Building better economic institutions

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Economic institutions

How can countries improve their economic institutions? Cross-country analysis shows that institutional quality depends not only on a country’s level of democracy, but also on many other factors. Some of these are fixed or difficult to change, such as history, geography, natural resource endowments or eligibility for EU accession. But there is potential to support improvements to institutions through international integration, political reform and greater transparency, particularly at the local level.

Economic and political institutions play a key role in defining a country’s long-term growth potential. Countries with a stronger institutional environment – effective rule of law, a good business climate, more secure property rights and market-friendly social norms – are better positioned to attract investment, to participate in trade and to utilise physical and human capital more efficiently.

And yet, as discussed in Chapter 1, the pace of economic reform in countries in the transition region has slowed. Is this because, on average, their economic institutions have caught up with those elsewhere? Or is the slow-down linked to limitations on political transition considered in Chapter 2? What other factors can explain the significant institutional differences seen across these countries which shared a broadly similar starting point? Do better economic institutions require more democratic political institutions? Or could countries improve them even in the absence of further democratisation?

This chapter addresses these questions, drawing on both cross-country analysis and case studies from a number of countries in the transition region. Economic institutions are measured using a range of indicators, such as the World Bank’s Worldwide Governance Indicators (WGIs) for government effectiveness, regulatory quality, the rule of law and control of corruption (as well as a simple average of all four). These indicators are based on data sources that include expert judgement and surveys of households and businesses. They therefore reflect the quality of institutions as perceived by users and professional opinion, rather than just the laws on the books. The WGIs are available annually from 1996 to 2011 for a large number of countries. They typically range from about -2.5 to +2.5, with higher values corresponding to better institutions.¹

The analysis also uses the EBRD’s transition indicators. These look at the period since 1989 and reflect cumulative reforms, as assessed by EBRD economists, in the areas of privatisation, liberalisation of prices, trade and exchange rates, enterprise restructuring, corporate governance and competition policy (see the methodological notes in the online version of this Transition Report). Hence, they are primarily a measure of structural policies – economic liberalisation and privatisation – which are typically undertaken in the early stages of transition. Only two indicators – governance and enterprise restructuring, and competition policy – have an institutional flavour.

Lastly, the analysis uses the World Bank Doing Business reports, as well as two surveys conducted by the EBRD and the World Bank: the Business Environment and Enterprise Performance Survey (BEEPS) and the Life in Transition Survey (LiTS). The Doing Business reports, in particular, complement both the WGIs and the EBRD transition indicators by focusing on practical measures of the business environment – such as the number of days needed to obtain approval for a start-up or the cost of opening a bank account. An economy’s performance is summed up by the “distance to the frontier” – that is to say, the difference between it and the best performer in each category.² The distance to the frontier is indicated on a scale of 0 to 100, where higher scores correspond to a better business environment.

One aspect that is largely absent from these datasets is the quality of private economic institutions, such as corporate governance in specific sectors. This arises from the interplay between the state – through its legal frameworks and their enforcement – and company practices. The quality of corporate governance is rarely measured, although one example, focusing on the corporate governance of banks in the transition region, is considered in Annex 3.1.

Chart 3.1 plots the main measures – the four WGIs, the average transition indicator and the distance to the frontier – for countries in the transition region (after rescaling to express all indicators in the same units as the WGIs). The measures are correlated across countries, but also reveal some interesting differences.

With some exceptions (such as Belarus and Turkmenistan), the countries on the left-hand side of the chart – those with scores for the rule of law that are below the median rule – tend to have transition indicator scores that are higher than their WGI ratings. This indicates that it is fairly easy, even for countries with weak economic institutions, to undertake first-generation market reforms that move them up the transition indicator scale.

Towards the other end of the chart, Slovenia has very good economic institutions according to its WGI scores. However, its transition indicator score is less impressive. This reflects its continued relatively high level of state ownership and involvement in the economy.

The chart also shows that the correlation between the distance to the frontier and the WGIs or transition indicators is lower than that between the WGIs and the transition indicators.³ This reflects the fact that the distance to the frontier can, to some extent, be lowered by rolling back and simplifying business regulations, although this may not improve other aspects of economic institutions (such as the rule of law). Several countries – such as Azerbaijan, Belarus and Georgia – undertook such efforts towards the end of the last decade.

1. See Kaufmann et al. (2009) and the methodology and sources described at http://info.worldbank.org/governance/wgi/index.aspx#doc-sources. [back]
2. For example, New Zealand represents the frontier when it comes to starting a business, while the Hong Kong Special Administrative Region represents the frontier for dealing with construction permits. For each country, the distances to the best performers in each category are aggregated to form a composite measure of the distance to best practices and rescaled. See World Bank (2013) for details. [back]
3. The correlation between the average transition indicators and the average of the four WGIs shown in Chart 3.1 is 0.88. The correlation between the latter and the distance to the frontier is 0.80; and the correlation between the transition indicators and the distance to the frontier is 0.70. [back]

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