Private and Financial Sector Development Unit Euro

INDUSTRIALGROWTHANDQUALITYOFINSTITUTIONS:WHATDO(TRANSITION)ECONOMIESHAVETOGAINFROMTHERULEOFLAW?DavidA.Grigorian1andAlbertMartinezPrivateandFinancialSectorDevelopmentUnitEuropeandCentralAsiaRegionWorldBankAbstractThepaperattemptstoempiricallytestthelinkbetweenInstitutionalQualityIndicatorsandIndustrialGrowth.WefoundsignificantevidenceoftheeffectoftheaboveindicatorsonIndustrialGrowthin27AsianandLatinAmericancountries.TheresultssuggestthatdevelopedlegalandregulatoryframeworkworktheirwaytoindustrialgrowthboththroughinvestmentandTotalFactorProductivity.Thefindingsarerobustwithrespecttothetypeofinstitutionalqualitymeasuresusedintheanalysis.ThemainpolicyrecommendationmadeinthepaperisthatinstitutionbuildinginTransitionCountriesshouldbeanessentialcomplementarymeasuretoaccompanyprivatization,flowofpublicandprivateinvestmentsineducationandR&D,andmeasurespromotingForeignDirectInvestment.JELclassification:O11,O40,L50.Keywords:EconomicDevelopment,IndustrialPolicy,QualityofInst[e-mail]aperwasfurnishedasabackgroundpaperforKazakhstanIndustrialPolicyReview.TheauthorswouldliketothankDavidDollar,PhilipKeefer,SteveKnack,andLevFreinkmanoftheWorldBank,ananonymousreferee,andconferenceparticipantsinSt.Louis,Missouriformanyvaluablecommentsandsuggestions.Theremainingerrorsareourown.2I.IntroductionThepre-transitionindustrialstructureinEasternEuropeandtheformerSovietUnionwasprimarilydrivenbyarawmaterialbase,influencedbycentralplanningdecisionsandrarelybasedoncomparativeadvantageconsiderations.IntheSovietUnioninparticular,enterpriseswerehighlyintegratedintoanindustrialnetworkandthuswerelargelydependentonsuppliesofrawmaterialsfromotherpartsoftheregion.FollowingthecollapseofthesocialistsystemandtheresolutionofCMEA,thetradeandsupplylinksbrokeupvirtuallyovernightandwhatmighthavebeenaneconomicallyviableproductionnetwork–averystrongassumptiontomakeconcerningsoviet-eraindustrialgiants–turnedouttobemakinghugelossesonpublicaccounts.Industrialenterpriseswhichwerealmostneverinvolvedinmarketinganddistributionoftheirproductssuddenlyfoundthemselvesinanenvironmentwheretheyhadtomaketheirownproductiondecisionsandadjusttoneweconomicconditions.Thesedevelopmentscoupledwithdeterioratingmacroeconomicconditionsdrasticallychangedtheenablingenvironmentforindustrialsectorenterprises.Fromtheinitialyearsoftransition,countriesofEasternEuropeandformerSovietUnionhavefacedthechallengeofindustrialrestructuringandgrowth.Varioussub-sectorprogramsdefining‘strategicdirections’ofdevelopmentweredesignedandputinplace.Yetquiteoftenpolicyresponseswerelimitedtoprotectionistmeasuresaimedatpreservingoutputand/oremploymentof(mostlystillstateowned)industrialenterprises.Bearinginmindthepoliticalimportanceoflargeindustrialfirms,inmostcasesgovernmentswerereluctanttoliquidatethem,henceeffectivelyallowingthemtocontinuerunninglosses.Moreover,incaseswhereenterpriseswereconsideredimportant,directstatesubsidiesandcreditsweremadeavailable.Thisresultedin3situationswherestateownedenterprisesweresubjectedtoverylittleornofinancialdiscipline–anunlikelygoalofanyindustrialpolicyintheregion.Herewedonotintendtodiscussspecificdetailsofanyindustrialpolicyintransitioneconomies.Neitherdowefocusontheroletheconventionaldeterminantsofindustrialpolicy(e.g.TradeandExchangeRateRegimes,InvestmentandCapitalAccumulation,etc.)playedinshapingtheoutcomesofthosepolicies.OurintentionhereistointroduceyetanotherchannelthroughwhichindustrialpolicymakersInTransitionEconomiesarelikelytobeabletoaffectindustrialgrowth.Followingrecentstudiesoneconomicgrowth,andinparticularthoseexploringthelinkbetweeninstitutionalqualityandeconomicgrowthingeneral(e.g.KnackandKeefer[1995],Clagueetal.[1995])weattempttotesttherelationshipbetweenindustrialgrowthandinstitutionalqualityindicators.Owingtothelackofsufficientlylongtimeseriesandrelativelypoorqualityofdata,wedidnotbaseouranalysisontransitioneconomies.Insteadweusedasampleof27developingcountriesofAsiaandLatinAmericacontainingdatafrom1982to1997toderiveourconclusions2.Wepresentevidenceofastrongeffectofvariousindicatorsofinstitutionalqualityandfinancialdevelopmentonindustrialgrowth.Wethenhypothesizethattheresultsobtainedinthepaperwillholdforawiderangeoftransition/developingcountries.Thepaperisstructuredinthefollowingway.SectionIIestablishesthetheoreticallinkbetweenqualityofinstitutionsandgrowth.SectionIIIgoesontodescribetheinstitutionalqualityindicatorstobeusedinthestudy.Wethenoutlinethebasic2LatinAmericancountriesare:Argentina,Bolivia,Brazil,Chile,Colombia,CostaRica,DominicanRepublic,Ecuador,ElSalvador,Honduras,Jamaica,Mexico,Panama,Paraguay,Uruguay.Asiancountriesare:Bangladesh,China,HongKong(China),India,Indonesia,SouthKorea,Malaysia,Nepal,Philippines,Singapore,SriLanka,Thailand4econometricmodelanddiscussregressionresultsinSectionIV.Finally,SectionVcontainsconcludingremarksandpredictions.II.QualityofInstitutionsandEconomicGrowthItisonlyrelativelyrecentlythateconomistshaveattemptedtoexplainthefracti