The impacts of institutional implementation on provincial economic performance, the case of vietnam (2007 2011)

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIESVIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS THE IMPACTS OF INSTITUTIONAL FACTORS ON PROVINCIAL ECONOMIC PERFORMANC

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACTS OF INSTITUTIONAL FACTORS ON PROVINCIAL ECONOMIC PERFORMANCE: THE CASE OF VIETNAM

(2007-2011)

By

PHAN THACH TRUC

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

Ho Chi Minh City, December, 2013

UNIVERSITY OF ECONOMICS INSTITUTE OF SOCIAL STUDIES

VIETNAM - NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACTS OF INSTITUTIONAL

FACTORS ON PROVINCIAL ECONOMIC PERFORMANCE: THE CASE OF VIETNAM

(2007-2011)

A thesissubmitted in partial fulfillment of the requirements for the degree of

Master of Arts in Development Economics

By

PHAN THACH TRUC

Academic supervisor

Dr TRUONG DANG THUY

Ho Chi Minh City, December, 2013

I declare that: "The impacts of institutional factors on provincial economic performance: The case of Vietnam (2007-2011)" is my own work; it has not been

submitted to 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 2013PHAN THACH TRUC

i

First and foremost I would like to extend my gratitude to my supervisor, Dr TruongDang Thuy, for invaluable comments, guidance and engagement through the learningprocess of the thesis I am much obliged to Dr Pham Khanh Nam for introducing me tothe topic as well as for the availability of the dataset In addition, I am thankful for LeDuc Anh for all your kind help during my time in class 17 Then I feel lucky to havetime doing the thesis with Nguyen Thi Ngoc Linh and Nguyen Quang, from whom Ihave a lot of things to learn Lastly and obviously, I am deeply indebted to my familymembers for all the kind understanding and spiritual support Forever, I will bewholeheartedly grateful for your love

Given the intensive PCI score race among Vietnamese provinces in the past year so as

to improve the enabling environment for local economic development, this study is tojustify the imperativeness of such a race Employing the PCI and its nine sub-indices asproxies for institutional quality, we explore the institutional impacts on GDP for thedataset of 58 Vietnamese provinces from 2007 to 2011 In realizing this objective, wemake an attempt to incorporate into the estimation models of both Cobb-Douglas and

Translog functional form the de facto overstatement of provincial GDP While the

positive impacts of PCI on provincial GDP are statistically confirmed, the regressionresults obtained for the nine sub-indices are divergent across functional forms andoutlier treatment approaches To the extent that the economic significance of differentinstitutional factors is assessed, our research objective is realized and respective policyimplications are then suggested

Key words: PCI, GDP overstatement, institution, Cobb-Douglas, Translog

iii

ACKNOWLEDGEMENT

ABSTRACT

TABLE OF CONTENTS

Chapter 1 INTRODUCTION

1.1Problem statement

1.2Research objective and research questions

1.3Contribution of the study

1.4Organization of the study

Chapter 2 LITERATURE REVIEW

2.1Theoretical literature: The New Institutional Economics

2.1.1 2.1.2 2.1.2.1 2.1.2.2 2.2Theoretical model: the aggregate production functions

2.2.1 2.2.2 2.3Empirical literature

Chapter 3 DATA AND RESEARCH METHODOLOGY

3.1Data and variable measurement

3.1.2

3.1.2.1

3.1.2.2

3.1.3

3.2

Research methodology

3.2.1 3.2.2 3.2.2.1 Data cleaning – OLS regression for panel data

3.2.2.2 Modeling the overstatement of growth data – The Stochastic Frontier Analysis (SFA)

3.2.3 Model validation

3.2.3.1 Testing the model overall significance

3.2.3.2 Statistical test of individual coefficient significance

3.2.4 Analytical framework

Chapter 4 EMPIRICAL RESULTS AND DISCUSSION

4.1 Overall explanation and hypothesis testing

4.1.1 4.1.2 4.1.2.1 Statistical test of model overall significance

4.1.2.2 Statistical test of individual significance of institution variables

4.2 Model estimation – Institutional impacts on GDP

4.2.1 Transaction cost institution: Entry cost, Time cost and Informal charges

4.2.2 Property right and Contract enforcement institution: Access to Land and Legal Institution

4.2.3 Information problem institution: Access to information, Private sector

development and Pro-activity of provincial leaders 56

4.2.4 Labor policy and training 62

4.2.5 The PCI 64

Chapter 5 CONCLUSION AND PERTAINING ISSUES 70

5.1 Conclusion 67

5.2 Policy implications 68

5.3 Limitations and further studies 69

REFEERENCES 70

APPENDIX 74

LIST OF TABLES

Table 3.1 Variable summary 28

Table 3.2 Summary statistics of key variables 29

Table 3.3 Between and within variations of key variables 30

Table 3.4 Overstatement of provincial growth data 35

Table 4.1 Attempted regressions of this study 44

Table 4.2 Hypothesis testing of overall significance of multiple regression 44

Table 4.3 Hypothesis testing of individual significance for institution variables 45

Table 4.4 Regression result– Transaction cost institution 48

Table 4.5 Regression result - Property right and Contract enforcement institution 54

Table 4.6 Regression result – Information problem institution 56

Table 4.7 Regression result – Labor policy and training 62

Table 4.8 Regression result –the PCI 64

vii

LIST OF FIGURES

Figure 3.1 Institution and economic outcomes: mechanism and channels of influence 27

Figure 3.2 Time-series plots of real GDP against year and PCI against year 31

Figure 3.3 Overall scatter plot of real GDP against PCI 32

Figure 3.4 Scatter plots for within and between variations of real GDP against PCI 32

Figure 3.5 Illustration of growth data overstatement 38

Figure 3.6 Different distributions of u 39

Figure 4.1 Effects of Time cost scores on GDP 51

Figures 4.2 Effects of Informal charge scores on GDP 52

Figure 4.3 Effects of Information access scores on GDP 59

Figure 4.4 Effects of Private sector development scores on GDP 60

Figure 4.5 Effects of Pro-activity of provincial leader scores on GDP 61

Figure 4.6 Effects of Labor policy and training scores on GDP 63

Figure 4.7 Effects of the PCI scores on GDP 65

Chapter 1 INTRODUCTION

There has recently been a resurgence of interests and discussions on the relationshipbetween institutional framework and economic performance among economists andpolicy-makers across countries The interest in investigating this issue has beenmotivated by the increasing consensus in considering institutions as a crucialdeterminant shaping economic performance From a methodological perspective, thestudy of this relationship has been initiated by the debut of the New InstitutionalEconomics, the origin of which could be traced back to Coase (1937) with the well-known message emphasizing the importance of institutions in the presence of hightransaction costs “When it costly to transacts, institution matters” According to Bates(1995), this strand of analysis contributes to explaining sources of economic growth byintegrating institutions, which are defined as the formal and informal “rules of thegames and their enforcement characteristics” (North, 1994, p.361) into economictheory The basic argument for the roles of institution in the growth literature is that inthe absence of efficient institutions, it is challenging for standard factors of production

to deliver rapid growth (Eicher, Garcia-Penalosa & Teksoz, 2006), especially intransition economies Theoretical and empirical literature on the issue suggests thatchannels of institutional influence on economic outcomes may be direct via affectingrelevant costs incurred or indirect via affecting the incentives for investment in factors

of production Despite a great number of studies in the empirical literature focusing onthe institutions – growth nexus, institutional analysis is still in its development stage(Brousseau & Glachant, 2008; Chang, 2006) and further research needs to be conducted

“before the institutional perspective can be fully operationalised” (Pelikan, 2003;Rodrik, Subramanian & Trebbi, 2004)

Being a transition economy experiencing recent institutional reforms, Vietnam offers anappropriate empirical context for addressing the above-mentioned issue A provinciallevel study for the country is of imperative concern for plenty of reasons Since the

1986 economic reform called “Doi moi”, Vietnam has witnessed a significant

growth of the non-state sector with its legal recognition in the early 1990s andremarkably, the promulgation and enactment of Enterprise Law in the year 2000.Despite this legal milestone, the sector still faces numerous constraints to itsestablishment and business operation, the majority of which is closely related to theimplementation of central policies by local governments, which varies substantiallyacross provinces Such institutional variations arise, for the most part, due to thecomplexity of law, which entails the issuance of quite a great number of sub-lawgazettes for enforcement purposes This, in turns, makes the implementation of lawsdepend a great deal on the interpretation of local officials, who can always apply theirown interpretation to central policies even when regulations are not vague (Nguyen,Pham, Bui & Dapice, 2004; Tenev, Carlier, Chaudry & Nguyen, 2003) Put differently,there exists a high level of discretion by Vietnam’s local authorities compared withother developing countries, which is a prominent feature of Vietnam’s institutionalreforms (Fforde & Vylder, 1996; Tran, Grafton & Kompass, 2009).

On the other hand, Vietnam’s provinces differ substantially in their achievement ofeconomic outcomes A preliminary analysis reveals, to some extent, high dispersion ofincome both in terms of growth and level across provinces for the 2007 – 2011 periods.Notably, the provincial GDP 5 - year average growth rate ranges from a striking low2.92% to an approximate ten-time greater figure of 29.52% Similar divergence isevident in provincial output levels as well In particular, Ba Ria- Vung Tau exhibitedhighest GDP of around VND122,000 billion and VND170,000 billion for the year 2007and 2008, respectively Likewise, Ho Chi Minh City maintained its reign as topperformer with impressive figures of VND131,000 billion, VND 151,000 billion andVND158,000 billion respectively in the 2009, 2010 and 2011 scores Standing at theother end were Bac Can for the year 2007-2009 and Lai Chau for the 2010-2011 periodwith GDP scores even below the VND3,000 billion level Against this background, acrucial question was posed on the contribution of institutions in explaining tremendousvariations in economic performance among Vietnam’s provinces

As the concept of institution means different things to different scholars and variesfrom studies to studies (Nelson & Sampat, 2001), inquiries firstly fall on how to

measure such a multi-dimension notion Compiled from survey-based responses ofrandomly selected private enterprises and hard data from published sources, which issubsequently aggregated into a provincial level score, the Provincial CompetitivenessIndex (PCI) is an annual composite index representing the voice of the local businesscommunity in ranking Vietnam’s provinces according to their governance quality.Specifically, nine aspects of governance are measured by nine corresponding sub-indices, namely Entry costs, Land access and security of tenure, Transparency andaccess to information, Time costs of regulatory compliance, Informal charges, Pro-activity of provincial leadership, Business Support Services, Labor and Training andLegal institutions Since its launch in 2005 by the collaboration of the VietnameseChamber of Commerce and Industry (VCCI) and the United States Agency for

International Development-funded Vietnam Competitiveness Initiative (USAID/VNCI),PCI has been considered as a critical tool for analyzing and monitoring progress in thelocal regulatory environment from the perspective of the private sector Importantly,using PCI ranking to measure progress in provincial institutional reform, Schmitz, Dau,Pham and McCulloch provide evidence for the essential role of Vietnam’s privatesector in driving the economic reform at provincial level, stating that “there was noformal public-private coalition but the dynamic was one of proactive governmentseeking the input from the private sector, and the latter lobbying for and contributing toresponsive and effective government” (Schmitz et al., 2012, p 3) On the other hand,facts and figures obtained from VCCI at the relevant website www.pcivietnam.org

reveal that there has been an intensive race to improve PCI scores among provinces inthe past years in an effort to create a better enabling environment for economicdevelopment This context raises the imperative question of whether higher PCI scoresreally result in better economic performance for provinces in Vietnam Employing PCIand its sub-indices as proxy variables for institution, this study investigates the impacts

of institutional implementation on economic performance of Vietnam’s provinces forthe 2007-2011 period

1.2 Research objective and research questions

This thesis aims to investigate the contribution of institutional factors to Vietnam’sprovincial economic performance through answering the following research question:

- How much of the variation in cross-provincial GDP of Vietnam could

be explained by institutional quality, both in a broad sense and as specificfactors of economic governance?

In an attempt to explain the economic differentials across Vietnam’s provinces, thethesis explores the contribution of institutional factors, particularly the PCI and its sub-indices, including Entry Costs, Time Costs and Regulatory Compliance, InformalCharges, Land Access and Tenure Security, Legal Institution, Transparency and Access

to Information, Labor Policy and Training, Business Support Services and Pro-activity

of Provincial Leadership

This study contributes to the existing literature in the following two ways First, sincethere have been few studies on the issue for the case of Vietnam so far, this thesis is anattempt to provide the first empirical evidence for the impact of institutional factors onthe country’s provincial economic outcomes Specifically, using PCI as the proxy forinstitution quality, a limited number of previous researches examine the issue forVietnam at firm-level in a particular year, that is they offer a cross-section analysis ofhow institutional implementation impact on firm’s productivity This study, on the otherhand, explores the issue at provincial-level over a five-year time span Second, in

realizing the above-mentioned objective, efforts are made to incorporate the de facto

overstatement of growth data into estimation models Treating such a sensitive dataset

in this way helps, to some extent, to deliver a more reliable regression results foranalysis

1.4 Organization of the study

The thesis is structured in the following way The second chapter reviews the theoreticalliterature underlying the institution – economic growth nexus along with the empiricaldimension of this relationship Chapter 3 describes the data, research methodology andempirical models for investigating the impacts of provincial institutional quality oneconomic performance Chapter 4 reports and analyses the regression results The lastchapter concludes the study with policy implications and discusses the limitations anddirections for further research

Chapter 2 LITERATURE REVIEW

This chapter is to review the theoretical and empirical literature on the central role ofinstitution quality on economic performance The chapter is divided into three sections.The first section reviews the prominent economic theory underlying the relationshipand discusses the theoretical models to be applied The second part reviews empiricalstudies on the issue The final section concludes the chapter with summary of empiricalevidence and conceptual framework

There has been a resurgence of interest in institution literature during the last fewdecades From a methodological viewpoint, the incorporation of institutionalperspective into economic analysis was initiated by a particular strand of analysis: theNew Institutional Economics (NIE) Crucially, NIE covers a wide range of institutionalissues with a growing proliferation of literature devoted to study the impacts ofinstitution quality on economic performance

Despite an early interest in the institution literature dated far back to the time of AdamSmith’s work, institutions did not regain its prominence in mainstream economics untilthe 1990s in response to the failures of neoclassical economics in interpreting economicgrowth and development issues (Nye, 2008) Specifically, experience of the ex-Sovietregimes in their transition period of worsening economic performance lends significantsupport to the essentiality of including “institutional factors in the corpus of mainstreameconomics” (North, 1994, p.367) In addition, given the technology diffusion andcapital mobility as the expected result of globalization, the widening gap of inter-country inequality in the late twenties has justified for the World Bank’sacknowledgement that “the main challenge for development policy at the turn of the

twenty-first century was the supply of effective market supporting institutions, and thecreation of demand for such institutions” (World Bank, 2002, p.4)

NIE draws on the backbone analysis of Williamson (1985) and North (1990), with theirdefinitions of institutions as “governing structures” and “rules of the game”,respectively As such, NIE assumes that individuals have incomplete information andlimited rationality, which accounts for the arising of uncertainty and transaction costs(Menard & Shirley, 2008) In this light, humans create institutions, both in writtenforms (the formal institution) as well as norms of conduct and beliefs (the informalones) In addition, they develop organizational arrangements to support transactionsand cooperation in production and exchange According to Brousseau and Glachant(2008), substantial efforts have been made in studying how institutions interact withthese organizational arrangements as well as “how these arrangements act in turn tochange the rules of the game” (Menard & Shirley, 2008, p.12)

NIE differs from its former variant, the Old or Traditional Institutional Economics,whose name and core elements were owed to Hamilton (1919) in his article “Theinstitutional approach to economic theory”, in two significant ways Firstly, NIE is built

on the fundamental assumption of neo-classical assumption of scarcity and competition.Secondly, while the former being shortage of “a systematic theoretical foundations aswell as supportive empirical analysis” (Joskow, 2003, p.6), NIE is, according to Menardand Mary (2008), “built around a backbone of some fundamental and originalcontributions” and has so far been characterized by extensive empirical studies

Remarkably, NIE is not an integrated theory; but a “combination of bricks coming fromdifferent traditions” (Brousseau & Glachant, 2008, p.2) Being the outcome of anevolutionary process, NIE is open to academic contributions of scholars from a widerange of social and scientific backgrounds This high level of openness, to a certainextent, helps to explain for NIE’s evolutionary perspective as well as the heterogeneity

of academic contributions in NIE

Overall, in exploring the contribution of institutional factors to variations in economicperformance, NIE does not reject the basic progress and analytical tools that has been

developed in the neoclassical tradition (Joskow, 2003); rather it acknowledges thelatter’s strengths and drawbacks as well as employs existing tools in its own way toaddress a broader set of relevant issues.

According to Smith (1976), institutional factors can explain not only the cross-countryeconomic differences in growth rates, but also regional disparities within a country.Institutions being “the underlying determinants of the long-run performance ofeconomies” (North, 1990), a significant body of institution literature has recently beenrevolving around the inquiry: “How do institutions matter?”

2.1.2.1 Theoretical approaches

From a theoretical perspective, the research of institutional issues proposed within NIEfalls into three broad categories of theoretical approaches, namely The HistoricalPerspective Approach, The Comparative Institutional Analysis and the ImperfectInformation Theory

Pioneered by North (1990), “The Historical Perspective Approach” analyzesinstitutions from a historical perspective As institutions are historically specific, it is ofvital importance that historical context be taken into consideration when coping withinstitutional change (Alston, 1996) In an attempt to accomplish this purpose, North(1990), in his seminal book “Institutions, Institutional Change and EconomicPerformance” combines a theory of Human behavior with a theory of Transaction cost.The main message delivered is that institutions matter for economic performance byeliminating uncertainty and transaction costs incurred in social transaction, therebyenhancing economic growth

The second strand of theoretical framework, The “Comparative Institutional Analysis”,owes its most systematic elaboration to Aoki (2001) Attempting to include bothEvolutionary and Repeated game theory into analysis, Aoki’s definition of institutionreflects the presence of these two sub-strand of approaches, whereby institution isconsidered as “self-sustaining system of shared beliefs” (Aoki, 2001) that may change

the incentive structures of games, thus influencing the strategic choices of andinteraction between agents.

Another influential strand of NIE is the one associated with the “Imperfect InformationTheory”, according to which, institutions are explained “in terms of strategic behaviorsunder asymmetric information among the different parties involved” (Bardhan, 2000).This analytical framework emphasizes that information and enforcement costs drivesome markets to be non-existent and others uncompetitive Against this background,institutions may be relied on as a response to missing markets or may help to eliminateinformation problems in other ones (Hoff, Braverman, Stiglitz, & Arnott 1993)

In brief, the basic difference among these three approaches lies in their analytical tools

to conduct investigation While there is an attempt to integrate economic theory andeconomic history in the Historical Perspective approach, the second one ofComparative Institutional approach makes good use of game theory in addition tohistorical information Finally, the Imperfect information framework is the mostmathematically-oriented out of the three lines of study (Nabli & Nugent, 1989)

2.1.2.2 Mechanism and channels of influence

The above-mentioned theoretical approaches lay fundamental analytical frameworksfor analyzing the “institutions matter” issue, specifically the institutional mechanismand channels of influence on economic performance

Among the institutions that are significant determinants of economic performance arethose involving property rights and contract enforcement According to Coase (1937),one way in which institutions can help resolving the problems of prisoners’ dilemma aswell as overcome the failures of their collective action is to provide for a well-definedproperty right Being norms and rules that confer the control of the returns to investedassets and/or produced values as well as stipulate the procedures for exchange ofexecutive, institutions provide the essential level of internal security and trust Byeliminating the potential risks of expropriation, institutions affect the economic agents’decisions and extent of saving and investing in physical and human capital Put another

way, the lower the risk of expropriation and the higher the level of security, the higher

is the level of investment and growth, all other factors remain unchanged

Moreover, institutions that provide for secure property rights lend great support to theprocess of patent registration, ideas dissemination, to list some, across creativeindividuals; all factors that stimulate research and development activities In this sense,good institutions contribute to boosting an economy’s rate of innovation (Tebaldi &Elmslie, 2008), thereby promoting economic growth

With reference to contract enforcement, institutions stipulate rules and regulations thatcan prevent or mitigate market failures and agency problems Measured by the extent ofregulatory burden, tax evasion, corruption and the like, institutions affect economicperformance by enhancing the efficiency of public policy and by mitigating the risk ofanti-competitive behaviors and rent-seeking by corporate actors Only with the rightinstitution in place that the collective action problem is resolved and the scope for rent-seeking is minimized

In the same line of study on collective action problems, Olson (1982) argues that facingthese problem prevent large groups of “self-interested economic agents” fromcooperation Subsequently, Axelrod (1997), in his comprehensive analysis of co-operation, raises the importance of internalized norms that encourage cooperativebehavior within such groups In the context that cooperation is essential for individuals

to capture trade gains in societies, the evolution of institutions helps facilitate a morefavorable environment for cooperative solutions, thereby stimulating economic growth

Besides, institutions that set ground for a well-functioning human capital market affectthe rate of returns to education, which, in turn, affects the productivity and allocation oflabor In this sense, institutions stimulate human capital accumulation According toWolf (1955), the “right institutions” are conducive to the formation of productivecapital as well as the adoption of new technology across regions and nations

In general, in terms of property rights and contract enforcement, institutions create anincentive structure that leads to the reallocation of efforts to engage in productive legalmarket activities Put differently, it facilitates the conduct of appropriate and

constructive property transactions as well as other contracting of mutual interestsamong economic agents; thereby promotes economic outcomes.

Another predominant source of institutional factors contributing to economic growth isthose closely related to transaction costs According to North (1990), this point justifiesfor the existence of institutions” In the sense that institutions, in combination withother factors of production, determine the structure of exchange that influencesproduction and distribution costs, they affect the feasibility and profitability ofeconomic activities It is through this mechanism that institutions are considered the

“underlying determinant of long-run economic performance”, according to North(1990)

In addition, transaction costs being on the path upward together with the increasinglevel of development (Wallis and North, 1986), institutions emerge as a significantfactor that offer a two-fold contribution to economic growth: one is efficiency gainedimplied by a lower measurement of costs per transaction and the other is a growingnumber of activities of mutual economic interest signaled by a higher volume oftransactions Institutions are, therefore, conducive to better economic performance inthe long run

The relevance of the underlying institution economic theory of information problems tothat of transaction costs lies in the fact that the former represents a significant source ofthe latter (Stiglitz, 1985) In this line of study, institutions are considered to be “well-understood rules of the game” that bring about a certain degree of predictability toindividual or corporate behaviors With the right institutions in place, uncertainty isreduced and contracting activities of mutual interests between economic agents will beencouraged to a certain extent, which results in better economic performance

The mechanisms of how institutions contribute to economic performance illustrated byprevious paragraphs reveal relevant channels of influence First, institutional factorsmay enter a growth regression in a linearly additive term As such, they may display adirect, linear effect on growth, which is the direct channel of influence Second, ininteracting with standard factors of production, institutions may have indirect effects ongrowth by altering the marginal effects of these production factors, which is the

interactive effect Another possibility that institutions indirectly matter to economicperformance is by affecting the relationship between economic growth and itsdeterminants through the latter’s parameter heterogeneity, which is the threshold effect(Minier, 2007) The basic argument for such an effect is that how growth fundamentalsdetermine a country’s growth may, to a certain extent, depend on relevant institutionsbeing adequately strong In other words, there exist some possible threshold levels ofinstitutional quality that must be reached before say, physical and human capital as well

as technological advances could exert their influences on growth There are theoreticalreasons to expect such indirect effects According to Wolf (1955), “growth-promotinginstitutions” stimulate, rather than impede the formation of physical and human capital

as well as allow for the adoption of technological advances; and thereby promoteeconomic growth In a nutshell, the literature review on the contribution of institutions

to economic performance from the perspective of NIE shows that institutionaleconomists have “won the war” in the sense that much insight has been increasinglyprovided on the proposition that “institutions matter for growth” (Joskow,2003).Despite substantial endeavors as well as progress having been made in the field overthe last three decades, pertaining inquiries about the institution-growth nexus, forinstance the potential endogeneity of institutional variables, the causality of therelationship, to name some, are still open for further research And the hard work is stillahead

In modeling institutional effects, a large number of empirical works on growth make use of the production function Section 2.2 provides a brief introduction tothe development of the production function The section also discusses the properties ofthe production function that are relevant for the application of institutions-growthanalysis

2.2.1 History of the production functions

There is widespread consensus among scholars in considering production function as acritical tool of analysis in the neoclassical economics According to Schumpeter (1954),the history of the production function dates back to the year 1767 when Turgot, in his

work of Observations on a Paper by Saint-Peravy, discusses how the variations in the

proportion of standard factors of production account for marginal productivities,

whereby the production function was implicitly formulated Later on, Philip Wicksteed

(1894) was generally believed to be the first economist to algebraically formulate the

input-output relationship as

provides some evidences for the fact that the first formulation of production function

was owed to Johann von Then in the 1840’s

During the 1950’s-1970’s period, production function attracted the attention and

discussion of a large number of economists, which results in various propositions and

analysis of the specifications for input-output relationship as well as their

corresponding conclusions (Mishra, n.d) In particular, Stigler (1952) noted that the

logarithmic production function was introduced by Malthus while (Humphrey, 1997)

demonstrated how the Cobb-Douglas function was firstly presented in “disguised form”

by Von Then in The Isolated State, vol – II In this line of investigation, it is noted by

Velupillai (1973) that Wicksell in his work dated 1900-1901 formulated his production

function identical to that of Cobb-Douglas Specifically, in Wicksell’s 1923 review of

Gustaf Akerman’s doctoral dissertation, his production function was formulated as

, with    

P ALC

was evidenced to be jointly formulated by Jevons, Menger and Leon Walras Overall,

certain academic achievements associated with individual scholars are not the sole

accomplishment of such individual; rather they are the “culmination of the research

efforts of an entire epoch” (Russel, 1984)

Arrow, Chenery, Minhas, & Solow (1961) formulated the Constant Elasticity of

Substitution (CES) production function allowing for the elasticity of substitution

between capital and labor to be valued between zero and infinity, which stays fixed

along and across the isoquant regardless the size of output or inputs used in the

production process In this sense, the Cobb - Douglas, the Leontief and the linear

production functions are only its special cases In the classical form, these production

functions assume that the technological progress is Hicks-neutral (Hicks, 1932),

whereby the marginal rate of substitution between any two factors of production is

independent of technical progress or level of output Generalization of the CES

production function was initialized by Brown and Cani (1963) to allow for constant returns to scale Fundamental contributions were made by Uzawa (1962) andKazuo Sato (1967) concerning the incorporation of more than two factors ofproduction Likewise, Nervole (1963) generalized the Cobb-Douglas productionfunction with variable returns to scale, which was further studied by Ringstad (1967).Diewert (1971) proposed a functional form for the production process that permitsvariable elasticities of substitution Generalization of the Cobb-Douglas and CESproduction functions in their classical form was almost complete by mid 1970’s.

non-The prominently restless area of research in the economics of production is theempirical estimate of the aggregate production function, an essential tool of analysis inmacroeconomics According to Felipe and Fisher (2003), there are two strands ofliteratures questioning the notion of an aggregate production function: the so-calledCambridge (UK)- Cambridge (USA) capital controversy and the aggregation literature.The former raises questions concerning the unit of measurement for capital goods as afactor of production in the aggregate production function while the latter explores theconditions for neoclassical micro production functions to be aggregated into aneoclassical aggregate one As there are considerable mismatches betweencharacteristics possessed by firms and that of industries, or moving upwards, theeconomy as a whole, when attempts were made in identifying the recipe for theproduction functions at macroeconomic levels, they have to be handled with significantcaution

As advocates of the aggregate production functions, Knut Wicksell (1923) justified theapplication of aggregate linearly homogeneous functions by making substantialcontributions to conclude that non-homogeneous production functions for firms areperfectly compatible with a linear homogeneous function for the entire industry(Humphrey, 1997) This line of investigation progressed rapidly with activity analysis

of Koopmans (1979), aggregate linear production function of Georgescu-Roegen(1951), separation theorems and generalization of Von Neumann’s model (1937) as well

as well-grounded proofs provided by Nikaido (1968), all of which strengthened thefoundation of using the aggregate production function in economic analysis

According to Felipe and Adams (2005), the Cobb-Douglas production function is stilltoday “the most ubiquitous form in theoretical and empirical analyses of growth andproductivity” Its origin officially dates back to the seminal work of Cobb and Douglas

in 1928, whereby an aggregate production function was, for the first time,econometrically estimated with the employment of 1899-1922 data for the UnitedStates manufacturing sector and the results were accordingly presented to thecontemporary economists (Cobb & Douglas, 1928)

2.2.2 Properties of the production function

The production function reflects the physical relationship between inputs and outputs,which can be mathematically defined as

The production function has the following properties

Firstly, there is no “free-lunch”, that is

monotonic As is well-known with respect to a (single output) production function,monotonicity requires positive marginal products with respect to all inputs, that is

2.3 Empirical literature

The last decade has witnessed a vast majority of empirical studies employing theproduction function of some forms to address the institution-growth issue acrosscountries In particular, the production function is mostly applied under the so-called

“extended production function” specification that “combines institutional proxies withtraditional growth factors” (Glaeser, La Porta, Lopez-de-Silanes & Shleifer, 2004).There is also a wide range of other “extended production function” specification inwhich other growth determinants say, trade openness, geography, macroeconomicpolicy, to list some, are further included as explanatory variables in modeling theinstitutional effects on economic performance (Jacob & Osang, 2007) In addition toindependent variables, other source of heterogeneities among model specificationsarises from the choice of dependent ones, which may be grouped into two broadcategories: output-level related variables and output-growth related ones According toEicher and Leukert (2006), empirical evidences of output levels show more robusteffects than those of output growth In the same line of investigation, main findingsreport that the choice of institutional proxies as well as the (non)treatment of itspotential endogeneity is also a primary source of heterogeneity Particularly,institutional factors have been proxied mainly by standardized aggregated indicesand/or survey-based indicators constructed at national level According to Aidis, Estrinand Mickiewicz (2009) and Shirley (2008), the multi-dimensionality together with thedisparity among institutional proxies, to a certain extent, poses skepticism on thevalidity of an ideal variable highly representative of the concept of institution Ingeneral, empirical institutional research is characterized by such substantialheterogeneities that it would be challenging to infer a representative empirical impactmagnitude for the whole literature (Efendic, Pugh & Adnett, 2011)

Dias and Tebaldi (2012) address the importance of interactions between institutions andhuman capital accumulation for economic growth process The paper employs panelOLS and GMM dynamic panel estimation technique for the sample of 61 countries overthe 1965- 2005 interval Regarding institution variables, democracy and autocracy areused as proxies for political institution while share of educated labor in the economyrepresents structural institution These institutional variables enter the formal growthmodel together with the human capital variable generated based on Hall and

Jones’(1999) piecewise function and the capital stock calculated following PerpetualInventory Method proposed by Easterly and Levine (2001) Empirical estimates lendsupport to the proposition that structural institutions are conducive to productivity andlong-term economic performance.

Siddiqui and Ahmed (2013) investigate how institutional factors shape economicperformance in 84 countries from 2002 to 2006 In order to capture the multi-dimensionality of institution, the aggregate index of Institutionalized SocialTechnologies (IIST) is used together with its sub-indices of Institutional and PolicyRents, Political Rent and Risk Reducing Technologies Other than institution, humancapital, savings and trade openness variables are used to specify a formal extendedgrowth model with the application of OLS and GMM methods Notably, interactivevariables are introduced into the model to measure the possible complementaritiesamong institutional variables Estimation results suggest a high degree of positivecomplementarities between institutions that protect property rights and politicalinstitution The authors conclude that institutions positively affect economic outcomes

Atul and Sal (2012) employs Solow’s growth accounting model with World Bankregulation indicators as proxy variable for institutional quality to study the impacts ofregulation framework on economic performance Fixed and random effects estimation

is applied to the data of 23 OECD countries over the 2002-2008 period Findingsconfirm that regulation quality has a positive effect on growth through its impact ontotal factor productivity

The paper by Gagliardi (2008) reviews the major theoretical and empirical literatureexploring the channels of influence of institutional framework on economicperformance Theoretical approaches within the New Institutional Economics areproposed, comprising of the historical perspective approach, the institutionalcomparative approach and the imperfect information theory Within the institutionalapproach, the concept of institutional complementarities is elaborated and has importantimplication from the policy perspective Despite difficulties in institutionalmeasurements, empirical evidences lend support to the proposition that a country’sinstitutional framework is critically conducive to its economic development

Using state-level cross-sectional data of the U.S and OLS regression, Sobel (2008)examines the relationship between institutional quality and entrepreneurial productivity,with the latter proxied by economic freedom index and net entrepreneurial productivityindex In addition to institutional variables, the paper includes variables of geographicand demographic controls such as median age of state population, population density,and percentage of male population along with the percentage of the population with acollege degree. The paper provides the first empirical evidence supporting Baumol’stheory that good institutions help to channel entrepreneurial efforts toward productiveentrepreneurship further concludes that entrepreneurship productivity helps to explaindifferences in economic performance across states.

Hasan, Wachtel, and Zhou (2007) review the link between China’s institutionaldevelopment and economic growth with emphasis on the three facets: financialdeepening, development of legal institutions and the degree of political pluralism Size

of private sector, Rule of law and Awareness of property rights are used as proxyvariables, which are measured by ratio of private sector total fixed investment to overallfixed investment, number of lawyers per 10,000 people and ratio of number ofdomestic trademark applications to number of firms, respectively The modelspecification based on Barro (1991)’s growth equation is applied to the annual dataset

of 31 provinces for 1986-2002 period with the employment of OLS, annual systemGMM and three-year average system GMM estimation method Conclusion confirmsthat institutional development contributes to explain for provincial economic growthdifferentials

Jalilian, Kirkpatrick and Parker (2007) investigate the role of regulatory framework oneconomic growth in developing countries Data set covers 117 countries for the 1980 –

1999 interval and 96 countries for the 1980 – 2000 period corresponding to twomethods of estimation: the cross-section and panel regression, respectively.Represented by the two indicators of Regulatory quality and government effectiveness,the impact of regulation on GDP per capita growth is estimated after controlling forinitial GDP per capita, gross capital formation, schooling, trade, inflation andgovernment expenditure Findings are supportive for the theoretical literature that thereexists a strong association between regulatory framework and economic growth

Using Vietnam’s firm-level data in 2005 and the Provincial Competitiveness Index 2006 asproxy variable for local governance practice, Tran, Grafton and Kompas (2009) analyzeVietnam’s institutional reforms in 2000 and their impacts on economic performance of thenon-state sector Other than institution variable, the model is specified with the inclusion ofcontrol variables that accounts for provincial initial endowments affecting firm’sperformance, such as human capital and market size In addition, dummy variables are alsointroduced into the estimated model to control for firm’s specific characteristics, includingfirm’s size, age, capital intensity and ownership type Findings confirm that improvedinstitutional quality concerning market information, securing land tenure and labor training

promotes firms’ labor productivity

There are some studies that do not support the proposition that institution causesgrowth Glaeser et al (2004) revisits the proposition that institutions cause growthusing cross country data from 1960 to 2000 Their results do not support theproposition They also find that the literature analyzing the relationship betweeninstitutions and growth is prone to the poor measurement of institutional variables andirrelevant instrumental variables for institutions

Unlike most of empirical studies on the subject assuming parameter- invariant, JennyMinier (2007) uses panel data of 70 countries (1960-2000) to analyze the indirecteffects of institutions on economic growth through parameter heterogeneity Other thanexecutive constraint, which is the proxy variable for institution, control variables ofgrowth fundamentals in the estimation model comprise of physical capitalaccumulation, education, geography and initial income Applying endogenous samplesplitting technique proposed by Hansen (2000), the author attempts to measure thevaried parameters of growth determinants in recognition of such a threshold Findingsreport that there is little evidence supportive for the threshold effect of institution onfactors of production through parameter heterogenity; rather institutions influence themarginal effect of policy variables on growth

Chapter 3 DATA AND RESEARCH METHODOLOGY

This chapter is to present the data and research methodology applied in modeling institutionaleffects on economic outcomes.

The chapter is divided into two broad sections The firstsection displays data analysis along with variable measurement and generation The secondsection of research methodology discusses model specifications, estimation methods andconcludes the chapter with analytical framework as summary of estimation strategyemployed in the study

In this study, we use secondary data from published sources, which vary across employedvariables In particular, investment and GDP data are obtained from the Provincial StatisticsYear Book of two sets: 2005 - 2009 and 2010 – 2011 Data for Labor force variable derivefrom the national General Statistics Office (GSO) at www.gso.gov.vn Regarding PCI and itssub-indices, data scores are obtained via the PCI Annual Reports from 2007 to 2011 and theircorresponding website

The PCI is the result of an intensive and ongoing cooperation between the Vietnam Chamber

of Commerce and Industry (VCCI) and the United States Agency International Development/Vietnam Competitiveness Initiatives (USAID/VNCI) managed by Development Alternatives,Inc (DAI) Notably, the creation of the PCI includes three steps: (1) collection of survey-based data and “hard” data; (2) construction of sub-indices and finally, (3) calibration of sub-indices to ensure that their relative weights reflect their contribution to the private sectordevelopment This means the PCI is generated from two general types of data: the perceptionindicators drawn from mail-out surveys and the hard indicators (“hard” data) deriving frompublished sources While perception data may deliver the specific information of interest,they are often prone to perception biases Comprising of more objective built-in indicators,

hard data, on the other hand, often limit researchers to a particular set of information.Combining perception or “soft” data with hard data, the PCI research team strives to seek for

an optimum approach that could minimize the drawbacks as well as maximize the advantages

of both data sources (PCI Annual Report 2007)

Regarding the collection and processing of “soft” data, stratified sampling method is applied

at provincial level in terms of business age, sector and legal form to ensure that the sample isrepresentative of the local business community with a sampling error of 3% Besides, thesample size ranges from approximately 7,000 to 10,000 private domestic firms as there areconsiderable fluctuations in rate of response over years Remarkably, the mail-out surveyrespondent component has been expanded to include more than 1,000 foreign invested firms

into the sample since 2010 Finally, the survey questions, which are separately designed for

domestic and foreign-invested firms, undergo a certain number of alterations andsupplementations over years in order to capture major updates in the provincial business andregulatory environment

It is worth noticing that alterations were implemented to PCI methodology in 2009.Complying with the principle set up from the outset that construction measures could be

“tweaked at the margins” (PCI Annual Report, 2009) while fundamental revisions should beconsidered with great caution so as to ensure the over-time comparisons of PCI, the 2009methodological changes fall into the following three categories First, against the background

of massive equitization of local state-owned enterprises (LSOES) around that time, the SOEbias sub-index was dropped Second, there were minor changes in indicators within each sub-index Finally, a new approach was adopted in calculating sub-index weights so as toeliminate the possibility that weightings were driven by accidental correlations (PCI AnnualReport,2009) In this light, appropriate actions will be taken in the subsequent sections of dataanalysis and estimation model building so as to capture any significant changes in theinstitutional impacts on provincial economic performance due to such methodologicalalterations

The Data for this study is annual data covering Vietnam’s 58 provinces for the 2007-2011interval Data for PCI index is available from 2005 to 2011, but the year 2005 and 2006 areremoved from the sample because provincial statistics of these two years does not displaysufficient figures for the majority of selected variables of this study, such as provincial GDP

and investment In addition, 6 provinces including Ha Tay, Cao Bang, Hung Yen, Thanh Hoa,Long An and Ninh Binh are dropped due to insufficient data for the variables of interest.

3.1.2.1 Response variable

RGDP stands for Real Gross Domestic Product Being a general indicator of economic

outcomes that reflects the final results of production and business activities of the province in

a year, this variable is calculated in constant price by deflating corresponding nominal values(GDP calculated in current price) with provincial annual CPIs, with 2005 as the base year.RGDP is measured in VND million

As annual provincial CPIs are not available for 5 out of 58 provinces, including Dac Nong,Hau Giang, Hoa Binh, Lang Son, Phu Yen, corresponding national CPIs are used assubstitution in calculating real GDP and investment for these provinces

3.1.2.2 Explanatory variables

LABFO stands for labor force, by which name it denotes the work force aged from 15 and

upwards who actively participate in the province’s business and production activities Thisvariable’s measurement unit is thousands of people

CAP denotes capital input variable Applying the Unified approach of the Perpetual Inventory

Method (PIM) proposed by Berlemann and Wesselhöft (2012), we generate the capital inputvariable with the employment of provincial nominal investment values According to GSO’sdefinition, investment is a measurement of expenses to increase and maintain material assets

in a given period, usually a year Investment can be calculated through investment projectsand national programs aimed to increase fixed and liquid assets In this study, real values ofinvestment are obtained by deflating nominal values using provincial annual CPIs, with 2005

as the base year

The net capital stock at the beginning of period t, let say K t , could be mathematicallyexpressed as

D t1 is the consumption of fixed capital of the previous period

I t is gross investment in the current period

For the sake of simplicity, depreciation is assumed to be at a constant rate δ of 5% and then

the capital stock could be rewritten as

Repeatedly substituting this equation for the capital stock at the beginning of period

K t1 yields

K t

In calculating the initial value of

employ the steady-state approach of Harberger (1978) Under the somehow unrealistic

assumption that our economy is at its steady-state, GDP growth rate is calculated as:

, we use average GDP growth rate

with the

22

Concerning the initial value of investment I t 1 , we apply the alternative procedure suggested

by Nehru and Dhareshwar (1993) in their later application of the Steady State Approach.According to this procedure, the time-series of log investments is regressed on time usingOLS

The advantage of this procedure as opposed to the traditional stead-state approach is that theinitial value of the investment time series can be generated without the sole reliance on theinvestment figure of any single year, thereby a more reliable initial value could be obtained

For all the institution variables, relevant information is obtained via PCI Annual Report from

2007 to 2011

PCI: a 100-point scaled composite index measuring and ranking Vietnam’s provinces based

on their overall economic governance quality It is created through the “Three Cs” procedure,namely Collection, Construction and Calibration In the first step of collection, survey dataare adjusted with hard data from published sources to correct for possible perception bias Atthe end of this step, indicators are available to be standardized into the ten-point scale sub-index construction in step 2 In the last step, sub-indices are calibrated into three weightclasses of high, medium and low 15%-20%, 10% and 5%, respectively, such a way that therelative weight of each sub-index demonstrates its contribution to the sector’s growth,investment and profitability For instance, PCI report 2009 reveals that Transparency &

access to information sub-index together with Labor policy sub-index receives the highestweight of 20 percent as they are both considered crucial to the business outcomes of thesector Meanwhile, the three sub-indices of Land access, Legal institution and Private sectordevelopment receive the lowest weight of only 5 percent since there are few variations acrossprovinces in their scores, making them not strongly correlated to the private sectordevelopment outcomes across the sample entities Correspondingly, medium weight class of10% and 15% are assigned for sub-indices with average correlation across the three above-mentioned outcome variables Time cost of regulatory compliance sub – index stands outfrom this group with 15% weight, leaving 10% weight for the remaining sub-indices.

For PCI as well as all of its sub-indices, a higher score represents a better governance quality.For example, a higher value of labor policy sub-index indicates better evaluation ofenterprises on labor policies of the province, and a higher value of informal charge sub-indexindicates lower (better) unofficial fees required to “grease” business operations It is well -noted that major changes in PCI methodology has been implemented since the fifth iterationPCI 2009, consisting of changes in the number of sub-indices, changes within sub-indices andchanges in sub-index weights in order to capture the dynamism of the provincial economicenvironment In particular, the index of State-owned enterprise (SOE) bias, which measuresthe biased perception of provincial authorities towards SOEs was dropped The key reasonwas that the local SOEs were equitized on a large scale As a result, the obstacle to privatesector development previously posed by the so-called SOE bias no longer prominentlyexisted

The below section offers an initial analysis of the nine sub-indices based on PCI report 2009for the mere purpose of illustration Similar to PCI, each composite sub-index is constructedfrom a whole range of indicators, the scores of which are standardized from a combination ofhard data and perception ones derived from survey responses

ENCOST stands for Entry costs, a measurement of costs in terms of money and time spent

on problematic procedures required for starting business Indicators included are Length of

business registration in days, Number of licenses and permits necessary to start operation,Wait for land use right certificate, Percentage of firms waiting for more than one month tocomplete all steps necessary to start operation, Percentage of firms waiting for more thanthree month to complete all steps necessary to start operation, Percentage of firms having

difficulties obtaining all licenses and permits necessary to do business The final sub-indexcovers both original indicators of the 2005 survey and new indicators firstly used in the 2006survey, which are equally weighted 50 percent each.

TIMECO stands for Time costs of regulatory compliance, a measure of time firms have to

spend on bureaucratic compliance This sub-index, therefore, reflects the costliness ofbusiness-related administrative procedures and paperwork It is worth noticing that inbuilding this sub-index, new indicators have been supplemented, reflecting improvement inlocal bureaucratic compliance, such as cuts in formal administrative fees as well as waitingtime for administrative procedures

INFOCHARGE stands for Informal charges, indicating extra fees and other unofficial

payments firms have to pay so as to facilitate their business operations

LANDACC represents Land access and Security of tenure, that is firm’s accessibility to land

as well as tenure security upon land acquirement This two-dimension sub-index measuresthe costs to obtain business premises and the risk of property expropriation, respectively.Each dimension accounts for 50% of the sub-index

LEINSTI represents Legal Institution, reflecting firms’ confidence in and reliance on

provincial legal institutions in settling business-related disputes, the actual costliness ofjudicial proceeding as well as firm’s actual use of local courts

INFOACC is a variable of Transparency and Access to information, measuring firms’

accessibility to legal documents as well as the availability of information essential to run abusiness This four-dimension sub-index covering Access to legal and planning documents,Equity and consistency, Participation of private enterprises in policy negotiation andOpenness of web page The first three dimensions are computed from survey data andaccount for 60% of the final sub-index The fourth dimension with 40% weight reflects thebusiness utility of provincial web page

PRIDEVELOP is coded for Business support services, a measurement of the availability of

business support services in the province This index is compiled of three equally weighteddimensions, including Use of business support services, Private business support and Quality

These dimensions cover access to business-related services, participation of private providersand the repeated usage of these services by private enterprises, respectively.

PROACT is a variable of Pro-activity of provincial leadership, measuring the dynamism and

initiatives of provincial officials in working with regulatory framework in order to supportprivate sector development

LABPOL stands for Labor and training, a measure of provincial officials’ efforts and

assistance in enhancing vocational training and local labor placement This sub-index is ameasure of provincial government’s efforts to enhance vocational training for localenterprises It is compiled of three equally weighted indicators, namely labor recruitment,labor training facilities and labor quality

P r o p e r t y

r i g h t / c o n t r a c t

e n f o

Sub-index No 9

Economicoutcomes

Channel #1:Channel #2:

Figure 3.1 Institution and economic outcomes: mechanism and channels of influence

27

It is worth-noticing that as all sub-indices are constituted into the final composite index PCI,

they are all scaled and scored in such a consistent way that any scoring incremental implies a

corresponding improvement in institutional quality Consequently, all sub-indices bear a

positive expected signs when entering the model estimation For more insights into these

sub-indices, how they are constructed from numerous indicators as well as their alterations over

years, see PCI annual reports from 2007 to 2011 which are available on the website:

provincial economic activities.