On the Interplay between Trade, Political Institutions and Economic Institutions

Developed countries often use trade sanctions and embargos to push a despotic regime to the negotiation table due to several reasons such as nuclear non-proliferation and humanitarian purposes. For instance, the United States maintains comprehensive trade sanctions against North Korea, Syria, Sudan and Iran virtually prohibiting all kinds of financial transactions with entities from those countries. However, these sanctions and embargos instead of bringing positive change in the country may end up hurting the people of the country in terms of missed opportunities that could have arisen if the country was involved in international trade. In my first published article titled “The effect of trade and political institutions on economic institutions“, published in the Journal of International Trade & Economic Development, I explored the impact of trade openness on economic institutions under different political regimes.

Earlier studies confirmed a positive link between trade openness and institutional quality, however, an isolated analysis of trade openness per se may grossly simplify the mechanisms at work. “From a short-term perspective, trade regimes and domestic rules of international trade participation clearly reflect the priorities of the ruling class and are, in this sense, political constructs. It is, therefore, an open question whether higher trade flows (henceforth, trade) will – independently of the political system – lead to an improvement in domestic economic institutions. This study shifts attention from trade openness as a construct of institutional quality to the realized trade and corresponding quality of economic institutions under different political institutions. The likely interaction effect between trade and political structures is far from trivial. Not only is this interaction important for understanding and predicting the direction of institutional change, but the assumed interaction effect should also help policy-makers devise context-specific policies. Ultimately, such analysis is crucial to understanding whether, in the short-term, bilateral trade with authoritarian regimes is actually helping to improve their institutional quality or merely increasing the survival chances of dictatorial rulers”.

To analyze the relationship between trade and economic institutional quality under different political regimes, in this study I employ a longitudinal data set covering 138 countries during the period from 1984 to 2010. The observation period, thus, includes a time of intense global trade liberalization followed by an average growth in world exports of approximately 6% between 1990 and 2008. Data on the quality of economic institutions comes from the investment profile index (IP index), which is available from the International Country Risk Guide (ICRG). Trade is measured using the commonly used indicator which is imports plus exports as a ratio of GDP. To proxy for the quality of political institutions, data are taken from the ICRG’s democratic accountability index (DA index).

The estimations yield two robust results: first, the results confirm a positive and significant effect of trade on the quality of economic institutions independent of the domestic political regime; second, the effect of trade on economic institutional quality is considerably smaller in the presence of authoritarian political institutions. For instance, a 10% increase in the trade-to-GDP ratio is related to an increment of 0.27 units in the IP index for a country with a DA index of 0. For a country with a DA index of 6, this effect decreases to 0.06, which is nearly 4.5 times less than the effect in a country with a DA index of 0. To put this into perspective, consider two countries, A and B, both with similar characteristics and an IP index of 6 in the first year, but with different DA scores. Let country A be an autocracy with a DA score of 6, and let country B be a democracy with a DA score of 0. If both countries experience a 10% increase in trade per year for 10 years with all other variables being constant, country B’s IP index will increase from 6 in year 1 to 8.7 in year 10, whereas country A will experience a marginal increase of 0.6 units in its IP index as shown in the figure below. These results are robust to changes in the measurement of political institutions as well as to different identification strategies, and the overall conclusions remain similar.

Figure: Development of IP index over a 10-year period for a 10% increase in trade-to-GDP ratio per year.

The findings suggest that in political regimes where there is some democratic accountability, increased trade will result in improvement in economic institutional quality, whereas in the absence of democratic accountability, higher trade volumes will have substantially smaller effects on economic institutions. This shows that increased trade flow alone cannot improve the quality of economic institutions in a country. Rather, political institutions also play a key role in this relationship. The results also invite several policy implications for donor agencies and international financial institutions (IFIs). Countries that transition from autocracies to more pluralistic regimes will benefit from increased trade in terms of improvements in their economic institutions. Thus, trade liberalization policies to lower trade barriers can be an effective tool for improving institutional quality in newly democratized countries. Moreover, preferential trade agreements that advanced economies initiate with newly democratized countries can lead to institutional change. The results also stress the importance of context-specific policy design, taking into account the domestic social and political context instead of simply adopting a blueprint approach.

To cite this article: Usman Khalid (2017) The effect of trade and political institutions on economic institutions, The Journal of International Trade & Economic Development, 26:1, 89-110, DOI: 10.1080/09638199.2016.1206142

Link to this article: http://dx.doi.org/10.1080/09638199.2016.1206142

You can request the full-text free here.

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