing boundary fences by Ellickson (1991) asserts that formal law always operates in the background of any conflict situation, the way people actually solve their disputes often differs markedly from formal law, because of culture, transaction costs, expectations, and other subtleties not incorporated into law books. Londregan and Poole (1990) analyzing political and economic data from 121 countries over the period 1950-1982, found a coup is followed by political instability that may lead to another coup. It is the economic well-being that can deter it. In another study, Alesina,Ozler, Roubini and Swagel (1992) employing a sample of 113 countries over the period of 1950-82 found lower growth associated with high level of political instability. 1.2 Rent-seeking Institutions There is a dearth of literature linking regulatory quality of public institutions to economic growth [Chong and Calderon 2000; Sarte 2001; Grigorian and Martinez 2001; Djankov et al. 2002; Rajkumar and Swaroop 2002; and Lamsdorff 2004]. Corruption is yet another form of rent seeking that can be dealt by proper institutional framework. Vast number of studies done on this topic, in particular, Wei (1997, 2000a, and 2000b) show that increase in corruption of about one standard deviation would be equivalent to 30% increase in taxes in terms of social impact. Tanzi and Davoodi (1997) link corruption to excessive and unproductive public investment, lowering public investment productivity and quality. This loss of quality is more pronounce in health care and educational sector Gupta et al. (2001). Perhaps the most important institutions are political institutions in terms of their effect on other institutions. Institutional weakness leads to political rents that can be curbed through checks and balances on political agents Keefer (2004) and Keefer and Knack (2002). Various studies have showed evidence supporting that political freedom and civil liberties greatly influence growth and welfare [Kormendi and Meguire 1985; Scully 1988; McMillan, Rausser and Johnson 1991]. Some of these contributions are briefly described below. Djankov et al. (2002) employing regulation of entry data of 85 countries, found that countries with high level of regulation lead to higher level of corruption and larger unofficial economies. A study by Sarte (2001) highlights lack of oversight by political authorities on their bureaucratic agents; reduces the effectiveness of government spending. These agents also require a large budget to provide public goods due to their inefficiencies. This will in turn reduce growth. Grigorian and Martinez (2001) attempted to find a link between quality of legal and regulatory institutions and industrial growth on 27 developing countries, and found significant evidence in this regard as it increases investment and total factor productivity. Rajkumar and Swaroop (2002) attempted to find if the differences in efficacy of public spending can be explained by institutional quality. They found strong evidence, especially in public health and primary education spending, as it lowers child mortality and increases the effectiveness of primary education in countries with strong institutions. Wei (1997) at another place claims that corruption increases uncertainty measured through industrial survey in FDI. He asserts that An increase in the uncertainty level from that of Singapore to that of Mexico, at the average level of corruption in the sample 124

raising the tax rate on multinational firms by 32 percentage points. Wei (2000b), at another place indicates corruption adversely affecting capital flows. However, its effect is distorted by government restrictions/incentives in FDI. Even after controlling these factors, coefficient of corruption remains large, negative and significant. However, host countries chances of getting bank loan is not linked with corruption and corrupt countries tend to ship their portion of capital flows from FDI to bank loan, making impact of corruption on capital flows insignificant. The similar conclusion reached by Wei (2000a) covering 45 countries over the period of 1990-91 and Smarzynska and Wei (2000) employing firm level data, proved corruption along with higher taxes, reduces FDI. Gupta et al. (2001) finds lower corruption is also associated with higher level of human capital in terms of low infant mortality and primary dropouts. Another rent seeking institution giving rise to the lack of political competition, can negatively impact development through asymmetric lack of credibility of preelectoral promises and incomplete voter information, as suggested by Keefer (2004). However, political checks increase its credibility. The impact of political competition of created worthiness is explored in Keefer and Knack (2002). They argue that the presence of multiple veto players (government decision makers) with polarized interests increases the credibility of sovereign commitments, but reduces the ability of governments to adjust policies in the event of exogenous shocks that jeopardize their ability to honor their commitments. However the net effect would depend upon the degree of social polarization. As their evidence suggests: multiple veto players matter more when countries are more ethnically polarized, but less when income inequality is greater. Acemoglu et al. (2002a) emphasizes that technological adoption and institutional development can be severally affected by political elites as it would erode their rent extracting potential and fear replacement. However, their effect would be reducing in high political competition. Shleifer et al. (1998) criticized the "helping hand" and "invisible hand" neo classical models and refuted North s stance of grabbing hand" where emphasis is on the political economy of the state. It is the Political agents personal interests that deviate the economy from maximization of social welfare. 1.3 Relative importance of the two brands of Institutions Both brands of institutions namely risk reducing and rent seeking does impact growth. The question however remains, which of the two impacts more. Acemogu and Johnson (2005) on empirical found institutions, based on predatory theory (Anti Rent Seeking institutions), do produce a considerable impact on economic performance. However, quite surprisingly, the role of institutions based on Contract theory (risk reducing institutions) was not very significant. The reason they give to this fact is quite convincing. In absence of formal risk reducing institutions contracting institutions, the gap is filled by private alternative institutional arrangement. Like in earlier times when formal institutions of courts and police didn t exist or were ineffective, people then resorted to dwell in groups where contracts were honored through informal pressure and risk of expulsion from group. Hence their rights were secured in other ways. In contrast, protection from rent seeking behavior would only depend upon the behavior of state with its people. If this behavior promotes corruption, inefficiency or predatory rents to privileged classes, those who don t have a level playing field cannot enter into similar contract with some other entity in place of state as in 125

case with contract theory. This lack of alternative would largely drive down long run growth prospects. 1.4 Growth Attributes of growth Apart from elaborative theoretical model, empirical literature attributes high level of growth to Physical and infrastructure investment (De-Long and Summers, 1991), Blomstrom et al. 1996), nature of financial system and structure [King and Levine 1993a,b;. Neusser & Kugler 1998; Beck et al. 2000; Demirg uc -Kunt and Levine 2001], trade openness [Dollar 1992; Ben-David 1993; Sachs & Warner 1995; Edwards 1998]. Study carried out by De-Long and Summers (1991), covering the period of 1960-85, estimates that a percentage increase infrastructure and machinery equipment investment would lead to one third percentage increase in growth. It also finds the social return on such investment in about 30% in well functioning markets. Blomstrom et al. (1996) made a similar effect using shares of fixed capital formation to GDP as a proxy for investment to account for its causal impact on growth, covering more than 100 countries for the period of 1965 to 1985, found more evidence of growth causing investment, rather than otherwise. However, high rates of fixed capital formation were found to accompany rapid growth in per capita income. Assessing the impact of financial development on growth is vastly researched. A comprehensive crosscountry study by King and Levine (1993a) on eighty countries covering the period of 1960-89, found a positive impact of various measures of financial structure and development on present and future rates of economic growth, capital accumulation and efficiency. At another place, King and Levine (1993b) explored that impact of financial sector on growth is through increase in innovation leading to increase in productivity. Better financial systems increase the rate of innovation causing accelerated economic growth. Neusser & Kugler (1998) found the similar conclusion on OECD countries. Based on time series causality analysis, it revealed that financial sector and GDP are cointegrated and exhibit granger causality. In a cross country context over the period 1960-95, Beck et al. (2000) also found a positive causal link between financial development and growth and productivity, capital accumulation and saving rates. Demirg uc -Kunt and Levine (2001) examine finance growth nexus using high definition financial data of about 150 countries covering areas such as size, efficiency, and activity of banks, insurance companies, pension and mutual funds, finance companies, and stock and bond markets, found positive link in this regards. It also that found institutions of property rights and contract enforcement are instrumental in financial sector development. 2. Institutions and Neo-Classical Convergence Neo classical theory predicts convergence of per capita growth of countries making developing countries come at par with developed countries over time. However, lack of evidence for convergence seems to weaken this theory on empirical grounds [Pearson el al. 1969; Romer 1994], and developed countries continue to grow faster than their steady state growth rate as proposed by neoclassical theories. In particular, Romer (1994) shows empirically that standard production function is ineffective for explaining productivity in cross country settings due to spillover effect of knowledge from transfer of technologies. This separate effect is not accounted in production function making biased productivity estimates. Hence there is no support for unconditional convergence. However, many economists believe that this convergence is conditional upon the quality of institutions. These institutions shape the innovative 126

activities in the economy and speed up technology adoption. Institutional weakness in form of government intervention, corruption, and unprotected property rights in developing countries can be attributed to low level of convergence [Shleifer et al. 1998; Rodrick 1998; Acemoglu 2002; Acemoglu et al. 2000, 2002, 2002b; Djankov et al. 2002 and 2003; Barro 1997]. In particular, evidence provided by Rodrick (1998) supports this hypothesis, as countries having high inequality, ethnic fragmentation, weak governance institutions like rule of law, citizens rights, experience a sharp drop in their growth rates after 1975. Acemoglu (2002) also attributed the lack of convergence to rent extracting institutions and inefficient policies serving interests of power brokers. In a similar context, Empirical support for convergence was captured by Barro (1997) in his study of 100 countries for the period of 1960-90. However, this convergence is found to be conditional upon factors such as initial schooling, life expectancy, rule of law, terms of trade, lower inflation. However, political rights observed to depict a non linear relationship reducing growth at both lower and higher levels. Knack and Keefer (1995) also support property rights institutions instrumental in growth. They also observe that inclusion of property rights also increases the rate of convergence. On a different account, Ben- David (1993) links trade liberalization and growth convergence in selected countries. In a similar study by Sachs and Warner (1995), covering 135 countries, for the period of 1970 to 89, found strong evidence of convergence in economies undertaking market reforms like trade and financial liberalization. On a similar account, Edwards (1998) covering 93 countries employing nine indices of trade, found it to be instrumental in TFP growth, concluding that TFP growth is faster in more open economies. 3. Regional Studies on Institutions Growth Analysis In the previous section, the empirical literature on the institutional determinants of growth across countries was discussed. The aim now is to review the empirical literature on investment behavior undertaken in South Asian economies, specifically in Pakistan. This topic is of special interest because due to diverse backgrounds and institutional arrangements, the determinants of growth in South Asian economies may be different from the determinants of growth in the rest of the world. However, due to the limited work undertaken to analyze institutions growth behavior in this part of the world, this issue is not as transparent as it is in the above mentioned studies. In this section, the review will cover few of the important empirical studies on institutional impact on growth, undertaken on Pakistan as well as in the context of South Asian region. Several studies have made attempts to examine institutions in Pakistan as well in south Asian region. Mahbub ul Haq Human Development Centre (1999), and Ahmed (2001) illustrates that institutions measured by world governance indicators indices of voice and accountability, political stability, regularity, quality, rule of law, and control of corruption appears to be significantly affecting poverty. Especially in Pakistan, institutional weakness is responsible for ad hoc policies, instability and corruption and has resulted in privileged segments extending their rents through lobbying and misuse of authority [Pakistan et al. 1998; Hussain 1999]. Institutional impact on poverty is explored in [Pakistan 1999; Hassan 2002; Haq and Zia 2009], which shows institutions are negatively and significantly correlated with poverty, hence weak institutions increase poverty in Pakistan. In particular, study made by Haq and Zia (2009) covering the period of 1996-2005, found governance indicators and well as pro-poor growth measured by inequality, poverty, both scored among the lowest in the world suggesting lower quality of 127

institutions also cause poor not reaping rewards of economic growth as both poverty and inequality have swollen during the period. However, in contrast to the popular notion, Studies like Shafique and Haq (2006) based on World Bank s governance indicators, find that weak institutions do improve welfare of the society but they have negative influence on GDP growth rate. At another place, Fernandes and Kraay (2007) and Easterly (2003) in a cross-country study based on averages, found a higher per capita income of Pakistan as compared to countries with similar level of institutional quality, suggesting Pakistan grew much more as compared of other countries with similar level of institutional qualities. Fernandes and Kraay (2007) asserts that The point estimates suggest that Bangladesh and Pakistan have per capita incomes that are between two and three times higher than their very weak institutional performance would suggest based on average cross-country relationships. In contrast, India's per capita income is only about half of what one might expect given its per capita income. The similar assessment in the context of political institutions in made by SPDC (2000), which shows that growth was considerably good under authoritarian rule as compared to democracy but they were not very successful in social sectors like education and health that are critical in improving human factor endowment. Authoritarian rule normally is associated to weak institutions, whereas the case is vice versa for democracy. In regional context, Fernandes and Kraay (2007) employing firm level data on South Asian countries find that private informal arrangement like business associations and community networks are frequently used by firms when formal contracting institutions are weak or missing. 4. Conclusion. This study reviewed empirical growth literature and explored whether the elaborative theories fit the ground realities. In empirics, economic growth is attributable to different factors like infrastructure investment, financial development, trade development, human capital and above all institutions. Empirical evidence suggesting convergence is scarce, and convergence is proved to be conditional upon other factors including institutions considered the most prominent. Large body of literature suggests institutions do produce a significant impact on growth as different brands of institutions are tested in sustainable growth models. The study has separately reviewed two brands on institutions and their impact on growth and development is assessed. In regional context, institutions growth nexus seems to be holding, however studies conducted on Pakistan suggest this relationship to be insignificant as country s growth performance is far higher than what it s institutional scores would suggest. 128

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