The impact of institutions on economic growth and income in southeast asian countries

UNIVERSITY OF ECONOMICS ERASMUS UNVERSITY ROTTERDAM HO CHI MINH CITY INSTITUTE OF SOCIAL STUDIE VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS THE IMPACT OF INST

UNIVERSITY OF ECONOMICS ERASMUS UNVERSITY ROTTERDAM

HO CHI MINH CITY INSTITUTE OF SOCIAL STUDIE

VIETNAM – THE NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACT OF INSTITUTIONS ON ECONOMIC GROWTH AND INCOME IN SOUTHEAST ASIAN

COUNTRIES

BY

PHAN CHANH PHONG

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

HO CHI MINH CITY, DECEMBER 2015

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM THE NETHERLANDS

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACT OF INSTITUTIONS ON

ECONOMIC GROWTH AND INCOME IN SOUTHEAST ASIAN COUNTRIES

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

PHAN CHAHH PHONG

Academic Supervisor:

DR CAO HAO THI

HO CHI MINH CITY, DECEMBER 2015

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DECLARATION

I declare that: “The Impact of Institutions on Economic Growth and Income in Southeast

Asian Countries” is my own work; it has not been submitted for any degree at other universities

I confirm that I have made all possible effort and applied all knowledge for finishing this

thesis to the best of my ability

Ho Chi Minh City, December 2015 Phan Chanh Phong

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ABSTRACT

The role of institutions has generated considerable interest among researchers and practitioners recently, with the various result approaches and proposals The studies often investigate the direct impact of institutions on growth; moreover, there are few researches on this topic in Southeast Asian area and Vietnam This thesis investigates both direct and indirect impact of institutions on economic growth and income in the context of Southeast Asian countries over the period 2000-2013 by using six measures of institutional indicators, all of which are developed by the World Bank in 2014 The model is estimated using an Ordinary Least Squares, a Fixed Effect as well as a Random Effect estimation strategy Estimation results show that the direct impact of the institutions on growth is insignificant; however, the direct impact on the income and indirect impact on growth through trade policies are high significant In addition, the results also show that the influence of corruption on income is stronger in low-income countries From that, respective policies are suggested to stimulate growth and income in Southeast Asian countries

Keywords: Institutions, Economic Growth, Income, OLS, Fixed Effect, Random Effect

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ABBREVIATIONS

AEC Asean Economic Community

COC Control of Corruption

FE Fixed Effects

GE Government Effectiveness

ICRG International Country Risk Institutional Guide NIE New Institutional Economics

OLS Ordinary Least Squares

PCI Provincial Competitiveness Index

PSNV Political Stability and Absence of Violence/Terrorism

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CONTENTS

DECLARATION i

ACKNOWLEDGEMENTS ii

ABSTRACT iii

ABBREVIATIONS iv LIST OF TABLES viii LIST OF FIGURES ix Chapter 1 INTRODUCTION 1

1.1 Problem statement 1

1.2 Research objectives 3

1.3 Research questions 3

1.4 Contribution of the research 3

1.5 Structure of the research 3

Chapter 2 LITERATURE REVIEW 4

2.1 Theoretical literature 4

2.1.1 Definition of institutions 4

2.1.2 Informal and formal institutions 6

2.1.3 The New Institutional Economics 7

2.1.4 How do institutions influences economic 8

2.1.5 Solow model 9

2.1.6 Measuring institution 10

2.2 Empirical review 11

Chapter 3 RESEARCH METHODOLOGY 15

3.1 Analytical framework 15

3.1.1 Model of institutional impact on growth 15

3.1.2 Model of institutional impact of income 17

3.1.3 Model of indirect impact of institutions on economic performance 19

3.2 Data and Variables 19

3.2.1 Data source 19

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3.2.2 Variable measurement 19

3.3 Estimation method and model validation 29

3.3.1 Heteroscedastic testing 29

3.3.2 White Heteroscedasticity –Consistent Stand Errors or Robust Standard Errors 29

3.3.3 Breusch-Pagan LM test for Random Effects 29

3.3.4 Hausman test for Fixed versus Random Effects model 29

3.3.5 Omission of relevant variables 30

Chapter 4 ANALYSIS RESULTS 32

4.1 Overall explanation and hypothesis testing 32

4.1.1 Statistical test of model overall significance 32

4.1.2 Heteroscedastic testing 33

4.1.3 Model Testing 34

4.2 Impact of institutions on economic growth 35

4.2.1 Voice and Accountability, Political Stability and Absence of Violence/Terrorism 36

4.2.2 Government Effectiveness, Regulation Quality 39

4.2.3 Rule of Law, Control of Corruption 41

4.2.4 Summary results of growth 45

4.3 Impact of institutions on income 46

4.3.1 Voice and Accountability, Political Stability and Absence of Violence/Terrorism 46

4.3.2 Government Effectiveness, Regulation Quality 50

4.3.3 Rule of Law, Control of Corruption 53

4.3.4 Summary results of income 56

Chapter 5 CONCLUSIONS 58

5.1 Conclusions 58

5.2 Policy implications 59

5.2.1 Policies for economic growth 59

5.2.2 Policies for income 59

5.3 Limitations and further researches 60

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REFERENCES 61

APPENDIX A HETEROSCEDASTIC TEST 65

APPENDIX B BREUSCH-PAGAN LM TEST FOR RANDOM EFFECTS 71

APPENDIX C HAUSMAN TEST FOR FIXED VERSUS RANDOM EFFECTS MODEL 75

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LIST OF TABLES

Table 3.1 Explaining the variables in growth model 16

Table 3.2 Explaining the variables in income model 18

Table 3.3 Institutional variables from World Bank 21

Table 3.4 Summary statistics of key variables 21

Table 3.5 Between and within variations of key variables 23

Table 3.6 Average of the institutional indicators of Southeast Asian countries in 2000-2013 27

Table 4.1 Hypothesis testing of the overall significance of regression 32

Table 4.2 Heteroscedasticity test 33

Table 4.3 Breusch-Pagan LM test for Random Effects 35

Table 4.4 Hausman test for Fixed versus Random Effects model 35

Table 4.5 Impact of institutions on growth - Voice and Accountability 37

Table 4.6 Impact of institutions on growth- Political Stability and Absence of Violence/Terrorism 37 Table 4.7 Impact of institutions on growth - Government Effectiveness 39

Table 4.8 Impact of institutions on growth - Regulation Quality 41

Table 4.9 Impact of institutions on growth - Rule of Law 42

Table 4.10 Impact of institutions on growth - Control of Corruption 43

Table 4.11 Summary of impact of institutions on growth 45

Table 4.12 Effect of institutions on income - Voice and Accountability 48

Table 4.13 Effect of institutions on income - Political Stability and Absence of Violence/Terrorism49 Table 4.14 Effect of institutions on income - Government Effectiveness 51

Table 4.15 Effect of institutions on income - Regulation Quality 52

Table 4.16 Effect of institutions on income - Rule of Law 54

Table 4.17 Effect of institutions on income - Control of Corruption 55

Table 4.18 Summary of impact of institutions on income 56

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LIST OF FIGURES

Figure 1.1 Income against years of Southeast Asian countries 2

Figure 1.2 List of the countries in ASEAN Economic Community 2

Figure 3.1 The impact mechanism of factors on economic performance 17

Figure 3.2 Income against years of Southeast Asian countries 25

Figure 3.3 Income against years of low-income Southeast Asian countries 26

Figure 3.4 Growth rate against years of Southeast Asian countries 26

Figure 3.5 Government Effectiveness against years of Southeast Asian countries 26

Figure 3.6 Average of the institutional indicators of Southeast Asian countries in 2000-2013 28

Figure 3.7 Average income of Southeast Asian countries against average institution index .28

Participation AEC (ASEAN Economic Community) will also be a great opportunity for

Vietnam to promote institutional reform and modernization of the economy, raising the level of development List of the countries in AEC is provided in Figure 1.2 However, in the coming years, Vietnam also faces a huge pressure on institutional reform, economic restructuring, improving science, technology, and competitiveness, in the context of ASEAN jumped from AFTA (Asia Free Trade Area) to AEC Currently, the level of development of Vietnam is far behind many countries

in ASEAN such as Singapore, Malaysia, and Thailand therefore, reform pressures pose with Vietnam is huge This context raises the question whether the urgent institutional improvements have actually led to the better economic performance in Vietnam

Although the question of the effect of regulation on economic growth seems to be the most appropriate in a context where there are significant weaknesses in the institutional setting (i.e the developing economies), we focus on Southeast Asian countries that also differ markedly

in quality of institutions

When concepts of institutions are different for different scholars and vary from study to study (Nelson & Sampat, 2001), the foremost requirement is how to measure such a multidimensional concept In fact, no single variable can capture the multidimensional aspects of the institutional structure of a country; as a result, there are many potential methods of studying the impact of the institutions Our research will change the Solow growth model to check the quality of the institution’s framework plays a prominent role in explaining differences in growth rate and income in these countries We use measures of institutional quality that were drawn from the governance indicators developed by the World Bank, on a scale from -2.5 (worst) to 2.5 (best) Our analysis covers the period 2000-2013 for the Southeast Asian countries, and we estimate our models using OLS, Fixed Effects and Random Effects

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Figure 1.1 Income against years of Southeast Asian countries

Figure 1.2 List of the countries in ASEAN Economic Community

Indonesia Lao P.D.R.

Malaysia Myanmar Philippines Singapore Thailand Timor-Leste Vietnam

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1.2 Research objectives

The main objective of this research is to consider the impact of institutions on economic

growth and income of Southeast Asian countries in period 2000-2013

In an attempt to explain the impact of institutions on economic, the research explores the

contribution of six institutional indicators, which are developed by the World Bank, including

Voice and Accountability, Political Stability and Absence of Violence/Terrorism, Government

Effectiveness, Rule of Law, Regulatory Quality and Control of Corruption

The research also recommends policies to improve the impact of institutions on economic

performance

1.3 Research questions

This research is expected to answer these questions:

- Do institutions impact directly on economic growth?

- Do institutions impact indirectly on economic growth through export trade?

- Do institutions impact directly on income per capita?

- Do institutions impact indirectly on income per capita through export trade?

1.4 Contribution of the research

Currently, there are few researches in Vietnam and Southeast Asian area Some

researches consider Provincial Competitiveness Index (PCI) as a proxy for institutions to assess the

impact of institutions on economic development of the provinces, therefore not assess the impact

of institutions on a whole country Moreover, researches often investigate the direct effect; this

research will assess the direct and indirect impact of the institutions on economic growth and

income in Southeast Asian Countries from 2000 to 2013

1.5 Structure of the research

This research consists of five chapters as followings:

Chapter 1, which is about the importance, the reason of conducting the research, is

clearly presented as above

Chapter 2 presents the concept of different institutions, institutional classifications,

institutional impact on the economy, how to measure institutional variables, and reviews the

empirical researches of the relationship between the institutions and economic performance

Chapter 3 describes the data, the statistical characteristics of the data, research

methodology and empirical models for considering the effects of the institutions on economic

Chapter 4 reports and considers the results of regression the economic performance on

institutional indicators

Final chapter gives the conclusions, policy implications, limitations and further research

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CHAPTER 2 LITERATURE REVIEW

This chapter presents the concept of different institutions, institutional classifications, institutional impact on the economy and how to measure institutional variables In addition, present the Solow model which is widely used to examine the factors that effect on economic performance Finally, the chapter reviews the research results on the impact of the quality of institutions on economics issued, along with analysis and evaluation

2.1 Theoretical literature

2.1.1 Definition of institutions

Until now, Adam Smith has been usually remembered as the founder of neoclassical economics with “invisible hand” theory (Smith, 1976) This theory confirms the significance of exchange and trading in the market, in which he pointed out that economic growth depends on

“the rules” or institutional constraints of production relation, business in society However, until

1914, the first definition of institution has been issued by Veblen Accordingly, institution is the standard of behavior or regulation that determines behavior in specific situations and be accepted and complied by members of social group Basically, compliance with this regulation is controlled

by itself or by external power

After Veblen, many new definitions of institution have been issued by economists Example, Schmid (1972) gave that institution is a collection of relations between people These relations determine right and responsibility of one person in correspond with other‘s right, and determine right and responsibility in general Similarly, North (1990) gave that institution is “the social rule,” or limitations in capacity and knowledge of human, establish the relationship between people Therefore, they create stimulation in polity, society and economy Institution includes informal constraints (something be accepted or forbidden according to customs, habits, traditions and morals) and formal regulation (law, or other regulations…) and mechanisms ensuring their effective enforcement According to North, the main role of institution in a society

is to reduce uncertainty by creating a solid structure for interaction of persons Institutions are created, developed and revised by human So, theories of institution have to begin from individuals According to Nugent and Lin (1995), institution is a system of rules created by human

to manage and shape interaction of human, thereby helping them to form the expectation about what others would do

Obviously, though there are differences between these descriptions, but the concepts mentioned above are unified in considering that institution is a set of rules or norms of human behavior, effective regulation of relations between human beings

In 2000, Sokoloff gave a more extended definition of institution He said that institution is

a political and law framework, creating legal principles and basic rules for activities of individuals and companies The voluntary organization or collaboration among entities that affect the nature and organization of the exchange: cultural values and beliefs effect on economic behavior through their impact on the willingness to participate and adhere to the principles of market and to content of goods and services Thus, in this definition, specific connotation of the rule is a

Although there are certain differences, but generally, the definitions of institution until now are unified in some important factors Specifically, the concepts gave that institution include the following:

- The set of rules, or the "rules of the game" (law, the rules of society, the rules of a community );

- The actors "play" or "players" (state authorities, social organizations, governmental organizations, businesses, communities, );

non Mechanisms to enforce the rules, or is the "how to play" (policies, support mechanisms )

In reality, economic development has shown that successful economies have very different institutions, and the development levels of countries with similar institutions are also highly diverse For example, most developed countries have already reached the productivity and general welfare (such as the UK, France, Germany, Japan and the US), but hard to say that these countries have similar institutions, review all aspects of the history and the present

When talking about the institutional system as a whole, some of the following characteristics often had been the researchers note:

First, the institutional system can fairly be divided into two categories: institutional environment and institutional management Institutional environment determines the institutional constraints on management Institutional environment focused on the overall level of activities while the institutional management related to the interactions and individual transactions

Secondly, it is necessary to distinguish the institutional environment (including rules, general social norms) with the separate organizational form (the sort of organization) as an entity

in the institutional environment Although organizations can also be viewed as a set of rules, these rules are primarily for internal application Organizations were created for individual groups with the functional purpose Organizations can be classified into: political organizations (political parties, parliaments, city councils, the executing agency ); economy organizations (companies, cooperatives, family farms .); social organizations (associations, clubs, churches .) Although these organizations are separate entities, they are bound together by some common purpose to achieve certain goals Creation of a model for the organization (organization will launch and

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operate like) basically is influenced by the institutional framework In turn, these organizations will again affect the evolution of the institutional framework Thus, there is a relationship between institutional environments and organizations The organization was created by a deliberate series of opportunities arising from the current limit (there are institutional limitations and media limitations of economy theory) In the process of implementing its goals, the organization is the major factor leading to institutional changes

Third, state institutions and non-state institutions are the two types of institutions most discussed now Along with the legal provisions, apparatus and tools implemented by the legislature, execution and judiciary, state institutions have the most profound impact on economic and social change However, non-state institutions are diverse and growing in importance What is noteworthy here is that the state does not merely set out the rules (laws and legal - which is an integral part of the institutional environment of a country) and enforce the rules that all other organizations must comply, but the state, as an institution, must also comply with these rules Every day, the state agencies invest resources, allocate of credit, purchase goods and negotiate contracts… these actions have a huge influence on the transaction costs, the activities and economy results Clearly, the state simultaneously performs two functions: (i) held the main role in creating the institutional framework and (ii) execute those institutions

Fourth, laws, rules can be enforced under the influence of stakeholders within or under the influence of external third parties The action mechanism of external third party (such as the court system or arbitration) plays a very important role in the development of links between actors in the market Enforcement mechanisms facilitate market participation groups to access to market opportunities

2.1.2 Informal and formal institutions

The institutions are usually divided into two categories as formal institutions and informal institutions

Informal institutions often operate outside the formal legal system, reflecting the unspoken code of social behavior (such as customs, traditions, and norms of social conduct) The informal institution is not illegal institution They have an important role in the development of the country and should be supported to become official institutions (with registration) Rodrik (2008) criticized neoclassical economics for undervaluing the informal institutions

Formal institutions include regulations and laws of the government and rules of private organizations operating under the public law Helmke and Levitsky (2004) gave that “formal institutions are openly codified, in the sense that they are established and communicated through channels that are widely accepted as official”

While the formal institutional characteristics and its enforcement can partly be measured and evaluated, then informal institutions dependent on the researcher's perception

The importance of formal and informal institutions is seemingly different around the world The informal institutions are more important in developing countries, where the formal institutions are underdeveloped

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Ideally, these formal and informal institutions must complement each other Together, they can reduce transactions costs than either could alone For example, the Court formally prevents disputes and facilitates informal settlement simply by providing the threat of enforcement

2.1.3 The New Institutional Economics

Because there are different aspects of institutions that have been concerned, researched

by economists, so the institution economics has been formed The institution economics includes two main fields: Old Institutional Economics and New Institutional Economics (NIE)

- Old Institutional Economics focuses on researching on a role of law, ownership, the formation and impact of organization on the economic power, the economy transaction, and the allocation of income According to opinion of old institutional economics, institution is formal or informal process to solve conflicts and contradictions

- New Institutional Economics focuses on researching on human behavior associated with ownership theory, transaction costs and information asymmetries According to opinion

of New Institutional Economics, institution is a tool to reduce chance costs and information costs This tool is set of rule, law that is formed in formal or informal types Although these economics fields have two different research perspectives, but basically, there is no opposition when considering nature of the institutional concept

From a theoretical point, the researches of institutions in NIE are divided into three categories of theory approaches: the Historical Perspective Approach, the Comparative Institutional Approach and the Theory of Imperfect Information

The Historical Perspective Approach proposed by North (1990) to the study of institutions represents an attempt to construct an analytical framework that integrates institutional analysis into economics and economic history in order to explain the factors that account for the different patterns of economic performance experienced by diverse societies Previous research on this issue has been carried out, among others, by Alchian (1950) with his evolutionary hypothesis, and North and Thomas (1973) that have offered an efficient explanation later confuted by North (1981) himself Since much of the developmental path of societies is conditioned by their past, institutions are historically specific For this reason, it is necessary to be sensitive to the historical context, especially when dealing with the issue of institutional change (Alston, 1996)

The comparative institutional approach has recently been developed to investigate issues regarding institutions and institutional change Of particular relevance are questions related to the emergence of particular types of institutions and their impact on the diverse spheres that contribute to build up a society (Greif, 1998b) In this analytical framework, institutions are conceptualized as the endogenously emerging equilibrium outcome of a game; thus, the prominent interest is in investigating how the rules of the game are generated and become self-enforcing through the strategic interaction of the agents, whose behavior is in turn influenced by the self-enforcing constraints determined within the existing set of rules Therefore, institutions are regarded as non-technological constraints that guide social interaction and provide incentives

to maintain certain regularities of behavior (Greif, 1998b)

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Besides the historical and comparative approaches, another influential recent strand of new institutional economics is the one associated with the theory of imperfect information In this line of study the underlying rational of institutional arrangements and contracts (formal or informal) are explained in terms of strategic behavior under asymmetric information among the different parties involved (Bardhan, 2000) More in detail, this conceptual framework stresses that due to information and enforcement costs some markets will not exist and other markets will

be largely uncompetitive, so that, in this context, institutions have at least two major roles: firstly, they are a response to missing markets; secondly, they may help to overcome the information

problems that preclude complete markets (Arnott and Stiglitz, 1991; Hoff et al, 1993)

The basic difference of three approaches lies in analysis tools to perform studies While the Historical Perspective Approach efforts to integrate economic theory and economic history in, the Comparative Institutional Approach uses of game theory and history information, the Imperfect Information Theory is most mathematically – oriented (Nabli & Nugent, 1989)

2.1.4 How do institutions influences economic

Institutional factors have a direct impact on growth, called direct influence channel Also through interaction with the standard production factors, they can also indirectly influence on growth by replacing the marginal effect of these factors, called the indirect influence channel Among the institutional determinations significantly influencing economic performance are a property right, contract enforcement, a transaction cost, democracy, and corruption

Romer (1990) demonstrated that knowledge is not a commodity because patents allocate monopoly power to innovators Therefore, patents serve as tools of knowledge creation; they provide the appropriate incentives for those engaged in R & D to make the investment that will eventually lead to the creation of knowledge This process heavily depends on the quality of the institutions Institutions provide security of property ownership right and lead to tremendous support for the process of registration of copyrights, ideas, creative activities of individuals In this case, good institutions promote innovation of the economy (Tebdaldi & Elmslie, 2008), thus promote economic growth

References to contract enforcement, institutions stimulate rules and laws to prevent market failures and agency issues Institutions impact operational efficiency and reduce the risk of anti-competitive behavior and rent-seeking by corporate actors Only with proper institutions, operational issues are resolved and selective scope of rent-seeking is minimal

Other sources of institutional advantages contribute to economic growth is associated transaction cost In this case the institution in conjunction with other production factors, to determine the structure of exchange that influence the cost of production and distribution, they influence the feasibility and profitability of economic activities Through this mechanism, institutions are considered "underlying determinant of long-run Economic performance" (North, 1990)

North (1990) studied the economic reality of democracy, has come to the conclusion that democratic institutions play an important role in maintaining good government, limiting corruption, promoting effective economic development and ensuring economic environment more freely The 2002 U.N Human Development Report considers democracy as an important

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feature of good governance It reports, “For politics and political institutions to promote human development and safeguard the freedom and dignity of all people, democracy must widen and deepen” (UNDP 2002) So far, there have been different ways to recognize the role of institutions for development, such as recognize the role of each institutional type for development (administrative institutions, political institutions, economic institutions ) or recognize the role of each field of development (economic growth, social stability )

Although some authors suggest that the specific type of corruption impacts positively on economic development (Nye, 1967; Khan, 1996), most studies show the negative consequences of corruption (Mauro, 1995; Akçay, 2006; Gupta et al., 2002) The mechanism here is that a corruption acts as illegal taxes distort decision-making and economic processes Akçay (2006, p 33) reviewed the impact of corruption on human development and found that "corruption may indirectly affect the development of the people by lowering economic growth and incentives to invest.” Moreover, as Rose-Ackerman (1996) has argued that corruption also tends to distort the distribution of economic benefits and contribute to inequality in wealth Therefore, corruption often impacts negatively on human development because it decreases economic growth and redirects money from social services

The 2000 United Nations Millennium Declaration gave that good governance is a requirement for countries to promote economic development and poverty reduction

Report of the World Bank in 2002 confirmed how institutions support market and affects the lives of people by affecting economic growth and how people participate in markets Further over, if institutions weakly support market, they would hurt poor people disproportionately However, critics have argued that the effects of institutions have been exaggerated

In the indirect influence channel, there is some evidence that the institutions concern with policy variables, especially trade policy Aghion et al (2005) showed impact of policies depends on a country's distance from the technological frontier Because the institution is considered a determinant of the technological position of a country (Parente and Prescott, 2000), meaning that the institutions could alter the marginal effect of policies on economic growth Minier (2007) showed the institutions do affect the relationship between trade openess and growth Therefore, in this research, in addition to direct effects, we analyze indirect effects of institutions on economic growth and income through a trade policy, namely export trade

2.1.5 Solow model

In recent years, there are a growing number of experimental projects on cross-countries growth and convergence In the theory and empirical growth literature, the Solow model (Solow, 1956) is summarized as the foundation of the exogenous growth model fundamentally Since, this research would use the Solow model to investigate impact of institutions on growth and income Considering a set of assumptions, the Solow model asserts that long run growth rate is determined exogenously More obviously, the economy converges to a steady state level of growth, which primarily depends on the rate of technological progress and labor force growth

The production function in Cobb-Douglas framework at time t is given by:

1( ) ( ) ( ( ) ( ))

Y t  K t  A t L t  0    1 (2.1)

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K is capital and L is labor

A is noted as the level of technology

α is capital share

L is assumed to grow at an exogenous population growth rate (n) and A is assumed to

grow at g which implies advancement of knowledge Also it holds,

s is a portion of output that is saved and reinvested

δ is the rate of depreciation

Equation (2.4) clearly converges to steady state level *

At steady state level, income per capita depends on the initial technology A(0), technical

advancement g, rate of savings s, rate of working-age population growth n, depreciation rate δ

and capital share α This research would use the equation (2.7) to consider impact of institution

on income

2.1.6 Measuring institution

Here we discuss three main measures that are used commonly

The first set, initially used by Knack and Keefer (1995), Hall and Jones (1999), and more recently by Acemoglu et al (2001), as indicators of the quality survey from the International Country Risk Institutional Guide (ICRG), collected in 1980 and 1990 The data include subjective assessment of risks for international investments of the same size as the law and order, the

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quality of government, corruption, the risk of rejection of government contracts and expropriation From 1982 to 1997, the risk of expropriation in Iran moves from point 1 (highest expropriation risk) to 9 (near the highest point of the 10), while the risks in Libya and Syria move from 1.5 to 9

The second set is a composite index of surveys and assessments of different aspects of governance, collected by Kaufmann et al (2003) Rodrik, Subramanian, and Trebbi (2004) also used this dataset These categories include six indicators and combine the views of a large number of enterprise, citizen and expert survey respondents in industrial and developing countries Due to their popular and available, this dataset would be used in this research

The final set, collected by political scientists (Jaggers and Marshall, 2000) from the polity

IV project, measures the limits of executive power Polity IV makes the attempt to measure the political environment, not choices of dictators Constraints on the issue refer to “the extent of institutionalized constraints on the decision-making powers of chief executives, whether individuals or collectivities.” Polity IV provides a rapidly consideration results of election over time, certainly not a measure of actual political constraints on bureaucracy, and not a measure of anything permanent or durable

2.2 Empirical review

Barro (1989) included two variables from Banks's [1979] data set to measure political instability The variable REV is the number of revolutions and coups per year, and the variable ASSASS is the number per million population of political assassinations per year Findings reported that measures of political instability (proxied by revolutions, coups, and political assassinations) are inversely related to growth and investment These relations could involve the adverse effects

of political instability on property rights and the linkage between property rights and private investment The correlation could, however, also reflect a political response to bad economic outcomes

Hasan, Wachtel, and Zhou (2009) investigated the relationship between institutions and economic growth in China Rule of law and awareness of property rights are used as proxy variables, which are measured by ratio of private sector total fixed investment to overall fixed invetsment, number of lawyers per 10,000 people and ratio of number of domestic trademark applications to number of firms The results show that institutional development contributes to explain for provincial economic growth differentials

Dias and Tebaldi (2012) analyzed the relationship between human capital, institutions and economic growth This paper used panel data 61 countries in 1965-2005 and employs OLS and GMM dynamic panel estimation technique Regarding institution variables, democracy and autocracy were used as proxies for political institution while share of educated labor in the economy presents structural institution, human capital variable is generated based in Hall and Jones (1999) Piecewise function and the capital stock were calculated following perpetual inventory method proposed by Easterly and Levince (2001) The authors concluded that structural institutions completely affect long-term economic growth, however, political institutions were found to not be correlated with productivity and long-term economic performance

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Phan (2013) analyzed the impact of institutional factors on provincial economic performance in Vietnam Regarding institution variables, PCI and its nine sub-indices were used as proxies for institutional quality The author used two most popular production functions, Cobb-Douglas and Translog, in the research The paper employed the Stochastic Frontier Analysis (SFA) model for the sample of 58 provinces over the 2007-2011 interval, making use of the component error terms to account for both statistical noise and data overstatement The author found that although the effect for PCI on provincial GDP is significant but just some of 9 sub-indices impact the economic performance of Vietnam's provinces for the 2007-2011

Siddiqui and Ahmed (2013) investigated the effect of institutions on economic growth in

84 countries in 2002-2006 In order to capture the multi-dimensionality of institution, the aggregate index of institutionalized Social Technologies (IIST) was used together with its sub-indices of institutional and policy Rents, Political Rent and Risk-Reducing Technologies with the application of OLS and GMM methods Estimation results gave that institutions positively affect economic outcomes

Dar and Amirkhalkhali (2012) investigated 23 OECD (Organization for Economic operation and Development) countries in 2002-2008 The authors use Fixed Method and Random Method estimation technique in the research that employs the Solow growth model The authors concluded that higher quality of regulation leads to higher growth and strongest impact does not appear to be in those countries which are at the lower end of the Regulatory Quality spectrum

Co-Jalilian, Kirkpatrick & Parker (2007) analyzed 117 countries in 1989-1999 and 96 countries

in 1980-2000 This paper used Regulatory Quality and Government Effectiveness as institution indicators and relied on cross-section regression, panel regression (Fixed Effects) Estimation results gave that a strong causal link exists for the institution - growth nexus in developing countries

Kaufmann and Kraay (2002) investigated effect running from better governance to higher income per capita They rely on 194 different measures gathered from 17 different sources of subjective governance data built by 15 different organizations (international organizations, political and business risk rating agencies, think tanks, and non-governmental organizations) The authors used OLS and IV estimation technique in the research Estimation results suggested that a one standard deviation improvement in the governance measure raises per capita incomes nearly four-fold in the long run

Olson et al (2000) analyzed to explain why a subset of developing countries is growing quickly, but other developing countries are growing slowly They argued that this difference is due

to differences in the quality of institution and found that productivity growth is correlated with the quality of institution strongly

While most of the research has focused on the direct effect of institutions on economic growth, Minier (2007) investigated indirect effect of institutions on economic growth through parameter heterogeneity The author used panel data of 70 countries from 1960 to 2000 and considered whether the quality of a country’s institutions could affect the relationship between growth and its other determinants, such as human and physical capital accumulation, geography, and government policies Applying exogenous and endogenous sample splitting technique, the

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author attempted to measure the varied parameters of growth determinants in recognition of such a threshold Findings reported that there is not much evidence that institutions affect growth indirectly, in the sense of affecting the parameters of the aggregate production function However, institutions influence the marginal effect of policy variables such as export trade, import

on growth In particular, countries with weak institutions appear to suffer from trade openness in ways that countries with better institutions do not Although the correlation between “openness” (measured by the quantity of trade) and growth is close to zero in countries with strong institutions, this correlation is negative among countries with weaker institutions Papageorgiou (2002) employed the data-sorting method which allows the data to endogenously select regimes using different variables It is shown that openness, as measured by the trade share to GDP, is a threshold variable that can cluster middle-income countries into two distinct regimes that obey different statistical models Their result suggests that openness may not be as crucial in the growth process of low and high-income countries but it is instrumental in identifying middle-income countries into high and low-growth groups

Converse, there were some studies that do not support the proposition that institution causes growth Glaeser et al (2004) reviewed the proposition that institutions cause growth using cross-country data from 1960 to 2000 Their results did not support the proposition They also found that it is challenging to establish a causal link between institutions and economic growth due to problems in institutional measurements and limitations in econometric techniques By analyzing the history of the economic development and specific governance reforms of the United States, Mauritius, Argentina and Jamaica, Goldsmith (2007) showed that economic growth of the United States and Argentina gone up before major governance reforms had been adopted Holmberg, Rothstein & Nasiritousi (2009) reviewed the importance of good governance and offered a benchmark statistical analysis The authors showed that three QoG variables such as Rule of Law, Corruption Perception, and Government Effectiveness have positive but weak correlations with economic growth, but their correlation with income per capita is so strong

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Summarily, this chapter presented the different concepts of institutions, in generally, the definitions of institution until now are unified in some important factors, including the set of rules (law, the rules of society, the rules of a community), players (state authorities, social organizations, non-governmental organizations, businesses, communities) and mechanisms to enforce the rules (policies, support mechanisms)

Among the institutional determinations significantly influencing economic performance are a property right, contract enforcement, a transaction cost and corruption Institutions provide security of property ownership right that leads to tremendous support for the process of registration of copyrights, creative activities of individuals, promoting innovation of the economy thus promotes economic growth References to contract enforcement, institutions stimulate rules and laws to prevent market failures and agency issues and reduce the risk of anti-competitive behavior and rent-seeking by corporate actors Additionally, institutions determine the structure

of exchange that influences the cost of production and distribution They influence the feasibility and profitability of economic activities Besides, some studies show the negative consequences of corruption such as an illegal tax that distorts process of decision-making or economic processes

In this chapter, we discussed three main measures that are used commonly The first set, indicators of the quality survey from the International Country Risk Institutional Guide (ICRG) includes subjective assessment of risks for international investments of the same size as the law and order, the quality of bureaucracy, corruption, risk of rejection of government contracts and the risk of expropriation by the government In all three sets of data, this is probably most problematic The second set is a composite index of surveys and assessments of Government Effectiveness that be collected by Kaufmann et al (2003) and is a clear outcome measure The final set, coming from the polity IV dataset, collected by political scientists (Jaggers and Marshall, 2000), measures the limits of executive power directly

While considering the research relate to impact of institutions on economic performance,

we see that most of the research has focused on the direct effect of institutions on economic growth The study uses many different concepts of institutions, since the results are divergent Kaufmann and Kraay (2002) suggested a one standard deviation improvement in the governance measure raises income per capita nearly four-fold in the long run Dias and Tebaldi (2012) concluded structural institutions completely affect long-term economic growth; however, political institutions were found to not be correlated with productivity and long-term economic performance Moreover, Minier (2007) investigated the indirect effect of institutions on economic growth through parameter heterogeneity Converse, there were some studies that do not support the proposition that institution causes growth

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In this chapter, the author will investigate models respectively for institutional impact on growth and income, as well as variations when considering the indirect impact of the quality of institutions on the economics, then present the concept of the variables used in the model, the source of data, as well as survey the statistical characteristics of the data Finally, this chapter reviews the different testing methods of models, including Heteroscedasticity test, variable omission test, Hausman Test, Breusch-Pagan Lagrangian Multiplier Test, White Heteroscedasticity

- Stand Consistent Errors

3.1 Analytical framework

3.1.1 Model of institutional impact on growth

In the research, the Solow model would be used to investigate impact of institutions on growth The standard growth accounting model can be written as:

Where:

GY is the growth rate of real GDP

GK is the rate of real capital accumulation

GL is the growth rate of the labor force

We models total factor productivity as depending upon export growth GX and institution

I, as well as upon other unmeasured differences across countries As a result, we can write:

A  a  a GX  a I  u (3.2) Where:

u is the time and country specific random disturbance

αi0 measures unmeasured cross-country but time-invariant differences

From (3.1) and (3.2), we have:

GY  a  a GK  a GL  a GX  a I  u (3.3)

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In (3.3), the investment rate (INV) is a proxy for rate of real capital accumulation (GK) We also use the growth rate of employment rather for GL to capture the extent of labor utilization better

Equation (3.3) could be rewritten as follow:

GY  a  a INV  a GL  a GX  a I  u (3.4) Expected sign of variables is showing through the Table 3.1

Table 3.1 Explaining the variables in growth model

Dependent variable

Independent variables

INV Investment rate Percentage Positive sign (+)

GL Employment Growth Rate Percentage Positive sign (+)

Figure 3.1 describes the impact of factors on economic performance

Export

Figure 3.1 The impact mechanism of factors on economic performance

3.1.2 Model of institutional impact of income

As described in section 2.1.5, Solow model is used to investigate impact of institution on income The equation (2.7) in Chapter 2 is rewritten:

L t is GDP per capita or Income

Following Mankiw et al (1992) and Islam (1995), g and δ are assumed to be fixed because

g is the advancement of knowledge and technology which is not country-specific and “there is

neither any strong reason to expect depreciation rates to vary greatly across countries nor any data that would allow us to estimate country-specific depreciation rates” (Mankiw et al, 1992) The sum of depreciation rate (δ) and advancement of knowledge and technology (g) is assumed to

be 0.05

And ln A(0) + gt = ln (A (0)*egt) = ln A(t)

So we have:

INV is the investment rate

GL is the growth rate of employment We also use the growth rate of employment rather than growth rate of population for GL because employment more accurately captures the extent

of labor utilization

Some studies have investigated the relationship between productivity and trade also instittutions (Bhaumik et al., 2012; Minier, 2007; Dar & Amirkhalkhali, 2012) In generalization models, productivity factor depends on the export rate and quality of institution, as well as other unmeasured differences across countries As a result, we can write:

ln Ait  ai  a *ln EXit a ln Iit  uit (3.7) Where EX is the rate of export, I is an institution index, u is the time and country specific random disturbance and ai0measures unmeasured cross-country but time-invariant differences Substituting (3.7) into (3.6) yields:

ln GPit  a  a ln INVit a ln( GLit  0.05)  a ln EXit a ln Iit ui (3.8) Then we use (3.8) to consider the impact of institutions on income

Note: Institution variables have value in [-2.5; 2.5], so to takeln I , we shift it into

[0; 5]

Expected sign of variables is in the Table 3.2

Table 3.2 Explaining the variables in income model

Variable Meaning Measurement Expected sign

Dependent variable

Independent variables

INV Investment Rate Percentage Positive sign (+)

GL Employment Growth Rate Percentage Positive sign (+)

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3.1.3 Model of indirect impact of institutions on economic performance

As discussed in section 2.1.4, in this research, in addition to direct effects, we analyze indirect effects of institutions on economic growth and income through a trade policy, namely export To evaluate this effect, in the regression equation in Section 3.2.1, 3.2.2, add interactive variables of institution and export, we get the equation to examine the indirect impact of the institutions as following:

Indirect impact of institutions on growth:

GY  a  a INV  a GL  a GX  a I  a I GX  u (3.9) Indirect impact of institutions on income:

- Export Growth Rate (GX): Annual growth rate of exports of goods and services based on constant local currency

- Export Rate (EX): Exports of goods and services (% of GDP)

- Institution Index (I):

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The most frequently used definition of “quality of government” rests on the notion of governance of World Bank It includes:

- The process of selecting, monitoring and replacing governments

- The capacity of formulating and implementing sound policies of the government effectively

- The respect of the state and citizens for the institutions that govern economic and social interactions among them (Kaufmann et al., 1999)

In accordance to this definition, the World Bank compiled a large range of governance data to measure the different aspects of governance These categories include six indicators in Table 3.3, called Worldwide Governance Indicators (WGI) “These aggregate indicators combine the views of a large number of enterprise, citizen and expert survey respondents in industrial and developing countries They are based on over 30 individual data sources produced by a variety of survey institutes, think tanks, non-governmental organizations, international organizations, and private sector firms.” (The Worldwide Governance Indicators project, n.d.) These data are rescaled and merged to construct the six aggregate indicators using Unobserved Components Model Governance indicator scores fall between -2.5 and +2.5, with higher scores corresponding

to better governance

Table 3.4 provides a basic summary of key variables used in the thesis There is a change

in GDP per Capita variable, with the standard deviation of 14.768, which is 1.4 times of the mean

of 10.477

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Table 3.3 Institutional variables from World Bank

No Institutions from World

of association, and a free media.”

3 Government

Effectiveness (GE)

“Reflects perceptions of the quality of public services, the quality of the civil service and the degree of its independence from political pressures, the quality of policy formulation and implementation, and the credibility of the government's commitment to such policies.”

4 Regulatory Quality (RQ)

“Reflects perceptions of the ability of the government

to formulate and implement sound policies and regulations that permit and promote private sector development.”

5 Rule of Law (RL)

“Reflects perceptions of the extent to which agents have confidence in and abide by the rules of society, and in particular the quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence.”

6 Control of Corruption

(COC)

“Reflects perceptions of the extent to which public power is exercised for private gain, including both petty and grand forms of corruption, as well as "capture" of the state by elites and private interests.”

Table 3.4 Summary statistics of key variables

Variable Obs Mean Std.Dev Min Max

Annual Real GDP Growth 104 5.32 3.04 -2.33 15.24 GDP Per Capita 104 10,477.09 14,768.38 299.98 55,979.76 Investment Rate 104 24.29 6.44 10.44 39.57

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Employment Growth Rate 104 0.04 0.63 -2.40 1.40 Export Growth Rate 104 7.73 9.35 -16.76 30.30 Export Rate 104 81.01 52.50 23.98 230.27 Regulatory Quality 104 0.27 0.81 -0.78 2.12 Government Effectiveness 104 0.35 0.92 -0.97 2.43 Political Stability and Absence of

Violence/Terrorism 104 -0.16 1.01 -2.12 1.40 Rule of Law 104 -0.01 0.84 -1.25 1.77 Voice and Accountability 104 -0.51 0.50 -1.56 0.51 Control of Corruption 104 -0.05 1.01 -1.23 2.42

Additional information is described in Table 3.5, which offers the variance decomposition

of the key variables into between-variations and within-variations Especially, GDP per Capita, Export Rate and institutional variables vary more between countries (between-variation) than within countries over time (within-variation) In contrast, the Export Growth Rate has changed over time greater than between countries

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Table 3.5 Between and within variations of key variables

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Figure 3.2 Income against years of Southeast Asian countries

Looking at Figure 3.2, we see a significant difference between the incomes of Singapore, Brunei compared with the remaining countries Applying outlier analysis, we see these two countries out of upper bounds Therefore, we divide the full 8-country sample into two subsamples: subsample 1 includes the countries with lower levels of income (Cambodia, Vietnam, Philippines, Indonesia, Thailand, Malaysia), while subsample 2 includes the countries with higher levels of income (Brunei, Singapore)

Indonesia Malaysia Philippines Singapore Thailand Vietnam

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Figure 3.3 Income against years of low-income Southeast Asian countries

Figure 3.4 Growth rate against years of Southeast Asian countries

Figure 3.5 Government Effectiveness against years of Southeast Asian countries

Table 3.6 and Figure 3.6 indicate average values of the institutional variables for the period 2000-2013 Results show that there are fairly large differences in institutional quality between countries Singapore tops the institutional index and outperforms the rest of the

Indonesia Malaysia Philippines Singapore Thailand Vietnam

Regulatory Quality

Political Stability and Absence

of Violence/

Terrorism

Rule of Law

Voice and Account ability

Control of Corruption

Brunei

Darussalam 0.790 1.040 1.180 0.557 -0.802 0.523 Cambodia -0.890 -0.432 -0.469 -1.098 -0.921 -1.088 Indonesia -0.310 -0.409 -1.252 -0.712 -0.157 -0.785 Malaysia 1.100 0.527 0.193 0.499 -0.415 0.236 Philippines -0.020 -0.102 -1.448 -0.497 -0.005 -0.627 Singapore 2.150 1.869 1.164 1.635 -0.104 2.234 Thailand 0.290 0.265 -0.843 0.007 -0.234 -0.270 Vietnam -0.300 -0.616 0.230 -0.448 -1.435 -0.630

Figure 3.7 shows the relationship between the average income of each country and their average institutions in the period It shows a high correlation between income and RQ, GE, RL, COC

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Figure 3.6 Average of the institutional indicators of Southeast Asian countries in 2000-2013

Figure 3.7 Average income of Southeast Asian countries against average institution index

-2,5 -2,0 -1,5 -1,0 -0,5 0,0 0,5 1,0 1,5 2,0 2,5

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3.3 Estimation method and model validation

We will estimate the models using Ordinary Least Squares (OLS), Fixed Effects (FE) and Random Effects (RE) estimation in Stata, and then use them to test for the appropriate estimation technique

3.3.1 Heteroscedastic testing

Heteroscedasticity is the problem of unequal variances of the error term This problem often occurs in cross-sectional data because of outliers in the data, incorrect function of the regression model, inaccurate translation of data, or different measures of scale

To check problem of unequal variances, we do an auxiliary regression analysis The squared residuals are regressed onto a set of regressors that contain the original regressors, their squares and cross-products

The Lagrange multiplier LM  n R 2, n is sample size

This follows a chi-squared distribution, and degree of freedom is P-1 (P: the number of estimated parameters)

The null hypothesis is that the error variance is homoscedastic or not Heteroscedasticity

If the chi-squared value is large or has a low p-value, we can reject the null hypothesis of homoscedastic Vice versa, then the error term from the original model is homoscedastic

3.3.2 White Heteroscedasticity –Consistent Stand Errors or Robust Standard Errors

White has suggested a procedure to obtain Heteroscedasticity – Consistent Stand Errors, which are known as Robust Standard Errors The procedure does not alter the values of the coefficients but corrects the standard errors to allow for Heteroscedasticity

3.3.3 Breusch-Pagan LM test for Random Effects

The Breusch-Pagan Lagrange multiplier (LM) test is designed to test Random Effects The null hypothesis is that cross-sectional variance components are zero.H0:u2 0

If the null hypothesis is not rejected, the pooled regression model is appropriate

With the large chi-squared, we reject the null hypothesis in favor of the random group effect model

3.3.4 Hausman test for Fixed versus Random Effects model

Hausman test can be also used to differentiate between Fixed Effects model and Random Effects model in panel data In this case, the null hypothesis here is that Random Effects is preferred due to higher efficiency, while under the alternative hypothesis, Fixed Effects is at least consistent and thus preferred

If the chi-square value exceeds the critical chi- square value for given df and the level of significance, we conclude that Random Effects model is not appropriate because random error